naked capitalism

Churchill’s famous dictum, “Democracy is the worst form of government, except for all those other forms that have been tried from time to time,” could also be applied to mark-to-market accounting. However, like democracy, mark-to-market may be on its last legs. The stock market rally of late last week was fueled by the rumor that Timothy Geithner’s “save the bank” program, now due to be presented on Tuesday, will include a relaxation of accounting rules.

The bad feature of mark-to-market accounting, as it opponents are letting anyone who will listen know, is that it is pro-cyclical. In good times, asset values rise, which creates accounting gains for banks and financial firms that in turn boost their equity capital. Now in this competitive world, no self-respecting firm (at least of the American persuasion) wants to have idle capital, so they go out, willy nilly, to borrow and invest more.

Funny how no one had a problem with that feature in the good times. But in the bad times, the process goes into reverse: shrinking asset values are a direct hit to equity capital, which necessitates further balance shrinkage to get equity ratios back in line.

So if this is such a terrible system, why was it implemented in the first place? Because other approaches gave bankers considerable latitude in how they valued assets, which they can and frequently did abuse. And the funny bit is that the generous valuations would typically come a cropper in bad times.

Now various pundits have come up with ways to combat procyclicality (for instance, having countercyclical capital requirements; some of these proposals have been worked out in some detail).

However, the financial sector has been crying for relief now, arguing that mark to market is painting an unflattering picture. I’m not sure I buy that at all. Given that the Treasury is still considering a “bad bank” plan, that suggests that there are plenty of assets on bank balance sheets at fictive values (otherwise, if they were at true market prices now, they’d be able to sell them and move on, and the damage would already be reflected in their equity). William Black, a former FDIC examiner, says the the accounting fraud in banks is at Enron levels.

Moreover, the idea that this move will make matters better is delusional. The reason banks are unable to sell equity now is that investors do not trust their financial statements. They can’t tell a good bank from the “impaired but might make it” and “radioactive” varieties, so they shun them all. Further obfuscating the accounts puts them all behind a veil. It makes it even harder to sort out quality, and will lessen rather than increase trust.

Lloyd Blankfein, in a Financial Times comment, concurs:

Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.

Tyler Durden does a good job of recapping the current rules and discusses the expected fix:

The table below, courtesy of UBS, summarizes some of the key concepts incorporated in FAS 115, but the gist of the rule is that losses or impairments are handled differently depending on the categorization of the asset: trading, available-for-sale or held-to-maturity. This rule will likely gain more visibility in the coming months, as it provides a tidy loophole for commercial banks (which post September 15 includes virtually all major financial institutions), which make heavy use of the available-for-sale security categorization. Securities classified as available-for-sale or held-to-maturity can be categorized at temporarily impaired when Fair Values fall below amortized cost: this is relevant since impairments defined as temporary are reported as a component of Accumulated Other Comprehensive Income (AOCI) and have no effect on income or regulatory capital. The issue arises when an impairment is defined as other than temporary, or written down from a previous temporary status, as the securities then must be written down to fair value, which impairs earnings and regulatory capital. The fair value also becomes the new cost basis and may not be written up for subsequent recoveries in Fair Value, but rather hit AOCI, thus not having a favorable impact on regulatory capital in an improving economic environment! As a side note, unlike commercial banks, broker dealers can not use the temporary impairment loophole as all their assets are categorized as trading, and thus all gains and losses are transparent and immediately have an impact on the bottom line and capital.

An interesting point that UBS brings up is whether the upcoming wave of financial company earnings releases will show commercial banks with significant available-for-sale holdings recording temporary impairments. And if that is in fact the case, what is the nature of these assets and what is the likelihood these will eventually have to be written down over time if values do not recover. FAS 115 requires that disclosure of temporarily impaired securities be broken down into those impaired for less than 1 year and more than 1 year, together with a security description, and calculation of unrealized losses (FV – cost) for each type of security. It is expected that after 12 months of temporary impairments, commercial banks may be pressured to take write-down on many categories of temporary impairments.

It is not surprising that as we anniversary the events from Bear Stearns, which set off so many asset reclassifications in motion, there is a substantial push to do away with Mark-to-Market altogether. It is feasible that banks anticipate having to disclose significant temporary impairments on RMBS, CMBS and other wholesale impaired portfolios in this, and likely even more so, the next quarter, and have been lobbying the administration behind the scenes for much loosened accounting standards, while maintaining a public facade which extols the virtues of Mark-To-Market. As the earlier clip with Kanjorski indicates, the administration is terrified of a repeat bank run, so Wall Street has a carte blanche to “educate” Congress and Senate in any way that benefits its interests, it is a highly likely outcome that Mark-To-Market will be done away with entirely. Even though this event will incite another brief market rally as the ugly truth is hidden from investors, this time however with the government’s blessing (and the assumption that taxpayers will foot the bill for any Fair Value-to-Cost disparities), we believe that the ultimate outcome will be a destruction of value of unseen proportions. All MTM abolition will do is stop dead in its tracks the weak ongoing attempt at market transparency, and veil the entire market with a shroud of inability to calculate the true worth of any single asset. And of course, the ultimate beneficiary in the near-term will be Wall Street, while taxpayers will, as always, foot a staggering long-term cost. We hope we are wrong.