Murphy: Mark-to-Market Should Have Been Required for Monoline Insurers

In a recent Financial Times Alphaville article, risk management and regulatory capital expert David Murphy explains his position that monolines – insurers whose sole line of business is bond insurance – would not have played as big of a role in the financial crisis if they were required to mark credit risk to market.

Consequences of mark-to-market mostly vary around volatility issues, says Murphy. “You have to fund losses caused by credit spread volatility; you have to support the risk of credit spread volatility with some equity; and the risk of the position includes the risk of movements in the non-default component in the credit spread,” he says, noting that a non-mark-to-market holder would not have these issues.

But the unfunded risk – risk that is not marked to market – begat methods by the insurance industry to avoid the potential volatility, says Murphy.

Though many insurers before the crisis did mark risk to market, Murphy “believe[s] that the availability of the non-mark-to-market model in the early 2000s acted as kind of a ‘gateway drug,’ getting some insurers into credit risk taking.”

IASB Mulling Change in Fair Value Rule

The International Accounting Standards Board (IASB) is said to be modifying its rules on fair value accounting, according to IASB board member Stephen Cooper’s remarks at a recent accounting conference.

The IASB rule was put in place after political pressure during the financial crisis prompted hasty action at the international accounting rules-setting body. A move to tweak the rule has been expected since differences in opinion on the topic derailed “convergence” of standards with the United States-based Financial Accounting Standards Board (FASB). The convergence of standards between American and international accounting principles was initially set for June of 2011.

“If we are going to consider the FASB position and think what we should do and ask constituents’ views, then implicitly we have to contemplate the possibility of reopening IFRS 9 and making changes. Otherwise, what is the point of consulting?” Cooper said.

Noting that the FASB has been influential in dictating fair value standards, Cooper continued: “If FASB ends up in a different position…and if we want to achieve convergence then somebody has got to change. No decisions have been taken on this.”

The United States Securities and Exchange Commission will eventually make a ruling on whether or not to adopt IASB rules outright, hinging on the board’s fair value decision. The U.S. is the only major economy not using IASB.

Ritholtz: Despite Deregulation, Banks Not Healthy

Author, financial commentator, and FusionIQ CEO Barry Ritholtz says that big banks are “under-capitalized, overexposed, and opaque.” In an article published to EconoMonitor, Ritholtz criticizes the U.S. Treasury and Federal Reserve for their actions in response to the financial crisis. “The banking system was not saved; The massive injection of liquidity temporarily salved the day-to-day operations of banks, but they did not repair what ailed our financial institutions,” he says.

Bank holdings remain full of declining assets, capitalization rules remain too thin, and compensation and bonus structures are misaligned, says Ritholtz. Balance sheets are “unnecessarily opaque” due to the removal of fair value accounting in 2008-2009. He continues, “Eliminating fair value accounting via FASB 157 did not fix balance sheet problems, but instead allowed banks to hide them.”

Instead, Ritholtz proposes a full reorganization of the nation’s largest banks, most importantly shedding under-performing holdings that are now hidden by marking assets at original value.

Economic Recovery at Two Years Running

It has been over two years since the United States financial market bottomed out on March 9th, 2009. Financial publication The Street reported on the financial regulation and gains that have led to this recovery.

The very first catalyst noted by The Street is the repeal of mark-to-market accounting rules. As banks lend based on the value of their reserves, lending was difficult as debt prices plummeted. Though often criticized for allowing banks, not the market, to determine the financial worth of their debt reserves, mark-to-market’s repeal has been noted as a key factor to the recovery, as banks could now lend freely.

Though mark-to-market’s repeal was only part of the recovery, as bank balance sheets were still struggling a year after the bottom-out. Federal Reserve Chairman Ben Bernanke’s Quantitative Easing programs, where the Fed would purchase Treasury bonds to pump more money into the economy, is the key follow-up to the recovery noted by The Street.

4th Quarter Earnings Almost Complete, Appear Strong

With 4th quarter financial reporting over 95% complete, reports appear to be strong from this earnings season. Zacks Investment Research has received reports from 479 firms and is awaiting the results from the straggling 5%. The investment research company noted that typically, the early-reporting firms perform much better than those filing reports last, but that the firms reported represent almost all of the potential earnings for 4th quarter. Thus, the remaining firms are not expected to have much of a negative effect on the overall earnings in 4th quarter.

Total net income has risen a very strong 29.6% versus the same quarter one year ago. Zacks points out that significant growth came from the financial sector, which posted huge net margins. The researchers did caution that the quality of the reports versus prior years can be subject to interpretation due to the absence of mark-to-market accounting. Much of the growth might be attributed to firms setting aside fewer reserves for bad debts compared to a year ago, said Zacks.

Bernanke “Very Cautious” About Mark-To-Market on Long Term Loans

Federal Reserve Chairman Ben Bernanke faced questioning at the hands of the Financial Crisis Inquiry Commission (FCIC) recently. Bernanke’s comments indicated some reservation about the scope of the proposed fair value accounting changes.

“I think we should do our best to get appropriate market values of assets” when they don’t have a market price, Bernanke said. “Now this is a somewhat different issue (when) you’re dealing with long-term credit in the banking book.”

“I’m in favor of accurate accounting. I think that there are sometimes problems when markets are very illiquid. The FASB tried to move in the direction of clarifying how to deal with so-called level 3 assets in illiquid markets.”

“But I’m also very cautious about applying mark-to-market accounting to the long-term loans,” he said.

The FCIC also asked about mark-to-market accounting’s relation to the financial crisis.

“I think it exacerbated it, somewhat,” said Bernanke, noting that while the nature of financial markets often move asset prices frequently, accurate valuations are a better long-term solution to eliminating the issue.

Former Federal Reserve Chairman Paul Volcker Talks Mark-To-Market

Paul Volcker, former Chairman of the Federal Reserve and current Chairman of President Obama’s Economic Recovery Advisory Board recently discussed current financial regulation with Steve Forbes in an interview for Forbes.com. Volcker expressed his opinion (congruent with many other financial experts) that this particular recession is atypical and that standard means of recovery will not suffice. He went on to say that the current financial regulations, many of which he has worked on with the Economic Recovery Advisory Board, are not the final answer, but rather “a definitive step in the right direction.”

Recently proposed changes by the Financial Accounting Standards Board (FASB) have drawn Volcker’s concern as well. In the interview, he says “…my impression is just that FASB is much more toward insisting upon mark-to-market accounting in areas that I don’t think it’s appropriate.”

Volcker also speaks about critics’ claims that his famous “Volcker Rule” – designed to curtail proprietary trading by commercial banks – is being watered down, despite claims by the author himself that it will last.

The entire interview is available on Forbes’ Intelligent Investing website: http://www.forbes.com/intelligentinvesting.

I think we should listen to Volcker. The guy was present, and active, during the last major economic crisis.

Kaletsky’s New Book Has Positive Outlook On Financial Markets

One of the few publications with a somewhat positive outlook for the world’s financial future is Anatole Kaletsky’s Capitalism 4.0: The Birth of a New Economy (Bloomsbury 2010). The title stems from Kaletsky’s writing that the United States has now entered a fourth era of capitalism, after the third era of free-market economics that ran from 1980-2008. His belief is that, in historical terms, the 2008 collapse was an aberration, a blip on the historical map. Also crucial is his belief that the 2000-2006 housing bubble was merely a correction of a previous slump and not a bubble at all.

However, Kaletsky is critical of many financial decisions that led to global panic, specifically mark-to-market accounting in the banking sector. Much of his blame is directed towards Hank Paulson, former U.S. treasury secretary and head of Goldman Sachs. Kaletsky argues that the adoption of mark-to-market accounting rules for securities was a disaster for assuming that the market value is always the correct value, thus minimizing regulators’ discretion. This practice, according to Kaletsky, overly exaggerated the peaks and valleys normally associated with financial markets.

While critical of recent economic rule changes, Kaletsky believes that pragmatism on the part of financial leaders will lead us out of the economic slump.



Authors and Publishers Producing Books Related To Financial Changes

This summer, booksellers nationwide are displaying two new books related to the financial crisis of 2008 and the subsequent struggle to fix it with various regulations.

Former Federal Deposit Insurance Corporation (FDIC) Chairman William M. Isaac has authored Senseless Panic: How Washington Failed America (Wiley, June 2010). Isaac’s book serves as a memoir for much of his time at the FDIC, a discussion of decisions and changes made in the ‘80s and ‘90s under his watch. Isaac also discusses the current crisis, as well as various regulatory operations designed to correct it, specifically the mark-to-market accounting rules. Michael Hanson of Fisher Investments calls it “the best breakdown of FAS 157 [the new mark-to-market accounting update] published so far.”

Also on shelves is The Squam Lake Report: Fixing The Financial System (Princeton University Press, June 2010), an analysis by no fewer than 15 collaborators representing some of the most prominent minds in modern economics. Squam Lake is a textbook-like compilation of insights, analysis and recommendations from the group.

Aflac Sells Greek Sovereign Debt

Aflac Incorporated has announced that it has sold its holdings of Greek sovereign debt and reduced its investment exposure to “hybrid” securities through two separate transactions. Their waning value, when marked to market, led to the decision.

In a press release, the insurance company declared it sold its entire holdings of Greek sovereign debt, which totaled $270 million of par value at March 31, 2010.  The company will incur a realized after-tax investment loss of approximately $67 million on a generally accepted accounting basis in its second quarter financial statements as a result of the sale. Aflac also exchanged a perpetual, Upper Tier II security of a European issuer for a higher-rated, fixed maturity, senior debt instrument.

Commenting on the transactions, President and Chief Financial Officer Kriss Cloninger III said, “As a result of extensive credit analysis, we believed it was prudent to trim our exposures to Eurozone sovereign debt. As we’ve done in the past, we also concluded it was in our best interest to take advantage of opportunities to selectively reduce our holdings of perpetual securities.”

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