New Study Says Mark-to-Market Not to Blame
A new study published by the Federal Reserve Bank of Boston says that mark-to-market accounting had only a minor impact on large financial institutions during the financial crisis.
Sanders Shaffer, Director of Accounting Policy and Analysis at the Boston Fed maintains that:
Capital destruction was due to deterioration in loan portfolios and was further depleted by items such as proprietary trading losses and common stock dividends. These are a result of lending practices and the actions of bank management, not accounting rules.
Mr. Shaffer, who studied banks with at least $100 billion in assets, did not find any evidence that mark-to-market rules drove banks to sell assets at distressed prices. Instead, to raise the capital they desperately needed, institutions mostly tapped government programs and the debt and equity markets.
For most banks in the sample, fair value adjustments had only a small percentage impact on regulatory capital. Mr. Shaffer did not ascertain any link between fair value and capital destruction.
If You’re “Too Big To Fail” Are You Too Big?
It’s a question that has aligned an interesting mix of people. As impossible as it might seem, everyone from House and Senate Republicans to the AFL-CIO, Ralph Nader, and Democrats of virtually every stripe agree that the answer is a resounding, “yes.”
Admittedly, liberals and conservatives have their own reasons for drawing the same conclusion, but they agree that Citigroup, Bank of America, JPMorgan Chase, and others that are too big. And the sentiment is shared on the other side of the Atlantic as well. European politicians are pushing for the break-ups of ING, KBC and Lloyds.
The bankers are understandably not so keen on the idea of being broken up. They do present the valid argument that their size makes them a powerful force in the world market. If forced to break up, they maintain, banks in countries that are not forced to downsize (Possibly themselves after they move?) will have the advantage.
The option to a break up is more regulation — so much regulation, in fact, that these banks would function as quasi-public institutions like AIG, Fannie Mae or Freddie Mac.
So what will happen? That’s easy. When you have two unpleasant options and banks pushing millions into campaign coffers to keep the status quo, all the consensus in the world is useless. Not only will nothing happen, these mega banks will have less incentive than ever to avoid staggering risks … because they’re “too big to fail.”
Dollar Daze
Every administration has pledged to hold our currency strong since Nixon devalued the dollar in 1971. Since the Euro was introduced only ten years ago, the dollar has lost more than 50%. During the same period of time, the dollar is down almost 25% against the Yen.
The inconvenience of more expensive European vacations aside, the precipitous slide is something that needs to be stopped. The idea that a weak dollar is good for American exporters is a fallacy. Except for agricultural commodities, we export virtually nothing. All a weak dollar will do is exacerbate our trade deficit, bring on inflation, lead foreigners to sell off US investments, and make it more difficult to pay down our debt.
A weaker dollar devalues everything — our assets, our incomes, and particularly our nation’s role as the preeminent economy. The dollar is still the reserve currency for investors, but the pace at which it is falling means it will be only a matter of time until the Euro has the critical mass, or investors start to become comfortable with a communist Yuan, and the dollar will lose its position as the world’s currency of choice. Every administration has pledged to hold our currency strong since Nixon devalued the dollar in 1971.
Is Everybody Happy?
The mark to market debate doesn’t need to be winner-takes-all. We can create a system that will satisfy the FASB and investors.
Assets and liabilities can both be held at cost on the balance sheet while current market value is disclosed. Investors will get the fair value number they need to determine current shareholder value, and the FASB gets their market value. Maybe we also disclose a weighted average rate and term for bonds, loans and the like. We can even post the margin based on fair value.
Well, maybe the FASB will be happy. The critical piece is that assets need to be held at cost. The balance of the information is simply disclosed.
No matter how fishy mark to market prices may be, there is no mistaking it. They do force real world investment and credit decisions that have painful and unnecessary consequences. When mark-to-market losses reach “stop loss” levels, solid AAA-rated securities are dumped at steep discounts for accounting reasons that are purely contrived.
Good for the guy who buys the assets, of course. Not so good for the guy forced to sell. And the FASB is smug in its thinking that they have done the world a service. Let’s make everyone happy instead.
Sunny Days Will Return
Say what you want about the deposed junk bond peddler at Drexel Burnham Lambert, Michael Milken, you have to admit that he’s right on this one. He once noted, “Liquidity is an illusion. It is always there when you don’t need it and rarely there when you do.”
To elaborate, in volatile times, money moves toward rock-solid investments. Specifically the Federal Government (Have you seen the short-term Treasuries recently?). In more stable times it moves toward investments that deliver a better return.
The last year or so can hardly be called stable. Predictably, money fled the markets, depressing the value of everything. When compounded by the housing collapse and the problems that rating agencies have had assessing bonds, long-term assets held to mark to market accounting rules got hammered.
But these are all temporary events that are impacting long-term investments in the short-term. Nonetheless these are the criteria mark to market uses to evaluate an investment. It’s a bit like valuing the convertible you bought yesterday at 10% of its purchase price because it’s raining today.
There will again be a sunny day. And as bizarre as it sounds, the FASB should take advice from Mr. Milken. Liquidity will return. When we need it least, of course, but it will return nevertheless. We need accounting rules that acknowledge this.
Mark To Market Morals
Mark to market accounting is fundamentally flawed in so many ways, but perhaps one of its most egregious failings is that it requires the holder of an asset to play a silly game of make-believe: “Imagine you’re going to sell this long term asset today, what do you think it’s worth?”
Let’s assume this asset is in year one of rock-solid, 30-year investment with absolutely no chance of failing. And it pays 5%. Now let’s say the market makes a dramatic short-term shift so rates are now suddenly at 10%. Do I lose a corresponding percentage of the value of my capitalization because some mope – who only wants to buy my rock-solid investment to flip it when rates fall again, says so? Even if I have no intention of selling it for another 29 years?
That is crazy. That is mark to market accounting.
Markets go up. They go down. Over the next 29 years, the true value of that bond can only be determined by its performance. Market value changes should be disclosed, and are for transparency. But don’t focus capital reallocation for short-term price changes. The price of “transparency” is volalitility. Trying to value long-term assets to a tiny sliver of time and a price measured by something as capricious as the market is more than goofy given the damage it does not just to corporate balance sheets but also to peoples’ lives and careers. It is immoral.
Should we listen to these guys?
Those arguing for mark-to-market evaluation of long-term securities that banks and other organizations are holding are doing so primarily on philosophical and moralistic grounds. Invariably they couch the discussion in vague terms of right and wrong. They have yet to present a single argument for mark-to-market that presents any tangible advantage.
This moralizing mind you is coming from members of an accounting profession whose job it is to ensure, in part, that the financial community plays fair. This is the same financial community that just a few weeks ago brought the world’s economy to the brink of disaster.
Why attack the one change that actually helped to stabilize banks and insurance companies and restore credit markets?
Cutting “Too Big to Fail” Down to Size
Is a company that is too big to fail really a company? As Sarah Palin might apologize, “I don’t wanna get all philosophicky on ya” but think about it.
A company assumes some degree of risk to make money. You buy inventory in the hope it will sell at a price higher than you paid. You operate machinery in the belief that the goods you produce will sell at a price higher than your cost to produce. Guess right, you win. Guess wrong, you lose.
Fundamental to a market economy is this leap of faith. You need to have some skin in the game.
Too big to fail says this core principal no longer applies. It says, “go ahead do whatever you want, it won’t matter if you fail because we’ll have to bail you out.” This is not a free market economy. It isn’t right. It isn’t fair.
Funny thing is, we figured this out over a century ago. Republican Senator John Sherman wrote the first antitrust regulation in 1890. He, Teddy Roosevelt, and the conservative Republican, William Howard Taft (who some might say was also too big to fail) all saw the importance of fairness and stability in a market economy and they busted up the trusts.
True. Companies “too big to fail” aren’t trusts. But they are the modern equivalent of a Rockefeller or Carnegie monopoly that squashes fair competition. To restore stability to a market economy, like trusts, they need to be resized so their possible failure is again a healthy purging and not a catastrophic, economy-wide collapse.
For banks, let’s institute a sliding capital scale. The bigger you are, the more capital you need. Want to be a trillion dollar bank? Let’s say you need 50% capital. 500 billion? 25% capital. 100 billion? 25% capital. 50 billion?
15% capital. Less than 50 billion? 10% capital.
Who Da Heck is Ferdinand Pecora?
It’s understandable if your first guess was midfielder for the Italian soccer team. Pecora’s stature, regrettably, has fallen to a footnote in history.
Ferdinand Pecora led the Congressional investigation into the Wall Street collapse of 1929. He unearthed J.P. Morgan’s “preferred list”
that sold steeply discounted stock to influential friends, including former President, Calvin Coolidge. He revealed that National City sold off bad loans by packing them into securities and selling them to unsuspecting investors. (Sound familiar?) He exposed how top officers at National City helped themselves to $2.4 million in interest-free loans from the bank. But the news that made everyone in the soup lines nauseous was hearing that J.P.
Morgan and many of his partners paid no income tax in 1931 and 1932.
This all sounds pretty nasty, but believe it or not in 1929 it was all legal. As a result of these revelations Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934.
Sadly we need someone to emerge again from the depths of the bureaucracy to expose the foulness of how we buy and sell investments as well as manage risk. Derivatives, credit default swaps, collateralized debt obligations, and other instruments can be powerful and useful tools, but we need to be assured they are being used properly and transparently.
They need to be regulated.
With any luck, abusing these tools in 50 years will sound as egregious as the conduct Pecora exposed in 1933. The only problem is that we need another Ferdinand Pecora.
Accountants, Washington Helping Banks Fluff Profits
Look for another rosy round of profits when banks turn in their numbers for the second quarter ending in June when it will be legal for them to improve their balance sheets by shifting losses into the future, thanks to new accounting rules passed by a one-vote margin by the Financial Accounting Standards Board (FASB).
It’s just one in a series of changes made to accounting rules that allow banks to shift or ignore losses or pretend that liabilities aren’t liabilities. The struggle for control of the financial recovery — where the money goes, how it’s counted and who survives — is nothing short of war. Truth has been the first casualty.
The latest rule change allows banks to split losses into ones that they recognize immediately and others that are pushed down the road and may pop up on the books later. It passed in April with barely any notice from the press. The accounting tricks allow banks, which may otherwise be deemed insolvent, to continue to operate. It’s a hell of a time to be an accountant.
