IASB Responds to Criticism Over Mark to Market Accounting
In response to criticism about the effects of fair value accounting, the International Accounting Standards Board (IASB) has made public its proposed changes to the accounting standard for financial liabilities.
Should the proposal be approved, all gains and losses resulting from changes in “own credit” for financial liabilities that an entity chooses to measure at fair value would be transferred to “other comprehensive income.”
“Whilst there are theoretical arguments for treating financial assets and liabilities in the same way, it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding large profit,” said Sir David Tweedie, Chairman of the IASB. “Especially when investors tell us that such information is often excluded from their financial models.”
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Three Problems, One Solution
Binod Shankar is a CFA Charterholder consultant who runs Genesis, a Dubai-based financial training company. Writing for The National, he observed three problems with mark to market accounting and offers one solution.
Problem 1: When there is a crisis, buyers stop buying and the market grinds to a halt. Hence there is no market value to which one can “mark.” This is particularly true for long-term assets that are difficult to value in normal times.
Problem 2: Any change in asset value, negative or positive, passes through the income statement without any cash flowing in. This impacts profits but doesn’t bring in any cash when they rise, nor is there a “real” loss when markets are down.
Problem 3: If a company has an income statement that is inflated with fair value assets, investors will want higher dividends. If fair value assets deflate the income statement, perfectly stable companies’ capitalization can become suspect. Hence mark to market accounting is highly misleading in good times as well as bad.
Solution: Binod Shankar recommends that all changes in fair value should be routed through the balance sheet instead of the income statement. Additionally, investments that are intended to be held to maturity should not be marked to market.
We agree.
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How Mark-to-Market Can Work For Derivatives
Kevin Cook, an options instructor for the Options News Network, argues that mark-to-market will work for derivatives. He suggests following the “LaSalle Street” model that has functioned smoothly in Chicago for over 160 years for the trading of commodity futures and financial exchanges. To begin trading derivatives on an open exchange he lists five criteria that need to be introduced:
1. Standardize size and terms of contracts so they can be traded freely and that risk transfer and price discovery are obvious.
2. A centralized clearinghouse must stand between buyers and sellers to ensure transparency and the enforcement of rules.
3. Twice daily mark-to-market would force risk management. This makes risk management a real-time, robust process, not an after-the-fact accounting guess.
4. Performance bond collateral is what every trader in Chicago must post, and it is a “good faith” deposit that is a volatility-based measure of the risk. It forces futures clearing member firms to mind the risk on all positions held in their customer accounts.
5. Liquidity and price discovery in an open market would make it possible for banks to avoid investing in illiquid assets.
Cook then closes his argument by citing the fact that over 160 years of futures trading history, no trading counterparty has ever lost money due to the failure of another.
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One Year Later
It has been just over a year since the Financial Accounting Standards Board (FASB) suspended mark-to-market accounting. Since that time, when the Dow Jones Industrial Average was around 8,000, the market has gained about 35% in value.
No one is attributing the market rise solely to the change in accounting rules, but it can be argued that the change did have a positive influence on the overall state of the economy. Certainty over asset prices and the decreased volatility helped.
The banking sector, for example, was significantly impacted by the old mark-to-market rule. Since last year banks have been posting steadily improving profits. Citigroup recently announced a $4.4B for Q1 2010, their best in two years; JP Morgan Chase posted $3.3B for Q1 2010, up 55% from the prior year; and Bank of America exceeded analyst expectations with a $3.2B gain for Q1 2010.
Additionally it can be argued that the capitalization pressure on banks that was relieved by easing mark-to-market also made credit more readily available —credit that was necessary in every sector of the economy.
Bankers and Congress did pressure the FASB last year to change the rule. And although less onerous, the new mark to model version isn’t a license to mark things at any level the banks find convenient. There must be an economic rational for the marks, and the SEC can remind auditors that it is their job to make sure that is done prudently.
This all seems to be working. Let’s not change it now, or acquiesce to European rules. If it’s not broke…
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French Banks Argue Against Basel III Mark-to-Market Requirements
The French Banking Federation (FBF), which includes French banks BNP Paribas, Sociètè Gènèrale and Crèdit Agricole, pushed for loosening proposed requirements for Euro-zone banks including mark-to-market valuation requirements.
A French study estimates that European banks would need to raise 360 billion Euros ($503.3 billion) to offset the core capital deficit that the requirements would create. It also estimates that there is a shortage of stable funding of between 2 and 3.5 trillion Euros.
In an April 16 letter to the Basel Committee on Banking Supervision responding to Basel III proposals FBF Director-General Delegate Pierre de Lauzun writes, “Excessive capital and liquidity requirements would bring the economic recovery to a screeching halt.”
Among European banks the French are unusually exposed to stricter rules on capital because of cross-shareholdings rules.
Baudouin Prot, BNP Paribas Chief Executive and head of the FBF, has suggested that a new round of talks on these proposals be held later this year.
Mark-to-market accounting is destructive to capital, pro-cyclical and impractical. Let’s just disclose marks and let the market decide. Bad firms would go out of business and good ones would thrive (assuming we stop all of this TBTF and bailout nonsense).
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Mark to Market Would Make Banks Insolvent
Filed under: Credit Card Companies, Federal Home Loan Banks, Market News
The four largest American banks, JP Morgan Chase, Wells Fargo, Bank of America and Citibank together hold $408 billion in tangible common equity and an additional $129 billion in allowances for loan losses.
Their loan portfolios include: $445 billion in home-equity loans; $136 billion in pay-option adjustable rate mortgages; $44 billion in construction loans; $628 billion in residential mortgages; $238 billion in commercial real estate loans; $255 billion in consumer credit card loans; $351 billion in other consumer loans; and $861 billion in other loans. This totals $2.958 trillion.
Tangible common equity plus reserves would only cover a lost rate of approximately 18%. Real estate and banking analysts would likely agree that this is too low given current economic conditions in the real estate and consumer sectors.
If the analysts are right and the rate is too low, only Citibank would be marginally solvent. Three of the four biggest banks have such bad loan portfolios that they would be deemed insolvent under mark-to-market accounting rules.
The current slope in the yield curve is allowing banks to earn their way into more capital. Jamie Dimon is right not to increase his dividend. This isn’t over.
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New Financial Model Needed
Professor Haresh Sapra of Chicago’s Booth School of Business argues that a new method needs to be developed for valuing long term assets. Mark-to-market is too volatile; book value is often inaccurate and ignores market dynamics.
Instead, Professor Sapra suggests two methods: The first is to dampen the effect by valuing illiquid securities by some kind of average, for instance between fair value and historic cost. The second method is to base managers’ bonus payments on longer-term performance.
His rationale is that fair value effect subverts the efficient market hypothesis. Markets are only efficient with respect to information held by outsiders. However mark-to-marketing accounting changes the behavior of insiders. As a result fundamentals affect prices and prices affect fundamentals. The normal price mechanism is turned upside down.
The solution to this conundrum, Professor Sapra reasons, is to identify a more accurate value through averaging or by leveraging the power of compensation to assure a maximized long-term value.
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New Mark-to-Market Rules for Money Funds
In May the Securities and Exchange Commission will start requiring that money funds hold more liquid and high-quality assets.
Under the new rules, a fund will now need to disclose monthly its actual “mark-to-market” net asset value, on a 60-day lag. This is known as a fund’s “shadow NAV.” Currently the shadow NAV is reported only twice a year.
Funds will also need to shorten the average maturities of their holdings. The maximum weighted average maturity of a fund’s portfolio is shortened to 60 days from 90 days. Funds will also have to maintain 10% of assets in securities that mature in one day and 30% in securities that mature in one week.
These new rules are in response to when the Reserve Primary Fund “broke the buck” in 2008 when share values dropped below $1 and touched off a withdrawal panic.
These new rules will make it harder to earn any income in a sorry market and in a low interest rate environment.
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First United Chairman Blasts FASB
In a recent letter to shareholders filed with the Security and Exchange Commission (SEC), First United Chairman and CEO William B. Grant addressed the company’s “first annual loss in memory” of $12.8 million. 2009 was the bank’s worst showing in 75 years.
Grant recognized expanded lending in hospitality, insurance and other sectors new to the bank’s portfolio as well as ill-advised real estate investments as the primary culprits. He noted that most of the losses came from “trust-preferred securities” in banks and insurance companies that defaulted on or deferred their obligations.
But he also blasted the “controversial accounting guidance” of the Financial Accounting Standings Board (FASB), taking special aim at mark-to-market accounting. He felt its requirement to recognize the hypothetical losses of potential assets provided an unfair “challenge” to First United and other institutions.
If everything was mark-to-market, you really couldn’t run the bank at anything else than a quarter-to-quarter basis. Short-term loans and short-term liabilities are the only way to ‘manage’ mark-to-market.
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Marking A Loan Portfolio To Market Will Be Bad For Banking
Founder and Managing Director of Bradway Research LLC, Bill Bradway, when writing for Bank Systems & Technology, takes issue with the Financial Accounting Standards Board’s (FASB) efforts to expand banks’ use of mark-to-market accounting when valuing loans.
Aside from the risk of devaluation of the loans and the impact on capitalization, four questions Mr. Bradway raises are:
- What is the market value if the loan is current and has always been current?
- What loan underwriting variables need to be revalued? The borrower’s capacity to repay? The borrower’s latest credit score or rating? The value of the collateral underlying the loan? Two of the three? All three?
- Where do you start the mark-to-market process for a portfolio of loans?
- What technology applications are available to help value the loans? Compiling Excel spreadsheets would require an extraordinary commitment of time and resources.
Mr. Bradway then observes, “For all this effort, the mark to market portfolio of loans will not produce any more cash income as long as the borrower complies with the terms of the loan.”
This points out the problem with mark-to-market–isn’t a bond a loan? It is a loan, in a security form. Just because it has a cusip, does it deserve different or worse treatment?
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