Darling: Fair-Value Changes Will Be the End of Fixed-Rate Loans

In an editorial submitted to the ABA Banking Journal, George Darling, CEO of Darling Consulting Group, says that new Financial Accounting Standards Board (FASB) fair value accounting rules would spell the end of fixed-rate loans, among other negative ramifications for the banking industry.

According to Darling, fixed-rate loans would end because banks obviously would not want to mark their loans higher if interest rates rise. This would have a significant effect on American industry. Implementation of the new rules – especially when it comes to coding banking software – would be cost-prohibitive for most banks. Darling also says that comparing financial institutions’ financial statements would become impossible. “The models used to calculate the fair value of each financial institution’s assets and liabilities would differ in logic and scope. Each bank would have different risk ratings for loans and different models for calculation of core deposit values.” He goes on to say that fair-value assessments won’t accurately reflect the business model of many financial institutions, rendering their financial statements useless to investors.

The FASB proposal is up for comment through September 2010. Isn’t it ironic that the university professors and accountants want “pure” mark-to-market, and the real market participants, and tenured regulators (Volcker) warn that it is the wrong path? Which way should we go – theory or practice?

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.



Mark-To-Market May Affect Defined Benefit Plans

The Organization for Economic Cooperation and Development (OECD), a 32-country (including the United States) organization committed to protecting democracy and the market economy, has pointed to mark-to-market accounting rules as a primary factor in their review of defined benefit pension funding.

The OECD has sought to reform regulations on defined benefit funding, as the tide has increasingly flowed towards defined contribution plans. Juan Yermo, head of the private pensions unit of the OECD’s financial affairs division, and Clara Severinson, a division administrator, suggest in their recent document various reforms such as “reducing the reliance on market values of assets and liabilities in determining contribution levels, limiting sponsoring companies’ ability to tap surpluses or take contribution holidays and setting minimum funding levels.”

While the document agrees that mark-tomarket accounting has helped increase transparency and comparability in corporate financial statements, it “may increasingly dominate over other arguably more fundamental issues … as the biggest driver behind how and in what manner corporations remunerate their employees,” according to Yermo and Severinson.

Mark to Market Changes Could Spur Transactions in the Hotel Industry

At a July conference, members of the Industry Real Estate Finance Advisory expressed their views that proposed accounting changes will result in a boon for hotel investors as lenders become more willing to part with assets.

“If mark-to-market is going to go back into effect, then you’ll see a flush of hotels become available,” said Mark Elliott, a senior managing director with the brokerage firm Hodges Ward Elliot. Jackson Hsieh, real estate vice chairman for UBS, noted that while in 2009 most banks didn’t have the ability to take a write-down on an asset, “this year [they] made a lot of money” and will be able to do so.

Conference moderator Chuck Henry, president of Hotel Capital Advisers, echoed the sentiments by the panelists and said the time is right for investment in the hotel industry. “Absolutely it’s time to invest,” he said.

FASB Hires Mark Schroeder to Oversee New Standards

The Financial Accounting Standards Board announced on July 14 that they had hired Mark Schroeder as a post-implementation review leader in light of the upcoming rules and standards changes. Schroeder (now a retired senior partner at accounting firm Deloitte & Touche), in addition to his role at the FASB will have a similar position for the Governmental Accounting Standards Board.

This is another large step by the FASB to formalize its review process, especially in light of the new rules on mark-to-market accounting. Banks and investors alike had cried foul against the FASB, saying that the new mark-to-market accounting rules contributed to freezing the credit market in 2008 and 2009 and there was no formal process for review.

In 2008, an advisory committee to the US Securities and Exchange Commission recommended that the FASB establish a formal review process once the rules were established.

Mark-to-Market Impact On Munis is Positive

Municipal bond specialist James A. Klotz, has a bright outlook for Muni investors because of mark-to-market.

As a rule, municipal bond buyers are long-term investors.  Mark-to-market values are depressed and are driving rates higher. Because investors are rarely forced to sell their bonds, market-to-market is irrelevant and they are enjoying the higher yields. From their view, this is a unique opportunity to purchase high quality assets with a tax equivalent return of over 9.00% for those in the higher tax brackets.

Investors see a “yield to maturity” value in their bond portfolio that is not available in other investments. More and more new buyers are entering the municipal market, attracted by these higher yields, combined with the security that municipal bonds have always represented.

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.”

Survey Reveals Investors Reject Fair Value Proposals

Findings from a new PricewaterhouseCoopers (PwC) survey indicate that investors do not prefer mark-to-market accounting for long-held financial assets.

After conducting interviews with 60 leading U.S. and international investors, PwC found that amortised cost accounting for loans and deposits is preferred because the information “better reflects an entity’s underlying business and economic reasons for holding an instrument.”

Respondents indicated they considered fair value relevant but said it was “not necessarily the key consideration in their analysis of an entity.” Instead, investors said that when evaluating the value of a bank, for example, they would rather have more emphasis placed on its credit history and return on equity. Maybe regulators and legislators should listen to the actual participants.

Ex-FDIC Head Calls FASB Plan “Destructive”

In a telephone interview with Bloomberg Businessweek, William Isaac commented on the proposed Financial Accounting Standards Board (FASB) mark-to-market accounting rules. These would require banks to report both the fair value and amortized cost of loans and some other financial assets and liabilities on their balance sheets.
“This is a terribly destructive idea to even propose,” said Isaac. He believes that simply by making the proposal, the FASB will cause banks to quit making loans that do not have a clear market value and keep those whose value can be easily discerned to shorter maturities.
Isaac contends that mark-to-market accounting destroyed $500 billion of bank capital as traders marked down all assets during the crisis by a total of 27 percent. Only recently have many of those values returned to near par. “Now FASB is going to spread this disease throughout the system,” he said.
Bill Isaac is right. He has been on both sides of this fence. We should listen to him.

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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