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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The Horror, The Horror…
In case you haven’t heard, mark-to-market accounting is NOT completely dead. After the House Financial Services Committee leaned on the FASB to fix mark-to-market account in March of 2009 because it was unnecessarily destroying the capital of, in many cases, otherwise healthy financial institutions, the FASB acted quickly and changed the accounting guidance so that market values were still disclosed to investors but would not destroy their capital if they intended to hold investments longer than the duration of the fire sale. Now the FASB is making a push to go BACK to mark-to-market accounting! And this time it includes more than just investments. Read the article below for more details. The worst part of all of this is that not only will this impact a financial institution’s ability to implement their long-term business model of lending and investing, it will affect individuals’ and businesses’ ability to get loans!
Stop This Horror Before It Starts Again – Forbes Magazine, June 28, 2010
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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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Accounting Issues “Untouched” by Financial Regulatory Reform Bill
William Isaac, a former Federal Deposit Insurance Corp. chairman and now the chairman of LECG, expressed his objections to the Financial Regulatory Reform Bill now being debated in Congress. He is quoted in American Banker as saying that, among other omissions, “What’s wrong with these bills is they do not fix the regulatory system that led us into this problem…They don’t deal with the accounting at all. Mark-to-market accounting was a major contributor to this crisis.”
Other critics argue that rules governing banks have actually been softened by the changes in mark-to-market accounting. Banks are now free to “write-up” the values of assets that had few, if any, buyers.
Mr. Issac also notes that the bill does not deal with the Basel capital accords and the procyclical accounting for loan-loss reserves. Nor does the bill institute an independent watchdog to oversee the system.
What’s the rush? Let’s do it right. The economy seems to be getting better. Let’s find a solution that works, rather than one that is easy to pass through Congress now…remember the old saying, “Decide in haste, repent at leisure.”
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FASB and IASB Struggle to Meet in the Middle
While banks and politicians have leaned on accounting regulators to incorporate economic stability concerns into their accounting rules, the question of how banks should value financial instruments remains a subject of intense debate.
“Politicians have been saying a major objective of financial reporting is stability — we think it’s transparency,” said International Accounting Standards Board Chairman Sir David Tweedie.
The IASB had proposed to have assets valued at “amortized cost,” while the U.S. Financial Accounting Standards Board suggested that all financial instruments be valued at market levels. Valuing loans at a market rate would be a significant expansion of mark-to-market accounting, which has been vehemently opposed by the banks.
The FASB and IASB have been working over the last few months to reconcile their views.
Transparency is a better goal. Mark your bonds or loans to whatever price you think, then let the market decide whether you are a liar, a cheat or a charlatan. You just have to publicly disclose, quickly.
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New FASB Proposals Released
The FASB released two proposed accounting standards on Wednesday, 5/26/2010:
Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities—Financial Instruments (Topic 825) and Derivatives and Hedging (Topic 815)
Comprehensive Income (Topic 220): Statement of Comprehensive Income
The significance of the two proposals are that they would require virtually all financial instruments to be recorded at fair value on institution’s financial statements. This would be a radical change to existing financial reporting for lending and depository institutions and an unpopular one for the affected institutions. FASB recognizes this and the significant implementation issues and currently recommends an adoption date of more than 5 years for smaller institutions. The required adoption date for larger institutions is not yet determined.
Two of the five FASB Board members had some significant differences of opinion on the proposed standard.
The appropriate accounting for financial instruments has long been debated by the FASB and these current proposals are a part of a joint project the FASB originally started in 2005 with the IASB.
The two proposals can be found here:
Comprehensive Income (Topic 220): Statement of Comprehensive Income
Comment letters are due by September 30, 2010.
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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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US GAAP and IFRS Convergence Moving Along
International Accounting Standards Board Chairman Sir David Tweedie told the council of the European Union that the effort to reconcile Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) is advancing.
“Both the FASB and the IASB have agreed upon common principles to help us to achieve a common standard,” he said. “That is our objective. At the same time, the IASB is conscious of the strongly held view of investors and other stake-holders internationally that a combination of cost-based and fair-value accounting remains appropriate for financial instruments.”
Earlier this year, the U.S. Securities and Exchange Commission reaffirmed its commitment to make a decision in 2011 to adopt converged standards by 2015 or 2016.
“For nearly 30 years, the Commission has promoted a single set of high-quality globally accepted accounting standards, which would advance the dual goals of improving financial reporting within the U.S. and reducing country-by-country disparities in financial reporting,” SEC Chairman Mary L. Schapiro said in a statement. “But supporting this goal is only the beginning of the discussion, not the end.”
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