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?
Why Go Back?
There were mark-to-market rules during the Great Depression. Franklin Roosevelt had the good sense to suspend them in 1938. For the next 70 years? No problems. Then in 2007 the Federal Accounting Standards Board (FASB), went back to those halcyon days of 1936 and brought back mark-to-market accounting and forced banks to take losses before they happen.
You can burn a lot of calories wondering why the FASB didn’t leave well enough alone.
After a virtual banking collapse, in April of this year the FASB re-suspended the rules. And surprise, banks are suddenly in better shape. What’s more, it didn’t cost any one a dime, taxpayers have probably saved billions in bailout funds, and there is widespread optimism that the economy is turning around.
And oh yeah. The investments the FASB wanted downgraded by mark-to-market? Using the same mark-to-market rules, they’re worth more, too.
So why does the FASB now want to go back yet again to an archaic rule that exacerbated the Great Depression and clearly made the Great Recession far worse than necessary?
We can only speculate. But it’s clear that more than a few FASB members are miffed that they look like they caved to political pressure. I agree that having Barney Frank and Paul Kanjorski in your kitchen isn’t fun, but do you really want to see banks and the economy crumble again?
FASB Update
While there are some in the media that are suggesting this is a sudden reversal of the decisions made last April, it is actually part of a process that started years ago. Both the FASB and the International Accounting Standards Board (IASB) have a long term stated objective that the primary accounting for ALL financial instruments including liabilities should be fair value. They are now in the first steps of a very long process on how to exactly do this.
The initial recommendation is that fair value be the default accounting for financial instruments on the balance sheet. However, other factors such as the institution’s business model (buy and hold versus trade, for example) and characteristics of the financial instrument (cash flow volatility, derivative, market activity), along with other factors will determine whether the unrealized gain or loss is recorded in the income statement or the balance sheet via other comprehensive income. These determining factors have not been laid out in detail yet as they are at the conceptual stage. It very well may be that they are the same concepts used now for securities (primarily based on intent) with a few twists. What is happening now is the first step in a long process on the best way to do this, which includes seeking comments from the industry. The ABA came out quickly with a letter to the FASB with their opinions.
This is an important issue that we will follow closely and may ultimately result in significant changes to accounting for financial instruments. It will also probably force regulatory changes to capital requirements and calculations. However, it is not a sudden reversal of the April decision that changed how fair value is determined in inactive markets or how it is used for impaired securities. It simply is the first step in implementing a long stated common objective of the FASB and IASB.
As fair values become more part of the accounting process for less active financial instruments, it will put more of the spotlight on pricing models that value credit such as loans. I’m very curious to see if the loan fair value models used by many big banks that resulted in fair values of their entire loan portfolios (including commercial, construction, land development loans and consumer) in the high 90s for the last several quarters receive a little more attention.
SEC’s Schapiro Said to Weigh Kroeker, Ciesielski as Accountant
July 30 (Bloomberg) — U.S. Securities and Exchange Commission Chairman Mary Schapiro has two finalists to be chief accountant: acting director James Kroeker and Baltimore money manager Jack Ciesielski, people familiar with the matter said.
Read the full article at Bloomberg.com
This Year’s Battle Over Mark-To-Market Versus Mark-To-Model Accounting Was Worth The Fight
It became clear as the past year’s liquidity crisis deepened, that the banking industry would need to deal with the best way to determine the fair value of asset-backed securities. The mark-to-market theorists wanted to continue valuing these at their current market price; whereas, the mark-to-model advocates said fair value should be based upon expected future cash flow. The reasoning for the change was based on the fact that although the market for these securities had collapsed, the underlying assets were still performing. In April 2009 the Federal Accounting Standards Board (FASB) amended its guidance to provide a way to distinguish the credit and noncredit components of impaired debt securities. Now only the charge related to credit is recorded in earnings and Tier 1 capital. Banks welcomed the FASB action, but now these institutions need to be especially prepared to provide documented analysis for their decisions. Mark-to-model isn’t going “easy” on banks. Rather it enables the reporting of real economic value without penalties for long-term investors in an illiquid market.
To gain further insight into the mark-to-market debate read the full Douglas Wilding article, “This Year’s Battle Over Mark-To-Market Versus Mark-To-Model Accounting Was Worth The Fight” which was published in the June issue of Western Independent Magazine.
Doung Wilding on the Mark to Market Debate
What’s going on with MTM these days?
As the great mark-to-market debate winds down, it appears that pragmatism has overcome rule keeping zeal.
The strict reading of the rules has been deemed as too pro-cyclical, and the FASB bent to the Congressional timetable. It is a decision that was fair, consistent, on time and appropriate. It was also a decision in which neither side was completely satisfied with the outcome, which in many cases can be the sign of a good compromise.
Opponents of M2M demanded the use of a market price for non traded securities, claiming that it extinguished nuanced examination and removed the possibility of biased estimates. But in the end the FASB clarified the rules, recognizing that this “liquidation based” price method for illiquid assets contravenes accounting conventions that have traditionally been applied to other types of assets, such as plant and equipment.
This exact and inflexible application of the rule reminds me of the famous military logic of “Burning down the village to save it.”
Accounting should reflect economic activity, not drive it.
The latent complaints will ring in into the empty forum, but the debate is over.
Some bonds are worth what someone will pay for them. Liquid securities
Some bonds are worth what their economic value is. Illiquid securities
For illiquid bonds, the mark to market has two components.
An institution has to mark down immediately the loss on the security that is real, or caused by credit losses, directly to earnings and Tier 1 capital .
The part of the devaluation, or “loss” in a security that is caused by a lack of liquidity, is charged to “Other Comprehensive Income”.
This final ruling by the FASB is not a get out of jail free card. The loss components are explicit, stated and accounted for.
There can be no complaint mounted on a lack of transparency argument.
We will resume the debate once we have a few field examinations, and we find out how the clarified FASB instructions are being applied. We might end up back here, the debate back on.
Until then, we will continue to publish news and other regulatory updates.
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.
That Wacky Leap of Faith
The Financial Accounting Standards Board (FASB) at long last eased the rule for valuing depressed long-term assets banks carry on their books.
Now bankers can declare that they’ll hang on to an asset until its value recovers. No longer will they be forced to value it at what it would sell for today on a sometimes nonexistent market.
Nonetheless the debate rages. The crux of the problem rests on whether you can trust the bankers. Some say no. Others say you need to take the leap of faith.
Putting a discussion of human nature and greed aside, rest easy. We can take the bankers at their word. As tempting as inflating the value of long-term assets in the short term may be, the FASB ensured that how banks value these asset will be on balance sheets for the whole world to see. In the current climate the number of bankers willing to defend a bogus valuation to the investment community is few and far between indeed. Besides, we really don’t have a choice.
