Wednesday, October 1, 2008

Financial Pass - Fail Accounting

Do we need to mark our bank's 

assets on a curve?

"Mark to Market" FASBE and SEC requirements put in 

place as a result of Sarbanes-Oxley, appears to many as

 a significant causal element in today's financial mess.  

The result of this asset valuation process seems to deliver 

a pass/fail report, rather than a realistic valuation of the

 intrinsic value underlying the assets in the various 

mortgage derived securities.  

Many think that changing this requirement to 

reflect more accurate valuation, will ease pressure on the 

majority of our financial institutions.

Hollman Jenkins, Jr., in today's Wall Street Journal, 

spells out this perspective:

Mark to Mayhem? 

What would happen if we changed the rules? Let's find out.
Paulson plan's defeat on Monday was not the end of the world, and may not even be lasting. But it does invite us to revisit the sideshow of mark-to-market accounting.....
Banks,... are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.
Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.
We choose the adjective advisedly. These institutions are guaranteed by the federal government, implicitly or explicitly, so questions of solvency are largely academic -- except as to the value of their equity. In fact, much of the ferocious argument over mark-to-market really is a political battle between CEOs and short sellers for control of the stock price. Washington wishes they'd just shut up before savers and lenders join the argument -- because, in present circumstances, we'd call that a "bank run."
Then there's a third group on the sidelines who attribute religious or ethical superiority to mark-to-market. Their sentiments are simply misplaced. Mark-to-market and its alternatives all have their uses -- a rose by any other name. A savvy analyst looks at them all with the same gimlet eye.
But usefulness is not what we're talking about here -- we're talking about a regulatory trap for equity, created as an unintended consequence of a well-meaning accounting rule. Short sellers see this trap and try to exploit it. Uninsured lenders and depositors see it and worry about not getting paid back. That fear is why banks have all but stopped lending to each other -- and why Henry Paulson launched his plan, and why the SEC made its move yesterday.
Accounting straddles the real and unreal, so it's hard to guess how much difference getting rid of mark-to-market might really make. The only way to find out is to try.
A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.
A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.
No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?
Let's find out.
And here's more support for the idea of an alternative prescription to the $700 Billion taxpayer stick-up from Brian Wesbury:

How to Start the Healing Now 
Fix accounting rules and private money will come.

The most amazing paradox of 2008 is the continued growth of the U.S. economy and the sorry state of the U.S. financial markets. Despite major financial-market problems, real GDP has increased by 2.1% in the year ended in the second-quarter -- 3.1% if we exclude housing. Not everything is great, but we all must agree that the economy has remained remarkably resilient.
This paradox works both ways. Financial problems have not yet dragged down the economy, but it is also true that the economy is not the cause of financial-market problems. Most of the loans that have been going bad in recent months would have gone bad even if the economy had been growing twice as fast. So what is to blame for the "worst financial crisis since the Great Depression"?
The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.
For example, the prices of assets on the books of Washington Mutual, when it was bought by J.P. Morgan at a fire-sale price, were cited as a reason to mark-down the assets on the books of Wachovia. This, some say, forced the FDIC to arrange its sale to Citibank.
The same is true of what happened to Fannie Mae and Freddie Mac, which had positive cash flow when they were nationalized by the Treasury. Here's something you won't believe: Fannie Mae and Freddie Mac have not drawn a dime from the Treasury's $200 billion facility that was created to bail them out. It was the use of mark-to-market accounting that allowed Treasury to declare them bankrupt. On a cash flow basis, they were solvent.
Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.
Because the government has been so aggressive with the use of these capital regulations, private capital has been scared away. Just about the only transactions taking place in the subprime marketplace have been sales to private equity firms that do not have to mark assets to market prices. Their investors agree to commit capital for the long haul, and because they are able to bend the current holders of these assets over the knee of the accounting rules they get prices that virtually guarantee a huge profit.
Despite all this evidence, the government has yet to provide relief from mark-to-market accounting. However, the Financial Accounting Standards Board will meet today to discuss potential changes. One thing it ought to consider is that the Treasury plan tips its hat to the problem by acknowledging that its goal is to put a floor under distressed security prices. Warren Buffet understood this and invested in Goldman Sachs before the law had passed, but with full expectation that it would. Other investors will follow. There is no shortage of liquidity in the world.
Nor would relaxing mark-to-market rules temporarily in the U.S. -- let's say for three years, for troubled assets issued between 2003 and 2007 -- undermine our standing internationally, as some allege. If a $700 billion bailout fund and the takeover of Fannie Mae, Freddie Mac and AIG have not already undermined foreign confidence, then nothing will. On the same day the bailout bill failed in the U.S. House of Representatives, the dollar soared....... Nor will relaxing mark-to-market rules allow losses to be hidden or ignored. Basing prices for illiquid assets on cash flows would still reflect impairment, but not allow them to dip down to fire-sale levels.
Once private investors know they cannot be taken out by accounting rules and illiquid markets, their cash will flow freely. And if the real issue is to find a proposal that will help fix the problems in our financial markets urgently, then the current Treasury plan fails the test. Because of government bureaucracy and legal issues, the first purchases by the Treasury plan will not be made for at least two weeks and possibly four weeks. Mark-to-market accounting changes could start the healing overnight and prevent the U.S. from moving further away from free-market capitalism.


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