12 Oct 2008

Mark-to-Myth: FASB Does Its Part to Destroy US Financial Stocks

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According to news reports, on Friday night the Financial Accounting Standards Board (FASB) caved to pressure from the SEC and will suspend the “mark-to-market” rules:

Pressure is mounting on the International Accounting Standards Board to abandon its “mark-to-market” accounting principles, which many believe has been one of the key factors in causing the credit crisis.

The rules insist that assets be held on a bank’s book at the most recently traded market price. As the markets took fright from exotic credit derivatives, the prices fell well below what is considered to be their true economic value — leading to bigger than expected paper losses being taken by the banks. As the markets have crashed, the problem has become ever more acute.

On Friday night, America’s chief accounting body, the Financial Accounting Standards Board, revealed that it would suspend the mark-to-market rules to take account of extreme market conditions. Institutions will be able to use their own estimates of an asset’s worth instead. The move follows pressure from the US Securities and Exchange Commission.

In a “position” statement, the board said: “In determining fair value for a financial asset, the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available.”

For weeks now, I have been planning on doing a “mark-to-market” post, but I never got around to doing it justice. Well, looks like I better do the good-enough-for-Free-Advice-work version:

Investment banks and other troubled institutions are sitting on mortgage-backed securities (MBS). For example, there might be a pool of 10,000 mortgages from all over the country. Every month, most of the homeowners make their mortgage payment, and this cash flows into the pool. Then the owners of the MBS get their respective cuts of this cash flow. If some of the homeowners miss payment, the rules of the MBS specify which owners take the hit first. (These are the people who bought into the riskier “tranches” of the MBS originally, which had the promise of a higher rate of return but also the greater risk of an interruption in cash outflow.)

So, for regulatory and also just business reasons, a big bank needs to be able to tell outsiders what its solvency position is. I.e. it needs to be able to say, “We have total liabilities of $x trillion, and total assets of $y trillion, leaving us with a net worth [equity] of $(y-x) trillion.” If x>y, then the firm is insolvent and has to declare bankruptcy. (Or at least, that’s how it used to work; nowadays, if x>y, the government stampedes in, issues a few dozen billion of taxpayer money, and then hands the firm’s assets over to JP Morgan in a sweetheart deal.)

Now what does all this have to do with MBS and mark-to-market? Well, if the bank is holding a bunch of these MBS, it needs to assign them a value on its “assets” side of the ledger. The mark-to-market rule says the bank has to plug in the price from the most recent market exchange involving a comparable asset. (I am being fuzzy here because I don’t know the precise details. E.g., maybe the bank has to use the average price during the preceding 30 days or something, or maybe there needs to be a minimum level of volume. Otherwise it seems there could be all kinds of gaming.)

OK, we’re almost there. People have been blaming the financial seizure, at least in part, on mark-to-market. The reasoning is as follows: A bunch of financial firms get into trouble because they paid way more for MBS than those securities are worth. Specifically, the models used to price these MBS didn’t assign a very high probability to the scenario in which real estate markets across the country all suffer massive, simultaneous declines–and yet that is what’s been happening.

In this environment, troubled firms have to sell off their assets, and bankrupt firms get completely liquidated. But everybody is spooked about the MBS, and so they can only move at “fire-sale” prices.

Yet, the critics allege, mark-to-market sets up a vicious cycle. During the first round of fire-selling, the prices of various types of MBS get pushed way down. But then all of the other firms, even relatively healthy ones, now find that their net worth just plummeted, because the MBS on their asset side of the ledger just shed 40% of their official market value (or whatever). All of a sudden a new batch of firms are in trouble, they have to sell off assets, this pushes down the price of MBS even further, and so on.

I have not decided whether mark-to-market is really driving this process. As I have said repeatedly, I think the paralysis in (portions of) the credit markets is ultimately due to the hope of a government bailout, and now more recently, due to the erratic seizures (literally) of the feds. On the other hand, I have talked with some sharp people who know financial markets more than I do, and they think mark-to-market is definitely causing some unintended consequences.

In any event, the suspension of the rule, and its replacement with mark-to-myth, where the owner of the MBS is allowed to value the asset based on the owner’s own conjectures about future default rates in the underlying mortgages, is crazy. Michael Rozeff over at the LRC blog explains why:

This idiotic move will drive the prices of financial stocks down and carry the whole market down. The credit markets cannot function without transparency. Lenders have to know the real values of the assets of borrowers. If the borrowers can fabricate figures, they lack all credibility. Thus, FASB has undermined even the creditworthy borrowers with this move. Lenders will now be even more reluctant to extend credit, and interbank borrowing will lock up even more. The exchange economy is almost entirely a credit economy. Without credit, it will grind to a halt. We are looking at an imminent DEEP depression.

If you want to hear the same from a “serious” analyst, John Cochrane from the University of Chicago said the same thing (when it was still just a possibility, not a fait accompli):

There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting, i.e. to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks know this and would lend anyway. We might as well just ban all accounting if we don’t like [the] news accountants bring. No, we need more transparency, not less.

I’ve said it before, and I’ll say it again: If the feds were purposely trying to destroy the US financial sector, we would have to salute them on a masterful job. They are hitting it from at least 8 different angles. It’s like when the FBI shows up at a bank robbery and cordons off the area. Same thing here. Paulson et al. are engaging in a massive bank robbery, and they want to seal the area of from outside investors. Nobody in his right mind would buy stock in, or lend money to, the US financial sector after all the government’s meddling in the last few months.

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