I’ve written several times about the idiocy of not modifying or eliminating the current interpretation of an accounting procedure known as Mark to Market.
In short, “mark to market” means that financial institutions need to recognize the market value of their investments as they change rather than waiting until they dispose of the asset and recognizing a gain or loss. The purpose for “mark to market” is to reflect the estimated “value” change of the asset, real time, rather than having shareholders or mutual fund holders get surprised (up or down) in one fell swoop.
In a “normal” world, mark to market is a good tool. However, for mark to market to work properly there needs to be a fairly active market for the asset being marked. If the market for the asset has few trades (thinly traded), it has the possibility of causing “fire sale” pricing for assets that have actual, recoverable value that is much higher. This latter situation is what is happening to various financial instruments that many of the banks and other financial institutions (Citicorp) hold. Today, there are many reports that assets like the mortgage backed securities have been written down to as low as 30% of their face value. This while the actual cash flow performance of those same assets are performing at a level that is close to 90% of face value.
Various government entities, including the FDIC, require that banks have capital of a certain ratio to the loans they have outstanding. Part of the capital that a bank has is the value of assets that they invest in. When the assets, like CDOs get written down in a dramatic fashion, the bank or financial institution’s capital is also reduced. This is part of the reason that financial institutions have been chasing after capital infusions during this meltdown. Part of the reason that the TARP plan exists is to infuse capital into financial institutions to replace the eroded capital from written down assets. You can see from the previous paragraph that because of mark to market, it is possible that TARP is having to infuse 50% + more capital than they need to for the capital they are providing to support the CDOs.
Finally, FINALLY, after having first written about this nearly a year ago, it looks like the FASB is going to address and likely modify mark to market. About dang time!
You may ask, “Shoebox, if this was so obvious, why did it take a whole year to address?” Good question! This is yet another example where government’s “good intentions” led to unintended consequences.
Mark to market as we know it, was created by the Financial Accounting Standards Board (FASB) with FASB 157. FASB 157 was a direct result of the Enron scandal. Congress was so incensed by what happened at Enron that they basically told FASB and others that either they fixed the problem or Congress would. FASB 157 is the result.
The other result of Enron was that auditing firms became extremely conservative in interpreting FASB rules. All you have to know is that Arthur Andersen, then one of the largest auditing firms in the world, ceased to exist as a result of Enron and you can see why auditing firms quit “interpreting” and merely “implemented” anything that FASB promulgates.
Let me make one caveat to my advocacy for a change in mark to market. Many of complained that by eliminating M to M we will not have financial statements that fairly reflect the company’s status. In some respects that’s accurate. What I propose is going back to a mark to model for financial purposes but providing information in the financial statement notes that reflect the difference between mark to market and mark to model. This will give both sides of the argument the information they want/need and will allow knowledgable investors the information they need to make assessments.
The sad part of all of this is that FASB, the FDIC or Congress could have acted on this long ago. Had they done so, even if only doing so on the capital requirement calculations, some portion of the hullabaloo in the financial industry could have been avoided. Additionally, some of the financial bailouts could have been avoided or at least mitigated and maybe, just maybe, President Obama would not have had the door thrown wide open to waltz into any company he now chooses and dictate how they should do business.
I hope that FASB does act on Thursday. If they don’t, expect a nasty reaction from the stock market. If they do act, as I expect them to, this could provide a significant boost to the viability of several financial institutions. If that happens, we could see the end of the beginning of this financial downturn.
