Monday, December 8, 2008

Suspend Mark To Market Now

Complex policy issues typically require input from experts with different backgrounds and viewpoints. Somewhere there is a decision-maker -- where the buck stops. That person must evaluate the information and reach a wise conclusion. It is no good to have a group of "yes men" who rubber-stamp the viewpoint of the boss.

It is even worse when the boss is missing in action! Such is the case with mark-to-market accounting: For the health of our equities markets, SEC Chairman Christopher Cox needs to wake up and dump this rule now.

A Dash of Background

Scientists on the team typically thought that the right amount of pollution was zero. They favored regulatory approaches to put a stop to polluters and any aggressive action to minimize impacts. Political scientists looked to industry representatives who fought these approaches, with emphasis on jobs and economic impacts. Economists thought in terms of incentives. They looked for approaches that reduced pollution. They thought in terms of an "air basin" that had a certain level of acceptable pollution, seeking to find cost-effective methods to achieve a target.

Policymaking requires an evaluation of differing viewpoints, with a view to the practical consequences.

The Current Failure

A major problem in government reaction to the financial crisis has been the failure to balance the viewpoints of different experts. The nature of our current government structure is to cede important market regulation to an independent agency, the SEC. This insulation is designed to prevent partisan manipulation of market regulation, an idea that is good in theory.

The SEC further cedes accounting authority to the Financial Accounting Standards Board (FASB). This second layer of insulation is also good in theory, avoiding manipulation of accounting rules. In the post-Enron era, everyone wants increased transparency and accurate valuation of corporate assets.

Why This Went Wrong

At the worst possible moment we as a nation chose to alter the way financial assets were evaluated -- through something called FAS 157. We required financial institutions to mark holdings to forced trades in illiquid assets -- mark-to-market accounting.

The most powerful critic of this approach is William Isaac, the former head of the FDIC. His viewpoint is that the entire financial crisis -- the destruction of major financial firms, the huge bailouts, the destruction of retirement accounts, the socialization of private companies -- all could have been avoided with a more measured approach to the needed reducticon in leverage.

This rule could not have been changed by Hank Paulson, or Ben Bernanke, or even by the president, who cannot fire SEC members.

Here is an extended quotation from Isaac's participation in the SEC roundtable on this subject. Participants in this excerpt include Issac, Vin Colman of PricewaterhouseCoopers and John White of the SEC Division of Corporation Finance.

MR. ISAAC: Of course. That's what I'm all about is trying to protect our banking system and our economy, and our investors. Nobody ever talks about the hundreds of billions of dollars that pension funds have lost because of these rules, that my aunt has lost because she had her money conservatively invested in banks that were a stable source for an investor to earn dividends and have values that would creep up. She wasn't a dot-com investor. She got wiped out in banks, a conservative bank, she thought. And that's what I'm concerned about, are the investors. And I'm concerned about our economy and all the unemployment we're going to cause. It's senseless.

We had one hand of the government, the Treasury, handing out capital, just about as fast but not quite as fast as the SEC and the FASB are destroying it with mark-to-market accounting. It doesn't make any sense to me as a taxpayer that these rules are destroying capital and then you're asking me as a taxpayer to spend money to put more capital in banks, to replace the capital that we're destroying senselessly -- not because there are real losses, but because there are paper losses. When you market against some computer model, it doesn't make any sense. We keep on hearing about 35-to-1 leverage. Our banking system doesn't have 35-to-1 leverage? A couple of investment banks did that failed. But our banks are the best-capitalized banks in the world by far, and we're destroying them with these losses that are being run through the income statement that are not real losses. They're paper losses. They may never be realized.

And I want to take back the words "fair value." You can't have those words. You can't own those, because I am for fair-value accounting. So we're arguing about what is fair value, and I'm telling you that I don't believe that marking to a computer model or fire-sale prices based on distressed sales is fair value. Fair value is to take a look at the assets, look at the cash flows on them, look at the probability of default, look at the probable losses if you have a default, and then value those assets.

Let's take the 1980s. I said the money center banks were loaded up with third-world debt, and they were. And if you could sell it, you would fetch about 10 cents on the dollar. If we had made them mark that to 10 cents on a dollar -- which we did not consider to be a fair value for those assets -- if we had made them mark that to 10 cents on a dollar, we had a plan in place that we were going to nationalize all the major banks in the country, because they couldn't have survived that mark.

Now, did you want us to do that? Would that be right for investors? Would that be right for the economy and the country? Did you really want us to put the country into a depression and all the stuff that comes with that? I'd say no. So what we did is we looked at those assets and we said, "What's the income off of them? What's the likelihood there is going to be a default? And what's the likelihood that these countries are going to renounce the debt and never pay it back?" And we factored that in, and I don't remember what we marked them to, but let's say we marked them down 25%, and then a year later we would look at them again and say, "Was that mark OK, or should we mark them down more?" And that's what I'm asking, is that we use some judgment. We let the bank examiners do what bank examiners do best, and we let the auditors get involved in that process as well, and mark these assets to what is their fair, their true, economic value, not some arbitrary value based on computer models. So I have my investor hat on and I have my taxpayer hat on and I have my bank regulator hat on, and I think this is an issue we all ought to care about very deeply. Well, we do care about it, so that's why we're all here.


MR. COLMAN: Tom [Linsmeier] is here from the FASB, but I just want to clarify a more technical point. I mean, first of all, what the FASB and SEC in the press release put out was your comment around agreeing with judgment. I absolutely agree.

We need more judgment in the system. But one of the things that was tried to be clarified in the guidance that was out just recently was the concept of distress sale or distress market. To make it clear that those transactions are not determinative, they are input in the current market. But you should not be writing to distressed values, necessarily ...

MR. ISAAC: But we have been.

MR. COLMAN: ... and, lastly, I just wanted to comment on it again, to repeat maybe from my opening comments, the difference when you said, you know, and then we go to regulators. To separate the accounting and information for financial reporting of an investor to the information that you're giving to regulators for capital purposes, because those discussions get gray and they come together.

MR. ISAAC: OK. Well, let's deal with that, because that's a very important point. I don't understand how you can have applied these rules to a bank holding company that has publicly traded securities, the mark-to-market rules, and then say, "But regulators can do whatever they want with the banks," because when you are reporting that Citicorp (C) , let's say, loses $20 billion in the year, nobody stops to ask, "Well, what do the bank regulators think about that?" And so I don't think that works. And I'm also not trying to hide any disclosure.

I think all the disclosure ought to be there, as it is under the historical cost basis. You have footnotes. You have tables that show all the market depreciations. Anybody can look at it.

I just don't think it's appropriate to mark something arbitrarily to an index or to a market price when the market's not functioning and destroy value, run it through the income statement, and take it out of the capital accounts of the company. Because then the rating agencies pile on, the short-sellers pile on, and they destroy the company.

And it doesn't matter what the regulators think. I don't believe that a regulator would have wanted to close down Wachovia (WB) , but the market was sure closing it down. I don't think a regulator would have wanted to have closed down WaMu, but the market sure wanted to close it down, because of these reports we're forcing them to make about their losses and the depletion of their capital. So nobody even asks what the regulators think.

Isaac is far from alone on this topic. In August I described this as a self-inflicted nightmare. Former Fed member Bob McTeer writes as follows:

While spending and investing billions of dollars -- or is it trillions? -- trying to heal the sick credit markets, the government continues, inexplicably, to ignore the low-hanging free fruit of suspending or modifying mark-to-market accounting. We are hoisting ourselves on our own petard by adhering strictly to accounting rules that unnecessarily threaten to put thousands of viable financial institutions out of business.

Financial institutions will fail, not because of actual losses, but because of rules requiring drastic writedowns of securities that could be held to recovery or maturity because the market for them is temporarily frozen.

What Next?

As part of the TARP legislation, Congress required the SEC to do a study of these rules. This is a 90-day process, dragging on as markets move lower. The result will be announced on the last possible day, Jan. 2.

Meanwhile, by the time many of you read this column, Cox will give the first hints of the SEC's thinking in a speech before an accounting group. He speaks on this topic this morning at 9 a.m. EST. The Wall Street Journal reports in a story today that mark-to-market accounting will remain, according to a source familiar with the matter. The source goes on to say that the SEC will investigate tweaking the rule's application.

This policy will eventually be changed. I predict that the new approach will provide visibility about illiquid assets on balance sheets without actually requiring financial institutions to mark the assets lower. When the change takes place, it will be the single most bullish event possible for U.S. equities.

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