Can an Accounting Fix End the Financial Crisis?

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Thursday, October 02, 2008 at 4:03 pm
Sen. John McCain (WDCpix)

Sen. John McCain (WDCpix)

PHOENIX—Lost amid the Senate’s Wednesday night passage of a $700-billion Wall Street bailout plan was an effort by Sen. John McCain and others to “fix” an accounting rule that they believe has helped create the crisis.

The Securities and Exchange Commission and the Financial Accounting Standards Board, or FASB, on Tuesday issued “clarifications” regarding the rule, known as mark-to-market. The new directive allows companies to value their assets according to their estimated future cash flow, rather than current market prices.

Illustration by: Matt Mahurin

Illustration by: Matt Mahurin

There are few buyers for many of the assets on the books of financial institutions, especially mortgage-backed securities. That makes them difficult to value. The price uncertainty has driven their market value down as much as 80 percent, threatening the solvency of many banks.

Banks and securities firms have already written down $500 billion worth of mortgage-backed paper as home prices have fallen and foreclosures skyrocketed.

The Senate bill calls for the SEC to issue a report to Congress on the effect of mark-to-market accounting on the financial industry within 90 days of the legislation becoming law. It also gives the SEC authority to suspend the mark-to-market rule.

The bill now moves to the House, where a vote is expected Friday. Members of the House Republican Study Committee are saying they want the mark-to-market rule scrapped.

McCain first called for repeal of the accounting rule in March. His presidential campaign issued a statement Tuesday supporting the SEC decision to relax the rule.

“John McCain is pleased to see that the SEC had finally decided to permit alternative accounting methods to mark-to-market accounting for securities where no active market exists,” McCain’s senior policy advisor Doug Holtz-Eakin said.

The American Bankers Assn. also praised the SEC’s action, saying “This guidance will help auditors more accurately price assets that are difficult to value under current market conditions.”

Critics, however, contend that allowing companies to base the value of their assets on unknown future cash flows will only cloud their true financial condition.

William Black, former deputy director of the Federal Home Loan Bank Board, said Tuesday that the SEC’s decision to relax the rule is an attempt to “cover up” the extent of the financial problems facing lenders. Black blames a similar accounting change for worsening the savings and loan blowup in the 1980s.

The SEC, McCain and others “want to use the same phony accounting to try and cover up losses, which will only make the losses much greater in the future,” said Black, now an assistant professor of law and economics at the University of Missouri at Kansas City.

But many economists, business leaders and politicians are urging modification or suspension of mark-to-market accounting for lenders holding huge amounts of mortgage-related securities that have no market.

“Assets should not be marked to unrealistic fire-sale prices,” wrote William Isaac, former Federal Deposit Insurance Corp. chairman, in a Sept. 19 Wall Street Journal op-ed article.

Bob McTeer, former president of the Federal Reserve Bank of Dallas and now at the National Center for Policy Analysis in Texas, said on NYTimes.com on Wednesday that suspending the mark-to-market rule “would make a big difference” in easing the financial turmoil. “Mark-to-market was never intended for use in a declining market,” he said.

And in a commentary appearing Monday on Forbes.com, former House Speaker Newt Gingrich urged Congress to suspend the mark-to-market standard to “relieve stress on banks and corporations.”

Accounting groups, consumer advocates and bank analysts, however, oppose scuttling the mark-to-market rule.

The Center for Audit Quality, a nonprofit group funded by accounting firms, sent a letter Tuesday to Congress urging lawmakers not to abandon the rule, arguing that proposals to revoke it “are not in the best interest of investors or the capital markets.”

“The principles of mark-to-market accounting are rooted in the fundamental virtue of transparency and are central to informed market decisions and efficient allocation of capital,” Cynthia M. Fornelli, the group’s executive director, stated in the letter.

Representatives of the nation’s big four accounting firms also object to the rule change. “It’s just bad for investors,” Beth Brooke, global vice chair at Ernst & Young LLP, in Washington, told The Wall Street Journal Wednesday. “Suspending mark-to-market accounting, in essence, suspends reality.”

And Barbara Roper, director of investor protection for the Consumer Federation of America, told The Journal that, “Allowing companies to lie to investors and lie to themselves is not the solution to the problem–it is the problem.”

Black, the former bank regulator, said there is substantial evidence that many lenders have already abandoned mark-to-market accounting by overstating the value of their mortgage-related assets. He said the recent takeovers of Washington Mutual by JP Morgan Chase and Wachovia by Citigroup revealed that losses at the two acquired banks were far greater than anticipated.

“These were enormous losses in the subprime mortgage market that they pretended didn’t exist,” Black said. “That’s called fraud.”

Rather than suspend mark-to-market accounting, Black said federal regulators should conduct more thorough bank examinations of all lenders heavily invested in the mortgage-backed securities. “Look for the ones that have heavy subprime exposure and take supervisory control of the institutions,” Black urged.

Comments

23 Comments

gilmanc
Comment posted October 2, 2008 @ 1:32 pm

As an accountant at a financial institution, I believe it is ludicrous to allow this change.

First, people should understand that for mortgage loans, a company is NOT required to use mark-to-market accounting. In fact, companies could NOT do it until FAS 159 was issued.

Second, people should understand that companies make an election upon acquisition of a security whether they will use mark-to-market accounting or use amortizing cost. This is a one-time election based on intent, or lack thereof. If the company intends to trade in the security, they have to use fair value accounting (which is mark-to-market). If the company intends to hold the security until maturity, they have to amortize the cost of the security over the life of the security. The third option, is the option to not take a position, which is called “available-for-sale”. This is akin to how most individual investors look at their net worth, in that you consider the value of the security in your net worth, at it's fair value, but you do not treat gains as income or losses as loss until you sell the security. Most companies take this position because accounting firms don't take kindly to saying you're going to hold something until it matures, but then sell it. Since they can't trust your stated intent, then all your “held-to-maturity” securities have to be treated as available-for-sale.

What had happened in the past is that companies would use market prices when the price was to their favor, but they would use their own internal modeling of the cash flows when the price was against them. With the implementation of FAS 157, that was no longer feasible.

FAS 157 requires companies to state how they are calculating the fair values used for their books. Level 1 is based on quoted market prices. Level 2 means that the value is based on quoted market prices, but since the market price is for something similar and not exact, it's not as strong as Level 1. Level 3 means that the value is based on an internal model, using internal assumptions. This is sometimes derisively called “mark-to-magic”. The accounting firms and the SEC look down upon Level 3, and FAS 157 requires much more disclosure about how the values were determined. Further, the SEC has been fairly strong in stating a comapny should use the most accurate means possible, meaning Level 1 where possible.

Companies are not used to this type of disclosure, and they make the claim that using Level 1or Level 2 in an illiquid market is tantamount to an artificial price and does not indicate a “regular-way” price (a requirement of FAS 157 is the price is not based on stressed prices due to required liquidation).

An illiquid market is a sign that the price has not yet reached its equilibrium price, but the market is being made illiquid by investors who do not want to part with their assets at low prices. Further, this market is being made even more illiquid because of these bailouts, both private and public, that are occurring, as we do not get the luxury of seeing what these assets would fetch in an open market auction. If those securities were sold to bidders, rather than assumed by JPMorgan we could see what the actual fair value is of these.

That said, I do not see the banks lining up to buy like securities at the “net present value of the cash flows”. I would ask every company that is clamoring for this: “Would you buy this security at the value that you show it on your books?” If they say yes, have them prove it by buying an extremely similar security at that price. They won't do it, because they know that right now, the credit premium is too high and they feel they could get it for cheaper. If they feel they could get it for cheaper, why do they think their security is worth more?

Finally, I didn't see these companies shouting “wait! the fair value of my security is too high! It should be lower!” If the market is undervaluing these securities now, then it was undoubtedly overvaluing them before. If they want to go to the PV of cash flows method, then they should have to restate their earnings for the past 5 years using this for all their debt securities.


Orwell Wasn't Dreaming
Comment posted October 2, 2008 @ 2:35 pm

I have only five words to express my displeasure: E.N.R.O.N.


Thomas Dark
Comment posted October 8, 2008 @ 4:21 pm

I think the last line is really the answer. More regulation…more oversight. Every bank should have a thorough evaluation of it's lending and accounting practices. They want to try to change the fact that they tried to create alternate cash flows by using derivatives and other creative gambles. Once they banks got away from providing just mortgages and trying to constantly move money around using these volatile money items they were sure to run into trouble.


BARB
Comment posted October 11, 2008 @ 2:38 pm

THE WHOLE HOUSING MARKET PEOPLE ARE INVOLVED IN THIS MESS WITH GOVERNMENT LOANS. I WAS FRAUDED BY EVERYONE INVOLVED IN THE PROCESS OF BUYING MY HOUSE. IT ALL STARTS WITH THE SELLER OF THIS COMPLETELY REHABBED HOUSE, WITH EVERYTHING NEW????? IS WHAT THE REAL ESTATE LISTINGS ALL SAID, OF WHICH EVERYTHING FELL APART AS SOON AS I MOVED IN. ALL MAJOR PROBLEMS, NOT LITTLE ONES. NO BUILDING PERMITS ISSUED FOR THE REMODEL JOB, SO NOTHING IS UP TO CODE.
THE MORTGAGE CO HERE IN KC, WHICH HELPED INFLATE THE PRICE OF THE HOUSE.
THE TWO REAL ESTATE SALESPERSONS AND THEIR BROKERS, WHO HELPED INFLATE THE PRICE TOO AND THE HOUSE INSPECTOR, WHO WAS INFORMED BY MY REAL ESTATE AGENT OF WHAT TO LOOK OVER AND IGNORE COMPLETELY.
THE FHA INSPECTOR, WHO THE MORTGAGE CO. SENT, DID NOT EVEN LOOK AT THE HOUSE, AS ALL THAT WAS WRITTEN ABOUT THIS HOUSE, WAS NOT TRUE. ONE MAJOR ITEM WAS ALL THE EXPOSED ELECTRICAL WIRING AND THE CONCRETE FOUNDATION, WHICH HE SAID WAS CONCRETE BLOCK. THE NEW FURNACE & AC DID NOT WORK AT ALL. THE BREAKER BOX WAS A MESS THEN TOO. THIS HOUSE WOULD NEVER PASS A FHA INSPECTION, EVEN YET TODAY.
ALSO THE TITLE COMPANY CASHED MY EARNEST MONEY CHECK AND CASHED IT AND THEN INCLUDED IT INTO THE LOAN ALSO, SO I AM PAYING THAT TWICE.
AS I SAID, EVERYONE IN THE HOUSING MARKET IS INVOLVED IN THE FRAUDS AGAINST THE GOVERNMENT, AND IT IS NOT ALWAYS THE BUYER WHO IS RESPONSIBLE FOR THIS MESS, IT IS THE PEOPLE WHO GOT US HERE, WHO JUST HAD TO MAKE THAT EXTRA DOLLAR THE GOVERNMENT WAS SUPPORTING, WITHOUT ANY AUDITS AMONG ANY OF THEM. I AM REALLY DISAPPOINTED IN THE GOVERNMENT BECAUSE OF ALL THE FRAUDS GOING ON, AND IT IS US LITTLE PEOPLE WHO ARE SUFFERING THROUGH IT ALL.. THANKS, BARB


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Comment posted November 14, 2008 @ 8:24 pm

Assets should not be marked to unrealistic fire-sale prices,” wrote William Isaac, former Federal Deposit Insurance Corp. chairman, in a Sept. 19 Wall Street Journal op-ed article


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