Monday, September 21, 2009

IMPORTANT: Financial Accounting Standards Board changes mark-to-market rules

Hey All,

Please take a peek when you get a break in your day. For those of you lacking a natural affinity for accounting rules (I’m right there with you), I’d suggest you get some chocolate or coffee, or a stimulant of your choice, before reading this.

Get jacked up on something and tear through this because it is very important to understand…they flipped the board and changed the rules of the game.


Here are viewpoints from the New York Times and the Wharton School of Business from the University of Pennsylvania…


The change seems likely to allow banks to report higher profits by assuming that the securities are worth more than anyone is now willing to pay for them. But critics objected that the change could further damage the credibility of financial institutions by enabling them to avoid recognizing losses from bad loans they have made.

Critics also said that since the rules were changed under heavy political pressure, the move compromised the independence of the organization that did it, the Financial Accounting Standards Board.

During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.


But not everyone agrees that mark-to-market rules have been as damaging as the banks claim.

“I’ve never bought the idea that market-value accounting caused this crisis,” says Wharton accounting professor Brian J. Bushee. Changing accounting rules to accommodate the banks would be like changing the scoring system for tennis, he suggests. “It wouldn’t make you a better tennis player. Changing how we keep score — what these assets are worth — won’t change the problem…. In a sense, that’s what [the banks] are asking investors to do — to say, ‘Let’s use these four-year-old values, not what things are currently worth’”….

Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. At first FASB, pronounced FAS-bee, resisted making changes, but that changed within a few days of a Congressional hearing at which legislators from both parties demanded the board act.

If the FASB, which sets accounting rules in collaboration with the Securities and Exchange Commission, approves the rule change tomorrow [which they did], banks would be free to carry troubled assets on their books at higher prices, avoiding requirements to shore up balance sheets with new capital they cannot get now.

But potential buyers of toxic assets will make their own valuation assessments regardless of what the accounting rules allow the banks to claim, says Wharton finance professor Itay Goldstein. “After all, if assets are not marked down, investors would still fear that they are worth less” than they once were.

Mark-to-market defenders say that using market prices is the best way to derive honest values. Allowing banks too much latitude would paper over the problem, making banks look healthier than they are, they say. “It’s an issue because … the year before the crisis was the first in which firms were required to follow a new set of fair-value measurement tools,” according to Wharton accounting professor Catherine M. Schrand….

On the other hand, if the government’s toxic-asset purchase program does generate significant trading, the whole issue of how to value the assets remaining on banks’ books will become moot, since there will then be enough fresh data to justify mark-to-market accounting, says Wharton finance professor Franklin Allen.

Skimpy Trading

Many experts acknowledge that the skimpy trading in toxic assets creates difficulties. “If there is no trading then you can’t really mark to market,” argues Wharton finance professor Jeremy J. Siegel. “I think there’s been trading that is at too low a price…. I wouldn’t mind suspending mark-to-market for those assets right now.”

But Susan M. Wachter, professor of real estate at Wharton, thinks that for the financial and economic crises to begin to ease, the “murky” condition of banks must be clarified. That cannot be done with accounting changes that simply make the assets look more valuable, she says, arguing that the banks must instead be encouraged to get rid of those holdings. “In order for capital to come to banks, they must disgorge their non-performing assets. That mark-to-market component is necessary.”

Banks’ in-house systems cannot give accurate valuations because too many factors are unknown, such as whether the economy will deteriorate further and whether there will be additional government stimulus spending, according to Wachter.For the banks, a chief benefit of flexible accounting is that it will make them less likely to run afoul of capital-reserve requirements, since their balance sheets will look stronger.Siegel notes that if capital requirements are the issue, regulators could help the banks by easing those instead of changing accounting rules. Wharton finance professor Marshall E. Blume, agrees. “The regulators are in a difficult position, because these companies clearly are not as viable as they were. Having said that, you don’t change the accounting to make it look like they are viable.”

Wachter insists that capital requirements should be based on market-to-market rules, because investors who could pump capital into the banks will be reluctant to do so if they think accounting tricks make banks look healthier than they are. Easing the mark-to-market requirement, she says, “is a road to a long and sustained recession.”

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