Wednesday, October 01, 2008

Others Agree- The Culprit is A Foolish Congressional Insistence On "Mark To Market" Accounting

According to my search of this blog for 'mark to market,' I first touched on the topic in this post back in February of this year.

Among my favorite, later posts on the topic are these, here, here, here and here. In that first linked post, I wrote,

"You see, this entire financial services debacle is unique because it involves tradeable instruments. Whole loans could be valued at par so long as they were performing. But once magically transformed via financial engineering into CDOs and their ilk, market price became the dominating valuation metric. And, as I and others have noted for some time now, markets for structured instruments can vanish in an instant. Thus, zero price.

There is no ability for anyone to know how much is a sufficient writedown of an asset with no trading market, except 100%. And who wants to do that?

Yes, financials are still reeling. And it won't stop until all the CDOs are basically written off. Totally.

Or, short of that, a vibrant market suddenly erupts all at once as a few hedge funds and private equity groups, like Paulson's ,written about in yesterday's Journal, swoop in and briefly create a market in the instruments for pennies on the dollar.

The holders will get to value the instruments, though probably at lower values than they wished. But above zero.

As I've written elsewhere, these private firms will then enjoy a spectacular rise in value of these structured instruments which are mostly still performing assets.

But for publicly-held companies, there's absolutely no reason for any investor to take a chance on what has become a blind pool of assets which are valued based upon non-existent markets for complex instruments."

I wrote those passages assuming that mark-to-market regulations would not be modified.

Why another post on this? In today's edition of the Wall Street Journal, three of my favorite writers- two of them distinguished economists- write about the current financial sector debacle.

Holman Jenkins, Jr., spotlights mark-to-market accounting in his editorial, as does Brian Wesbury, in his piece. Nobel Laureate Edmund Phelps does not mention it, but, instead, in his piece entitled "We Need To Recapitalize the Banks," weighs various government interventionist proposals to remedy the current situation.

Taking Phelps' article's title as a perspective, one may think of the current financial sector mess as having four possible solutions, ranked below from simplest and least expensive, to most complex and expensive:

1. Per this post, scrap the current mark-to-market regulations and, instead, allow use of net present valuation for performing instruments. Remove the requirement that lower, 'fire sale' current values pertaining to 'non-active' trading markets be used in lieu of 'hold-to-maturity' values for performing assets.

2. Congress authorizes Treasury to sell default insurance on structured finance instruments, thus allowing banks to value the assets at economic value on their balance sheets.

3. Congress authorizes Treasury to invest directly in US commercial banks, taking warrants as a sweetener, so that taxpayers will benefit when the equity values of the banks recover. Capital is rebuilt, with taxpayers afforded some protection.

4. Paulson's plan of simply using $700B of taxpayer funds to buy distressed structured finance securities from bank balance sheets, at undetermined prices.

Jenkins and Wesbury both are in agreement with me on this issue. They believe that the first solution is sufficient to effectively recapitalize banks by allowing them to value structured financial instruments on their balance sheets at long-term, economic values which will not require massive writedowns.

To be honest, I feel very comfortable in such intellectual company. Wesbury wrote,

"So what is to blame for the "worst financial crisis since the Great Depression"?

The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.

Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.

Because the government has been so aggressive with the use of these capital regulations, private capital has been scared away. Just about the only transactions taking place in the subprime marketplace have been sales to private equity firms that do not have to mark assets to market prices. Their investors agree to commit capital for the long haul, and because they are able to bend the current holders of these assets over the knee of the accounting rules they get prices that virtually guarantee a huge profit.

Despite all this evidence, the government has yet to provide relief from mark-to-market accounting. However, the Financial Accounting Standards Board will meet today to discuss potential changes. One thing it ought to consider is that the Treasury plan tips its hat to the problem by acknowledging that its goal is to put a floor under distressed security prices. Warren Buffet understood this and invested in Goldman Sachs before the law had passed, but with full expectation that it would. Other investors will follow. There is no shortage of liquidity in the world.

Nor would relaxing mark-to-market rules temporarily in the U.S. -- let's say for three years, for troubled assets issued between 2003 and 2007 -- undermine our standing internationally, as some allege. If a $700 billion bailout fund and the takeover of Fannie Mae, Freddie Mac and AIG have not already undermined foreign confidence, then nothing will. On the same day the bailout bill failed in the U.S. House of Representatives, the dollar soared."

In his remarks, Wesbury sees the same scenario I did earlier this year. Without a reform of mark-to-market accounting, only private equity will be capable of holding structured financial assets which have no actively-traded market. And they will make a killing, buying for pennies on the dollar and recovering the full economic value over time.

Wesbury ends his piece as follows,

"Once private investors know they cannot be taken out by accounting rules and illiquid markets, their cash will flow freely. And if the real issue is to find a proposal that will help fix the problems in our financial markets urgently, then the current Treasury plan fails the test. Because of government bureaucracy and legal issues, the first purchases by the Treasury plan will not be made for at least two weeks and possibly four weeks. Mark-to-market accounting changes could start the healing overnight and prevent the U.S. from moving further away from free-market capitalism."

It's a brilliant insight, as he notes that, until mark-to-market is suspended or modified, private investors won't touch bank equities, because they know the government if forcing those institutions to incur punitive valuations.

Holman Jenkins, similarly, writes,

"The Paulson plan's defeat on Monday was not the end of the world, and may not even be lasting. But it does invite us to revisit the sideshow of mark-to-market accounting.

Even as this agnostic column was giving birth to itself, the SEC's chief accountant released a new "interpretation" late yesterday meant to relax these vexatious rules. The Dow jumped 485 points. Were investors reacting to the SEC announcement -- or hope of the Paulson plan being revived in Congress? Perhaps they concluded that the two are one in the same.

Now recall that accounting is a language of abstraction. In the normal case of a public company, whatever method it uses to value its assets, it merely provides a benchmark for investors to make their own judgments. Nobody takes accounting values as the final word.

Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.

Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.

But usefulness is not what we're talking about here -- we're talking about a regulatory trap for equity, created as an unintended consequence of a well-meaning accounting rule. Short sellers see this trap and try to exploit it. Uninsured lenders and depositors see it and worry about not getting paid back. That fear is why banks have all but stopped lending to each other -- and why Henry Paulson launched his plan, and why the SEC made its move yesterday.

Accounting straddles the real and unreal, so it's hard to guess how much difference getting rid of mark-to-market might really make. The only way to find out is to try.

A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.

A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.

No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?

Let's find out."

The third writer, Phelps, didn't mention mark-to-market explicitly. Instead, he revisited macroeconomics, and ended up simply judging default insurance to be, to him, not necessarily better than purchasing the assets. I don't agree.

Phelps reviews several other alternatives, including the Paulson plan, and prefers simply injecting capital into banks, in exchange for warrants.

But Phelps provides the important overview of the real issue- how to most efficiently, effectively and, then, quickly recapitalize banks.

And if this can be done via accounting rule modifications, that would be the route that trumps the other three. On all dimensions.

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