The accounting rule you should care about
The battle over how banks and Wall Street value their assets is at the center of credit crisis and the debate over the $700 billion bailout plan.


By Chris Isidore, CNNMoney.com senior writer
Last Updated: October 1, 2008: 4:29 PM ET.

NEW YORK (CNNMoney.com) -- It's easy to understand why the proposal to spend $700 billion in taxpayer money to rescue banks would inspire impassioned debate in Washington.

But in a sign of just how complex and controversial the current credit crisis has become, a move to potentially change accounting rules on how banks and Wall Street firms value the securities they own is almost as heated.

Some argue that tight accounting rules are a major reason for the credit crisis in the first place. Others contend that changing the rules will just bury problems lurking beneath the surface and could further shake investor confidence in the already battered financial sector.

Roots of the problem
First a bit of background. The one fact everyone agrees on is that the current financial crisis centers on trillions of dollars worth of mortgage loans that were packaged together into financial instruments known as mortgage-backed securities, or MBS. Those securities were purchased by banks and Wall Street firms.

But as home prices started to fall and foreclosures rose, the value of these securities plunged. Today, there is almost no market for the securities.

This is why Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke proposed that the government buy the securities. The hope is that doing so could restart the MBS market at something well above the current fire sale valuations and that the government could hold the securities until the market improves.

Some advocates of the plan argue that taxpayers will be able to eventually make money if the government sells the securities at a higher price down the road. But the more immediate hope is that banks and Wall Street firms, freed from the toxic loans on their balance sheet, will start lending again.

What is fair value?
Still, others contend that it was not real financial losses from these securities that led to the credit crunch as much as it was an arcane accounting rule known as "mark-to-market."

Mark-to-market means that companies have to report what the fair value of their investments were if they sold them at the current time.

In recent years, firms were required by the Securities and Exchange Commission and the Federal Accounting Standards Board to use mark-to-market valuations for all the MBS on their books.

As more subprime borrowers started to default on their loans, that quickly eroded the value of many MBS pools. Major banks and financial firms around the globe have taken writedowns topping $500 billion in the last year, as a result.

For this reason, some have argued that fixing the rule would solve the credit crisis.

"The SEC has destroyed about $500 billion of capital by their continued insistence that mortgage-backed securities be valued at market value when there is no market," said William Isaac, a former chairman of the FDIC.

"And because banks essentially lend $10 for every dollar of capital they have, they've essentially destroyed $5 trillion in lending capacity," he added.

Isaac believes that since the overwhelming majority of loans packaged together in even the weakest MBS pools are not in foreclosure, it is proper to value these securities based on the flow of cash from all the loans instead of a non-existent market value.

A change of course
Tuesday afternoon, the SEC and FASB seemed to change course on the rule, as they published new guidance to firms. The two organizations said when the market for a security disappears, it is now allowable to arrive at a value using "estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable."

In plain English, banks may not be forced to take huge writedowns on investments that lost all their value. But the guidance is just that: guidance. The SEC and FASB suggested that more concrete rule changes could come later.

While the possible end of mark-to-market might please critics of the rule, it doesn't satisfy everybody.

Some financial experts argue that even though banks and Wall Street firms may be able to make their balance sheets look better if the rule changes, these companies will be less attractive to investors because there isn't as much information about their true financial condition.

"The garbage is on the books and no one wants to admit the original error of purchasing this class of assets," said Barry Ritholtz, CEO of Fusion IQ, a research firm.

Ritholtz said mark-to-market accounting forces banks to honestly disclose what they own and how much those investments are worth. Changing the rule would make it tougher to come up with a bank's real value.

"I would advise our clients and the investing public that owning any financials that failed to disclose their holdings accurately is no longer an investment. It is pure speculation, with more in common to spinning a roulette wheel," he said.

Too little, too late
Accounting experts also think that determining the value of pools of loans based on expected payments isn't any easier than figuring out their market value after demand has dried up. Rising default and foreclosure rates makes estimates about future value very suspect.

"People talk about 'hold to maturity', 'economic value.' I'm in the business and I don't know what that means," said David Larsen, managing director at investment advisor Duff & Phelps.

Larsen said that even with the new guidance from the SEC and FASB, it's not clear if accountants and chief financial officers are going to be able to ignore the sharp drop in market value for MBS pools in the current environment.

"To try to put a genie back in the bottle and go backwards from a transparency point of view makes little sense," said Larsen.

Others argue that the potential benefit to banks and Wall Street firms from a rule change is much less than is widely assumed since much of the writedowns have already occurred.

And it's too late to save the large financial institutions that have collapsed because of exposure to soured mortgages.

"I think mark to market is seen as a panacea, but I don't think it's that simple," said Brian Gardner, the Washington analyst for KBW, an investment firm that focuses on the financial services industry. "I don't think it's as big a deal for a lot of the banks."

I put it in a quote. Your settings for how you view this website makes it scroll (I think).

Maybe all these securities should never have been traunched in the first place. It would be much easier to determine their market value if you can actually look at the note, the property to which it is connected and the ability to pay back the mortgage of the person associated with the property. If it is so sliced and diced that nobody can determine its value, why should anybody pay anything for it, including the U.S. taxpayer?

OCTOBER 2, 2008
Momentum Gathers to Ease
Mark-to-Market Accounting Rule
By ELIZABETH WILLIAMSON and KARA SCANNELL

WASHINGTON -- The banking industry and a band of lawmakers have used the scramble to salvage the financial-markets rescue plan to give new life to an industry push to avoid billions in further write-downs with the stroke of a regulatory pen.

A proposal contained in the revised financial-rescue bill the Senate considered Wednesday reaffirms the Securities and Exchange Commission's existing authority to suspend "mark-to-market" accounting. The language was meant to send a message to the agency to re-evaluate the issue. The practice, adopted in the aftermath of the savings-and-loan collapse in the 1980s, pegs the value of assets to their current market price, rather than the price paid for them. Banks have complained the strict application of mark-to-market rules has forced them to write down billions of dollars worth of mortgage-related securities, intensifying the squeeze in the credit markets.

Critics of the proposed changes to the "mark to market" rules say gains created by easing the rules would be illusory and would delay resolving genuine doubts about the value of mortgage assets that has caused the recent crisis in confidence.

As of Wednesday, the industry appeared to be gaining support for easing the rules, in part because some lawmakers believe it could cut the cost of a potential financial-industry bailout.

Banks and a diverse coalition of lawmakers scored a victory on the issue Tuesday, when the SEC and Financial Accounting Standards Board issued "clarification" to the mark-to-market accounting rules. The clarification allows executives to use their own financial models and judgment if no market exists or if assets are being sold only at fire-sale prices. FASB said it is preparing additional guidance for later this week.

The SEC and FASB stopped short of bowing to pressure for a complete suspension of fair-value accounting. But that pressure could intensify when the rescue bill reaches a House vote. Financial-industry lobbyists' work on the financial-markets bill has given them another opportunity to press their case through allies in Congress, many of whom are big recipients of campaign money from the industry. More than 60 lawmakers -- all but five of whom voted against the bill Monday -- wrote to the SEC Wednesday, urging the regulator to immediately suspend the mark-to-market rule.

The Sept. 30 timing of the SEC ruling is no accident. Bankers were clamoring for the SEC to issue guidance or suspend the rules by the quarter end, when banks would be forced to admit their losses.

Accounting firms and investors groups put up a united front Wednesday in opposition to the changes. "Suspending fair value accounting during these challenging economic times would deprive investors of critical financial information when it is needed most," said the Council of Institutional Investors, Center for Audit Quality and CFA Institute in a joint statement. "It would not help solve our economic difficulties."

Some members of Congress say easing the mark-to-market rules could help taxpayers avoid billions of dollars in potential costs by allowing banks to avoid booking losses on securities that might have value after the credit-market crisis has passed. "Onerous mark-to-market rules for certain financial assets that have no market value have worsened the credit crisis, and changing them has been a priority for House Republicans," House Republican leader Rep. John Boehner said in a statement.

Republican presidential candidate John McCain, in a statement, praised the SEC clarification, saying, "There is serious concern that these accounting rules are worsening the credit crunch, making it difficult for small businesses to stay afloat and squeezing family budgets."

In March -- the month the industry began to lobby for the change -- Sen. McCain called for a meeting of accounting professionals to study whether the accounting method was "magnifying problems in the financial markets."

The Treasury, Federal Reserve Bank, accounting firms and some bankers say that divorcing the value of assets from their true market price can lead to an artificially rosy picture of a company's financial health. Inflated asset prices, they warn, helped to contribute to the S&L collapse in the U.S. -- which inspired the mark-to-market rule -- and a decadelong economic slump in Japan in the 1990s.

"We have all seen what can happen when institutions are allowed to mask huge losses in asset values," PricewaterhouseCoopers LLC Chairman Dennis Nally wrote in a letter to Congress. Suspending the rules, he said, could "plant the seeds for the next crisis."

That hasn't swayed fiscal conservatives in the House, who cite the need to suspend mark-to-market rules in explaining their opposition to the rescue bill.

"One of the best reasons to fire [SEC Chairman] Chris Cox is the refusal to deal with the problem of mark to market," Rep. Darrell Issa (R., Calif.) said on MSNBC this week. "You do that, and you put trillions of dollars back into the lending pool. ... It's a tool that's available [to] the SEC, the Fed, the FDIC and the Treasury secretary, and they're not using it."

There is a continued push to change accounting rules as part of a broader regulatory overhaul after the election. "What it does show is next year as part of the regulatory structural reform ... accounting rules are going to be part of that discussion," said Edward Yingling, president of the ABA.