Investors and auditors call on the Securities and Exchange Commission chairman to resist urgings to suspend mark-to-market accounting.
Two days after the president of the American Bankers Association asked Securities and Exchange Commission Chairman Christopher Cox to, in effect, weaken the Financial Accounting Standards Board's fair-value measurement rules, investor and auditor representatives fired off a letter to Cox urging him to let mark-to-market accounting stand as is. Note: You can read the letter here.
The current financial crisis has put the fair-value debate into bas relief: on the one side are the bankers, who contend that the FASB rules, especially FAS 157, have speeded up the downhill slide; on the other are accountants, investors, and others who feel that mark-to-market accounting should be upheld even in illiquid markets as a way of keeping financial reporting transparent.
Today's letter seems to be a direct response to the ABA's letter to Cox [read the ABA press release here]. "We are writing to express grave concern regarding recent calls for the SEC to override guidance issued by the Financial Accounting Standards Board (FASB) and the Commission’s staff that would effectively suspend fair value or mark-to-market accounting," according to today's letter, which was signed by Cindy Fornelli, executive director of the Center for Audit Quality; Jeffrey Diermeier, president and chief executive officer of the CFA Institute; Barbara Roper director of investor protection of the Consumer Federation of America; and Jeff Mahoney, general counsel of the Council of Institutional Investors. "We believe such urgings are decidedly not in the public interest."
In his letter to Cox on Monday, Edward Yingling, the president and chief executive officer of the ABA, Yingling attacked FASB's position that the risk of a lack of liquidity must be included in measuring the cash flow of distressed assets when they're sold. The recently enacted financial rescue law, the Emergency Economic Stabilization Act of 2008, affirms the SEC's power to suspend mark-to-market accounting "for any issuer" and orders the commission to launch a study of whether fair value contributed to the crisis.
To the mark-to-market advocates, however, a "move by the SEC to suspend fair value accounting would be a disservice to the capital markets, would be inconsistent with the views of investors, would harm the credibility and independence of the standards setting process, and would run counter to fundamental notice and comment principles," they wrote. "With third quarter financial statements now in process and year-end 2008 imminent, such a change could jeopardize already-fragile investor confidence."
Along with Sir David Tweedie, chairman of the International Accounting Standards board, and other advocates, they contend that "the current crisis of liquidity, credit, and confidence was not caused by fair value accounting; rather, sound accounting principles helped expose the problem."
David M. Katz, CFO.com
Following two Bloomberg reports refer to the two sides on this debate:
ECB's Noyer Says Accounting Rules May Deepen Market Crisis
European Central Bank governing council member Christian Noyer said asset-valuation rules may be deepening the financial crisis and should be reconsidered.
The mark-to-market rule, also called fair value, requires companies to review holdings each quarter and report losses when the values decline. Noyer said it should be shaped ``so as to set the right incentives throughout the economic cycle.''
``In adverse market conditions, marking to market, together with solvency regulations, may generate a feedback loop from expectations of market-price changes to portfolio and balance sheet adjustments,'' Noyer wrote in the Bank of France's October financial-stability review.
``This may reinforce price volatility and exacerbate financial distress,'' wrote Noyer, who is also the governor of the Bank of France.
Still, the fair-value rules shouldn't be changed in the middle of financial turmoil and have the advantage to spur ``ex ante discipline in financial institutions' risk and capital management,'' Noyer also wrote. Other methods, based on amortized historical costs ``are not clearly superior, not least because they tend to delay recognition of impaired assets.''
Sandrine Rastello at Bloomberg
Reverse Leverage of Mark-to-Market Wrecks Banks
The world's banking system is caught in a vicious trap, with a forced sale of assets at one institution wiping out capital at others holding similar assets. Think of it as extraordinarily high reverse leverage.
You can blame mark-to-market accounting, the advent of new indexes that supposedly track values of a wide range of assets, or a market mind-set that assumes every asset is part of a bank's trading book.
Like the old Pac-Man character, this combination is devouring financial institution capital at a voracious rate. The question is whether it will gobble up even the new capital injections into banks by the U.S. and foreign governments.
It's way past time to suspend mark-to-market accounting -- or somehow to make investors and analysts understand that fire- sale transactions aren't supposed to be having such broad implications.
Of course, suspending mark-to-market would be greeted by screams of outrage by its devotees, including those at the Financial Accounting Standards Board and the Securities and Exchange Commission. After all, the mark-to-market rules are supposed to provide investors with needed information about the true state of a company's balance sheet.
In the midst of this financial crisis, mark-to-market isn't necessarily telling the truth. The notion of pricing assets on the basis of what they would bring if sold today -- even if an institution doesn't have to sell them -- creates a paper loss that reduces capital and restricts lending.
Federal Reserve Chairman Ben S. Bernanke has expressed reservations about mark-to-market on these grounds.
Nobel laureate Milton Friedman and his co-author, economist Anna Schwartz of the National Bureau of Economic Research, describe in their seminal work, ``A Monetary History of the United States, 1867-1960,'' how a similar process forced the closure of many banks at the beginning of the Great Depression.
``The impairment in the market value of assets held by banks, particularly in their bond portfolios, was the most important source of impairment of capital'' that caused them to shut down, not ``defaults of specific loans or of specific bond issues,'' they wrote.
``Friedman and Schwartz argue that during financial panics, forced asset sales bring down good assets as well as bad,'' said Lee Hoskins, former head of the Cleveland Federal Reserve Bank.
Instead of this mark-to-market approach, Hoskins said, ``What I would like to see is someone do a present-value calculation on mortgage-backed security holdings at banks using appropriate assumptions about future home prices and default rates.''
For individual loans or groups of similar loans, banks are supposed to set aside loan-loss reserves when questions arise about whether they will be repaid. If the risk of default is sufficiently high, interest payments, which normally are treated as income, are supposed to be booked as payments to principal.
However, adding to loan-loss reserves is a far cry from valuing a loan as if it were to be sold immediately -- which is the foundation of mark-to-market accounting.
For instance, on Oct. 9, some lists of highly leveraged loans being offered for sale were circulating in Europe. Included on them were assets seized from banks that had just been taken over by the Icelandic government.
The news that the loans were on the market caused the Markit LCDX, a benchmark credit default swap index used to hedge against losses on leveraged loans, to drop more than 6 percent over two days.
``This will affect the mark-to-market for all loans,'' Louis Gargour, chief investment officer at LNG Capital, a London-based hedge fund, who is setting up a distressed debt fund, said on Oct. 9.
The FASB staff on Oct. 10 issued additional guidance on the fair-value rules that could limit the fallout from forced sales. However, Gargour's view seems to be widespread in the market.
Saved by Forbearance
Back in 1982, when the world was a simpler place, the six largest U.S. banks -- Citicorp, Bank of America, Chase Manhattan Bank, Morgan Guaranty Trust Co., Manufacturers Hanover Trust Co. and Chemical Bank -- were in deep trouble. Collectively they had loaned more than $1 trillion to Latin American countries, which couldn't service their debts.
Had the banks been forced to recognize on their balance sheets how badly their loans were impaired, they would all probably have been declared bankrupt. Instead, the Federal Reserve and other bank regulators exhibited so-called forbearance -- letting the institutions continue in business without recording those losses. Had they done otherwise, it would have crippled the banking system in the middle of what was already the worst U.S. recession since the 1930s.
At the end of the 1980s, new international standards required banks to increase their capital bases substantially, though the current crisis has shown that the added capital wasn't adequate either.
Asset writedowns and credit losses are approaching $600 billion at the world's biggest banks and securities firms, and the $443 billion worth of capital raised to cover them hasn't been enough to reassure investors. I wonder what that balance would be if the world weren't fixated on mark-to-market accounting.
According to Bloomberg figures, Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. have all raised more capital than their writedowns and losses. Nevertheless, the stock prices of the first two have been hammered since the crisis began more than a year ago. (JPMorgan Chase has fared better.)
So one has to ask: How much capital will the U.S. government have to inject into these and other banks -- along with other actions -- to thaw the world's credit freeze? Given the mark-to-market climate, it may take more than the $700 billion authorized in the recent rescue package.
Harvard University economist Kenneth Rogoff said on Oct. 10 that it likely will take much more than that. If it does, the next president will have to demand that Congress provide it.
John M. Berry at Bloomberg