Friday, October 3, 2008

Buffet Advisor: Leave Mark to Market Accounting Alone

"Mark-to-market" accounting fight goes down to the wire
Longtime advisor to billionaire Warren Buffett Robert Denham is a partner at L.A.-based law firm Munger, Tolles & Olson. "We believe that once Congress starts setting accounting standards through its political process, the integrity of U.S. accounting standard-setting and the credibility of U.S. financial reporting will be dangerously compromised," Denham wrote in a letter to House Financial Services Committee Chairman Barney Frank (D-Mass.).

"Suspending the proper accounting of this paper is the refuge of cowards," financial blogger Barry Ritholtz wrote in a
strong defense of mark-to-market on Wednesday. "It reflects a refusal to admit the original error, it hides the mistake, and it misleads shareholders. I find it to be a totally unacceptable solution to the current crisis."

The language in the bailout bill passed by the Senate on Wednesday gives the SEC the authority to suspend mark-to-market accounting for any type of security, but doesn’t require the agency to act. That was the same watered-down wording that was in the first House bailout bill -- wording that some anti-mark-to-market conservatives cited as one of the key reasons they voted against the bill.

Mark-to-market madness
Dominic D’Alessandro is chief executive of Manulife Financial, the second-largest life insurance company in North America and the fourth largest in the world.

I just got an idea. I’m going to go on a crusade to expose the fallacy of these accounting and reporting rules that we’re subjecting our businesses to. It just absolutely makes no sense. When the book on this decade or so of finance is written there’ll be many chapters, but probably half the book will be about the financial reporting and accounting practices that industry and the business generally have been saddled with.

Now, I’ve no doubt that the subprime and all these other problems had to be flushed out. But did they need to be flushed out with quite this speed. And when you do something as mammoth as this, as complex as this in haste, you’re going to throw out a lot of babies with the bath water. No one knows what the real value of some of those asset pools are. But in our haste to try to get there, we’ve confused the market. People have no confidence in anything. And I’m not sure that in the end, we’re going to be all the better for it. I think these kind of accounting practices are wrong theoretically. They’re wrong operationally. They make no sense for anybody.

Posting Ugly Marks
"Opponents of dropping mark-to-market do not want banks to have discretion in marking paper but they want them to mark to a market that does not exist," writes Robert Brusca, economist at Fact and Opinion Economics. "The market they have tethered banks to is so thin with bid-offer spreads so wide that the parameters for value are elusive. So which fantasy is worse: the one foisted on banks that is bankrupting them, or the one the banks guess at looking to the future — with regulators looking over their shoulder?"

But Barry Ritholtz, chief investment strategist at Fusion IQ, argues that these banks made their bed when they decided to "
bypass the broad, deeply traded traditional markets (Equities, Fixed Income, Commodities and Currency) and instead create new markets for new products." What has happened, he says, is that the "net result was a flawed system of garbage paper, with too little room at the exits in case of emergency."

Within this context it is important to note that any sale of these products — such as a sale made by Merrill Lynch
earlier in the year at 22 cents, or a purchase by the U.S. Treasury Garbage Barge Trust — will effectively value these assets, perhaps at a level below what the banks expect. Once that happens, the companies will have no choice. Citigroup wrote down $10 billion to $20 billion per quarter for several quarters running; had they not done that, would they face a write-down of $70 billion to $80 billion if it all came at once? And what kind of psychological shock would that cause?

Mark-to-Market Accounting: What You Should Know
What is mark-to-market accounting? Loans and securities make up the bulk of a bank's assets. Thus, the method you use to establish values for these securities when preparing your financial statements affects shareholders' equity. (Shareholders' equity = assets – liabilities, remember?) That, in turn, has an effect on a bank's profit and loss statement.

Mark-to-market accounting sets the value of (or "marks") the assets on your balance sheet to reflect their market sale prices. In theory, that all sounds nice and clean. In practice, things get a little messier.
All the way down to Level 3 hell Not all securities are as liquid as Microsoft shares, for which anyone can look up the price on the Internet at any given moment. Some mortgage securities may not even trade once a day; what prices will you use for those?

To address this, there is a hierarchy of assets, with a set of guidelines for each:
Level 1 assets have market prices.
Level 2 assets don't have market prices; they're marked at fair value based on a model. The model is fed with inputs for which there are market prices (prices of similar securities, interest rates, etc.).
Level 3 assets don't have available market prices for the model inputs, forcing the people preparing the financial statements to make assumptions about those inputs' values.

Mark-to-market what?
Mark to market

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