Mark-To-Market: A Rule That Begs To Be Broken

Today a House Financial Services subcommittee will examine the hot-button accounting issue of mark-to-market, formally known as FASB 157.

The SEC’s already asserted its stubbornness. An anonymous source told Reuters this week, and I’m editorializing slightly, “There ain’t no way we’re suspending mark-to-market!”

But there are a lot of good reasons why they need to do exactly that. Unfortunately, the SEC doesn’t have a great history of proactive regulation. Here’s why we better hope our elected representatives see the situation differently.

Mark-to-Market - Increasing Transparency?

Proponents of mark-to-market contend, and rightfully so, that the rule increases transparency. It requires banks to “mark” or price assets based on the current market price. In other words, it forces banks to tell us what their assets would sell for in the current environment.

On paper, that’s a great principle. Who wouldn’t want to know what their investments are worth on a daily basis? If you’re like me, you probably mark your stocks to market every day - checking their prices after the closing bell.

However, doing the same for mortgage-backed securities - the assets at the center of this debate - is not as simple as punching in a symbol on Yahoo! Finance. You see, while stocks trade daily and by the hundreds of thousands of shares, these mortgage-backed securities might not trade for weeks or months at a time.

And when thousands of these investments exist, and only one trades in a month, can we really say a market exists? Not at all. So under the current conditions, mark-to-market is more like mark-to-make believe. Especially since the prices banks are forced to use are completely out of whack with reality.

Let me provide some examples to illustrate what I mean…

When FASB 157 Misses the Mark

In the fourth quarter, The Bank of New York Mellon (BK) was forced to write down a $5 billion portfolio of Alt-A mortgages by $1.24 billion or (25%). Yet, based on the performance of the underlying loans - the principal and interest payments the bank was receiving - they only expected to lose about $208 million.

Granted the bank’s estimates of losses could be wrong. But the difference between the two methods - net realizable value and mark-to-market - is gargantuan. And it proves mark-to-market fails to do its job when virtually no market exists for these assets.

For good measure, here’s another example of its shortcomings…

The Federal Home Loan Bank of Atlanta holds three private mortgage-backed securities. But, it has no intention of selling any of them. Again, based on the actual performance of the loans, the bank estimates it will lose $44,000, beginning in 2025.

That’s not a typo. It will be another 16 years before any losses are incurred on these loans. Yet because of mark-to-market accounting, the bank was forced to write off a loss of $87.3 million - a figure almost 2,000 times greater than the actual losses.

One could argue that over time - as a market returns for these assets - the huge price differences would correct themselves. That’s true. But banks can’t simply wait it out.

Due to Mark-to-Market, Banks Out of Compliance

The write-downs required by mark-to-market put many banks out of compliance with capital requirements - the amount of cash and easily liquidated assets they need to hold to offset their liabilities (i.e. - loans to others). And the only way to become compliant again is to raise capital by either issuing more stock or selling off assets.

Bottom line - the current application of mark-to-market forces banks to raise billions upon billions in real capital to offset losses that are never going to occur. And that makes absolutely no sense.

As for questioning the authority of the Financial Accounting Standards Board, their track record warrants it. Remember, their rules on special purpose entities allowed Enron to pull-off its accounting shenanigans and later required revisions to adjust for the deficiencies.

• Mark-to-market rules were supposed to fix problems from Enron. Unfortunately, they created a large batch of new problems.
• Mark-to-market is simply another one of FASB’s rules that’s good in principle, bad in practice, in desperate need of a revision.

Today’s Crib Sheet

Another regulatory item of note for market watchers this week was talk from the SEC that they might re-instate the “uptick rule.” The uptick rule was originally created by the SEC in 1938 to limit the amount of influence large institutions had to purposefully push the price of a stock down.

Specifically…

The Uptick Rule requires that in order to sell a security short, the price must be higher than the preceding sale. This had the impact of limiting the influence of “shorts” - those selling a security short to profit from the difference.

Amongst the other benefits, it was reported that the uptick rule reduced volatility and decreased manipulation.

The SEC eliminated the uptick rule in 2007, based on market tests they did during a bull market. No one had seen the effects of a bear market without the uptick rule since 1938.

As we know, extreme bull and bear markets are ruled by emotion, and little financial discipline. Rules like the uptick rule were designed to reduce the effect of this irrationality on the market.

Bringing the uptick rule back will be as welcome as adjusting the mark-to-market accounting rule.

Subscribe by RSS Subscribe by Email