Mark to Market NOT Mark to Myth
|April 13, 2009||Posted by Roshawn Watson under Uncategorized||
Is the new mark to market accounting change a bad thing?
Mark to Market Accounting Changes
Recently, the Federal Accounting Standards Board (FASB) decided to relax fair-value (mark to market) accounting rules. With the change, companies may use significant judgment in assessing the prices of some of their investments, including mortgage-backed securities. The measure is suppose to reduce bank write-downs and boost net income.
Previously, banks primarily relied on competitors asset sales to determine the value of similar investments they are holding. In the current economic climate, this led to the presumption that all securities sales are distressed unless evidence proved otherwise. However, certain situations cause this presumption to be very inaccurate: for example, if a firm is selling securities merely to comply with regulations or liquidating to prepare for future investment opportunities.
With the new change, bank management will have the autonomy to disregard transactions that are not orderly (i.e. the bank selling their securities is near bankruptcy).
Does this New Discretion Create Another Problem?
One problem is that many analysts believe toxic asset prices are still not low enough. In a recent statement, Texas banker Andy Beal remarked…
Half the country’s banks–4,000 in all–would be bust if they marked their loans to what the loans would fetch in an auction. Banks are fooling themselves by refusing to mark busted assets down. Banks are on a prayer mission that somehow prices will come back and they won’t have to face reality.
Beal is uniquely qualified for his assessment. Over the last 15 months, Beal has purchased nearly $2 billion in residential loans, $800 million in distressed assets from failed banks at huge discounts, tripled his bank’s assets, and nearly doubled his banking staff. He receives virtually no help from the government either. Even with an abundance of financial institutions looking to unload securities, he still only buys about 3% of what lands on his desk because the prices are still too high for many investments to make fiscal sense.
Who Will Assess the Accuracy of Their Judgments?
With the new mark to market regulation change, banks can now pretend that their assets are worth more than what they really are, and accordingly, they can inflate their earnings. This is equivalent to us wishing these financial problems will just go away as mentioned earlier.
By bank management using significant judgment in gauging the value of their loans, who will ascertain whether their assessments reflect the true value of the assets instead of their desired value?
Hopefully, auditors will keep management accountable for accurate records, but I have my doubts.
The new discretion allows banks to use more than market price to determine the value of their assets. One of the reasons the true value of these assets is below the face value is because of the likelihood of default. Thus, buyers just aren’t willing to pay what the assets are “worth” on paper because the likelihood of them getting the face value is low.
Interestingly, banking advocates have touted cash flow projections as a reasonable substitute for true market-based pricing. However, the fallacy with using cash flow projections is that it assumes that cash flow will remain constant in the future. For example, there are obviously mortgages and loans that are current today that will not be current in 8 months. Thus, they are not really worth their face value because the lender will not be able to reclaim the total amount owed.
If the problem was merely insolvency, then the bailouts would have done the trick. The real problem is an inflated price for bad assets.
Let’s Not Repeat Our Mistakes
Lenders argued that previous stringent accounting standards didn’t work in down markets. However, they are really saying that our fiscal health is really better than the numbers show.
Let us not forget that this is how we got into this financial mess in the first place.
Remember, Bears Stearns went bankrupt because they were marking their assets to myth. It was only when they were forced to sell some of these crappy assets that they were forced to reconcile the fact that their book values and actual values were disparate. This is my concern with the new regulation.
Allowing banks to selectively “adjust” the value of their assets can be deleterious if their judgment is bad. In the short-term, their write-downs decrease and their profits rise. However, hiding the problem will ultimately lead to insolvency, keep these poorly-run financial institutions in business longer, and allows them to keep on attracting new deposits until their eventual bankruptcy. Overall, there is more harm done than good because this destroys consumer confidence: the very thing that everyone is trying to build.
I once went into business selling some really good products at very hefty prices. Although I loved the products, it was initially hard to fix my mouth to ask for that much money. In the process, I learned something very interesting about value. The truth about the commercial value of an item is that it is only really a measure of what someone else is willing to pay for it.
If no one is willing to pay the face value of toxic assets, then why should banks be able to say they are worth more than market value?
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.