Monday, April 6, 2009

Mark-To-Market Rule Change Controversy

The new mark-to-market rule changes are very controversial. On one hand they have the potential to help stem some of the mounting losses being reported by financial institutions, but on the other hand there is the potential for some ambiguity in relation to the use of “judgment”. For more on this, read the following post from Mark Thoma.

John Berry likes the recent changes in the rules for valuing distressed assets:

Mark-to-Market Rule Gives More Clarity, Not Less, by John M. Berry, Commentary, Bloomberg: Mark-to-market accounting rules are being brought a little closer to economic reality -- accompanied by misplaced howls of outrage. ...[T]he standards have forced many financial institutions to overstate losses on trillions of dollars worth of assets, intensifying the global financial crisis.

Defenders of the rules say they protect bank investors and changing them will allow institutions to hide future losses. To the contrary, they have helped drive down the value of bank stocks, made shorting the shares much easier and caused bank stockholders to lose hundreds of billions of dollars in such companies as Citigroup Inc. and Bank of America Corp. ...

The problem with mark-to-market accounting is that it officially has presumed there’s a functioning market in whatever asset is being valued -- and that means a deal between a willing buyer and seller that isn’t being forced to sell. Actually, no such market exists for many mortgage-backed securities.

Nevertheless,... accountants have required many banks to calculate values based on distressed sale prices. That has meant large writedowns even on mortgage-backed securities that the institutions intend to hold to maturity.

Take the case of the Federal Home Loan Bank of Atlanta. Following the mark-to-market rules, it wrote down the value of its portfolio of mortgage-backed securities by $87.4 million in last year’s third quarter. Its actual projected loss on the securities: $44,000. For the fourth quarter the bank recorded a further $98.7 million loss on the securities.

That result makes no sense when the bank doesn’t trade such assets. ... A writedown might still be required under the changes FASB approved yesterday. Yet auditors can now use “significant professional judgment” when valuing illiquid securities. That’s what they should have been allowed to do all along. ...

The key points in this example are that almost all the mortgages involved are still performing and the bank plans to hold the securities to maturity -- and yet large writedowns were required. ...

Now accountants are supposed to use their judgment... That’s a big improvement over just using the last transaction price, as many auditors have been doing. ...

Here's an opposing view.

This post can also be viewed on economistsview.typepad.com.

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