Friday, March 13, 2009

Good and bad news on mark-to-market accounting

Some good news and some bad news on the mark-to-market accounting (MTM) front.

First the bad news:
Speaking to my dad a while ago, he argued that much of the current problems would go away if we got rid of MTM accounting and reinstituted the uptick rule for short sales. Yay for Fox News/CNBC talking points!

The good news:
There are some intelligent discussions of some of the nuances in MTM accounting. Two examples:

Nobody Says Mark to Market Doesn’t Matter as GE Falls
When I saw the headline, my immediate reaction was huge disappointment. "Not another badly-written article talking superficially about how MTM is the root cause of everything." But I was pleasantly surprised when the article spoke about exactly the opposite. The whole article is worth reading, but here's the punch line:

"For more than a decade General Electric Co. could easily avoid disclosing the value of its real estate and business loans. Not any more.

Since Jan. 2, GE has lost 45 percent on the New York Stock Exchange, mostly because shareholders are no longer willing to accept whatever the Fairfield, Connecticut-based company tells them about its finance subsidiary unless it’s based on so-called mark-to-market accounting rules."

That’s an excellent antidote to the arguments against MTM. Yes, firms are currently forced to reveal the substantial decreases in market value for their financial instruments, and that’s making them look bad. Maybe that decrease is temporary (liquidity-driven), maybe it’s permanent (reflecting changes in estimated future cash-flows). But it’s providing information to the market, which is likely better than not having that information at all. It seems investors may have been skeptical of GE’s non-MTM financial instruments because the absence of information is probably worse than the presence of (perhaps) noisy information.

The second piece of good news relates to the supposed consequences of MTM accounting. The critical issue for MTM accounting is this: What do you actually do with the MTM adjustments?

One of the big arguments against MTM accounting claims a sequential, recursive process:
  1. MTM accounting forces Firm A to write down the value of certain assets (perhaps residential mortgage backed securities) because they have declined in value since origination/purchase.
  2. After writing down those assets, Firm A is in violation of regulatory requirements and must de-leverage. The firm can de-leverage by raising capital through equity issuances or by selling off some assets and paying down debt.
  3. In the current environment, capital isn’t available, so Firm A has to sell off assets.
  4. When Firm A sells off those assets with highly uncertain value, it is forced to accept fire-sale prices, because investors require steep discounts to make up for the uncertainty about future cash flows.
  5. Firm B, which holds similar assets, is now forced to use the fire-sale price as the measure of market value, which to reduce the valuations on their balance sheets.
  6. In order to meet regulatory requirements, Firm B must de-leverage by selling off some of its assets.
  7. Firm C uses the new marks, ad infinitum.

Critics of MTM have said, “Stop the madness! End MTM accounting and you will end this recursive death spiral.” But what the critics should be saying is, “Stop the madness! Stop taking mechanical actions based on marks if those marks are uncertain. Keep the MTM accounting, but loosen up the regulatory requirements.” (This assumes that there is something wrong with the current process, which I’m not sure is a premise I agree with.)

I am not surprised to find myself agreeing with Warren Buffett, as conveyed by Holman Jenkins in the WSJ:
Buffett's Unmentionable Bank Solution
“Now comes Warren Buffett, a big investor in Wells Fargo, M&T Bank and several other banks, who, during his marathon appearance on CNBC Monday, clearly called for suspension of mark-to-market accounting for regulatory capital purposes.

We add the italics for the benefit of a House hearing tomorrow on this very issue. Mark-to-market accounting is fine for disclosure purposes, because investors are not required to take actions based on it. It's not so fine for regulatory purposes. It doesn't just inform but can dictate actions that make no sense in the circumstances. Banks can be forced to raise capital when capital is unavailable or unduly expensive; regulators can be forced to treat banks as insolvent though their assets continue to perform.


CNBC, sadly, has been playing a loop of Mr. Buffett's remarks that does a consummate job of leaving out his most important point. Nobody cares about the merits of mark-to-market in the abstract, but how it impacts our current banking crisis. And his exact words were that it is "gasoline on the fire in terms of financial institutions."

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