The Wonders of Mark-to-Market: Simultaneously Well-Capitalized and Insolvent

In last week’s piece on the economic value distortion and havoc caused by FAS 157’s mark-to-market accounting, I cited Capital One’s (COF) 2008 10-K to show how a company can be well-capitalized and solvent according to GAAP, but simultaneously insolvent from the point of view of many market participants. Several readers requested the pro forma balance sheet effect. Here goes:

So with full-bore MTM treatment of Capital One’s balance sheet, after net MTM adjustments of just over $12 billion, the company’s tangible book value of $28.24 per share falls to minus -$1.21. There are innumerable other examples.

The point is that the market takes Capital One’s MTM disclosure, does the math, and values Cap One as if the loans were marked to market anyway. That’s how Capital One and many other banks are well-capitalized according to GAAP and regulatory standards, but insolvent in the view of many market participants. GAAP results become irrelevant. And it’s how Roubini and others come up with their huge loss numbers, on their way to declaring the U.S. banking system insolvent.

The problem, of course, is that the MTM results have little to do with the intrinsic value to a bank of a loan or a security that it plans to hold to maturity. In a bank, the decline in a loan’s value is offset with a forward-looking provision for loan losses. The decline in the loan “prices” net of loan loss allowances is not due to credit deterioration; it’s the result of the distortions and speculation in the world’s financial markets. Mark-to-market accounting isn’t improving the transparency of bank accounting. It has reduced it, with enormous and growing damage to our economy and prospects.

The Financial Accounting Standards Board has said that it will issue new guidance on the application of FAS 157. That’s encouraging, but can anyone recall when the FASB has been timely?

The damage from this misguided rule is already huge, widespread, and growing daily. Mark-to-market accounting creates a powerful negative feedback loop. Actual or imputed FAS 157-related losses weaken capital ratios and undermine confidence in the financial system generally, which weakens the economy and adds pressure on loan pricing, causing more FAS 157 losses—and around we go.

This cycle needs to be broken. Mary Schapiro? Tim Geithner? Are you listening?

Comments

[Tradememe:]

When mark-to-market was making the balance sheet go up, everybody was fat and happy and giving one another big bonuses. But when it starts going in the other direction, then they ask for a change in the rules. That's the dilemma we are facing.

Mar 06 12:34 AM

[Parm Dhaliwal:]

The flaws of MTM are magnified exponentially during extreme market movements, grossly over/understating the actual picture. MTM should be either eliminated or modified to account for extreme market conditions.

Perhaps one way around this would be to group securities into 2 buckets and identify those that are to be held until maturity. This bucket should be exempt from MTM and the classification of these assets should be treated consistantly for each reporting period.

Mar 06 12:46 AM

[John Petersen:]

The problem with FAS 157 is that it abrogates both the cost principle and the going concern presumption in one fell stroke, and books all assets at the value the weakest market participant is willing to sell for. When I studied accounting, the principles that have been destroyed by FAS 157 were sacred. With FAS 157, it might make more sense to jettison the auditors in their entirety and turn the whole process over to MAI appraisers.

Mar 06 12:46 AM

[Jonny Rotten:]

>> and books all assets at the value the weakest market participant is willing to sell for.

Sounds like my 401K ;)

Mar 06 12:56 AM

[User 294807:]

It astounds me that this has not been addressed. MTM makes management think they are geniuses in the good times and hence they remunerate themselves accordingly, when in reality they are no better or worse than many of their predecessors in time gone by. How long will it take for the US administration to take on board a dose of good old fashioned common sense and wake up.Treating long term loans you intend holding to maturity like a day trader does his or her positions, must rank amongst the highest echelons of folly. All I will say to those that have shorted Citi and other banks down to thse absurd levels is I hope for their sake this accounting folly is not repealed. For the sake of common sense I hope it is done today !

Mar 06 01:09 AM

[GW:]

Perhaps the most intelligent proposal put into the media for consideration. Too bad the president is more interested in casting blame and punishing shareholders instead of seeking solutions. Come on Mr. President, listen to the people who put you in office and instill hope and be part of the solution not the growing problem!!!


On Mar 06 12:46 AM Parm Dhaliwal wrote:

> The flaws of MTM are magnified exponentially during extreme market
> movements, grossly over/understating the actual picture. MTM should
> be either eliminated or modified to account for extreme market conditions.
>
>
> Perhaps one way around this would be to group securities into 2 buckets
> and identify those that are to be held until maturity. This bucket
> should be exempt from MTM and the classification of these assets
> should be treated consistantly for each reporting period.

Mar 06 01:44 AM

[CalTexan:]

It's a little known fact I've read recently that Mark to Market accounting rules were last repealed by.......

FDR in 1938!

They didn't reappear until....

2007!

So all these people saying "Well, we had it in the good times, we can't change the rules now that times are bad" appear to be a little off base.

If we had Mark to Market in the 1990's, the economy would have gone spinning down into the toilet then, but we didn't. Because we didn't, banks, the government and the economy had the time required to work things out.

Mark to Market doesn't give you time. You've got to make up the difference between original price and whatever the market dictates. Today. In Cash. Otherwise you are deemed insolvent. When this rule is enforced in an economy that is extremely dependent (ours) on the flow of credit (read money paid back over TIME) to maintain monetary velocity, you have a recipe for complete disaster, which is exactly where we're headed if someone doesn't address it. Soon. Hopefully it won't be 9 years after the start of the Great Recession before we figure out the easiest, quickest and cheapest solution was actually the best thing that should have been done first...

Mar 06 02:01 AM

[Eric Fox:]

Where did you get the MTM adjustment of 12,044,507...I searched the 10-K and found no such number in the filing.

idea.sec.gov/Archives/...

Mar 06 06:46 AM

[fdsa:]

Derived from page 122 of the COF 10-K


On Mar 06 06:46 AM Eric J. Fox wrote:

> Where did you get the MTM adjustment of 12,044,507...I searched the
> 10-K and found no such number in the filing.
>
> idea.sec.gov/Archives/...
>
>

Mar 06 07:27 AM

[kommando:]

It's not just FASB 157 and MTM. Also factor in the abolition of the uptick rule (which, BTW, was ALSO first instituted during the 30's depression and ALSO removed in 2007). Then layer on the SEC'c criminally negligent lack of enforcement of the illegal practice of naked short selling, and......

Goodbye to $11 trillion dollars of wealth (and counting) and
hello to a thoroughly self-inflcited great depression redux.

Mar 06 08:00 AM

[Paul_L:]

I HOPE the Top, Help Mary and Timid Do Right Turtle Geithner will listen to you! It's already past due and we are witnessing this self-inflicted destruction to the economy, families, jobs, retirements and so forth.Where is WE CAN now, I suppose same old? Enough is enough, how much further the Gloom and the market will descend since Geithner spoke on 2/9?

Mar 06 08:25 AM

[Pullease:]

Please look at a real life case. In 1981, every money center bank was up to their eyeballs in Latin Debt trading at 10 cents. If we had M2M then, every single bank would have been insolvent. They were allowed to hold these loans, eventually package them as Brady Bonds and sold to (ultimatley) profitalbe investments.

Price to Panic is just stupid.

Mar 06 09:08 AM

[EYoung:]

IF we want to enforce MTM, let's just get everything over to Sotheby's, and let THEM auction the damn things off,,, THEN, get some competent, repeat, COMPETENT, Bank owners & managers who understand Market and Financial INTEGRITY to run the Finance Industry. This has been coming, and was written of in 1952,,, Read "ATLAS SHRUGGED",,, you are seeing this whole scenario play out, in real life,,, and John Galt WILL "Stop the motor of the world",,, I don't doubt it a darn bit~!

Mar 06 09:43 AM

[TommyG:]

Good op/ed piece in WSJ today on this subject by Steve Forbes. "Obama Repeats Bush's Worst Market Mistakes". Suspend MTM, put the "uptick" rule back in and end Naked Short Selling.

Mar 06 09:44 AM

[biomedlives:]

I take your point about the havoc MTM has created. Nonetheless, I'm sense that banks are often unrealistic when they set decide their quarterly loan loss allowances. As the current crisis was developing, many were setting nothing or almost nothing aside, even though loan balances were increasing.

Mar 06 09:59 AM

[fdsa:]

SEC rules don't allow excess reserving for loan losses


On Mar 06 09:59 AM biomedlives wrote:

> I take your point about the havoc MTM has created. Nonetheless, I'm
> sense that banks are often unrealistic when they set decide their
> quarterly loan loss allowances. As the current crisis was developing,
> many were setting nothing or almost nothing aside, even though loan
> balances were increasing.

Mar 06 10:24 AM

[fdsa:]

In my experience, most large banks have a strong well-defined provision for loan loss discipline.


On Mar 06 09:59 AM biomedlives wrote:

> I take your point about the havoc MTM has created. Nonetheless, I'm
> sense that banks are often unrealistic when they set decide their
> quarterly loan loss allowances. As the current crisis was developing,
> many were setting nothing or almost nothing aside, even though loan
> balances were increasing.

Mar 06 11:35 AM

[Berninvestor:]

Great job Gary Townsend! I wish there were more sensible folks like you. I hope President Obama,Tim Geither and Mary Shapiro are listening.

Mar 06 02:53 PM

[canadian_in...:]

CalTexan is perfectly right. I would add the following comment:

The problem with mark-to-market is not the VALUE of the (potential) losses, it’s their AMORTIZATION.

So far, accounting rules managed to come up with different AMORTIZATION (loss of value over TIME) periods for MANY kinds of ASSETS (depending on their nature, some are 3 years; others are 5 or 10 years). Why is it different with ABS, MBS and CDOs?
The ROLE of accounting is to REFLECT, AS CLOSE AS POSSIBLE, THE REALITY OF THE UNDERLYING BUSINESS!

Even if these “VERY ILLIQUID MARKETS” are right and those are the real values of these assets, requiring write downs (thus UPFRONT capital TODAY) for your next 3, 5 or 10 years of “MARKET ESTIMATED LOSSES” will look very stupid in 70 years from now… just like it probably did in 1938!

Mar 07 12:56 PM