What Consequence Will FASB's Expected Approval Have on Mark-to-Market Accounting?

Less than the market has priced in. The XLF is up nearly 50% from its March 6th lows.

Will the FASB approve this? Yes because they don’t want Congress attempting to do so, but the changes will be marginal as any big relief will only come on the regulatory side.

Is the FASB looking to repeal mark-to-market accounting (MTMA)? Absolutely not. Not even close. MTMA will be 90% of what it was on 12/31/08. Here are links to the FASB's two proposals.

The market is all lathered up that there is going to be some big relief from MTMA. There is no big relief proposed, only some incremental improvement. Apparently the market has not studied the proposals.

There are two proposals being voted on. The first, which addresses inactive markets and distressed sales, is not new. The concept is part of the original FAS 157. Similar guidance on inactive markets and distressed was provided in October, 2008 in FAS 157-3. The FASB is simply reinforcing the existing rules so that companies, auditors and regulators more closely follow them. Is this a real change? No. It basically says don’t use marks that are distressed and from inactive markets. It may be more of a short-term psychological boost but nothing more.

The second proposal would allow holders that have the intent and ability to hold to maturity to only record permanent (or OTTI) impairments to the extent these relate to credit losses, not incremental market losses. Example: If a holder of a security has taken a $70 permanent or OTTI (Other Than Temporary Impairment) impairment on a security with a par value of $100, it holds the security at $30 on its books. Assume the estimated credit losses are $50 and the incremental market markdown is $20 (total discount of $70). What this second proposal is saying is if the holder can hold the $30 security to maturity and intends to do so, then if the $20 market discount grows and would otherwise be viewed as permanent, it would not need to be recorded in the P&L but instead in stockholders' equity as part of "Ooher comprehensive income". This will provide some marginal help. However, the market declines are well ahead of the credit losses so I would contend that most of the market losses have run their course and will soon turn into credit losses.

The market anticipates outcomes and just as we are seeing in the credit default markets, the market is telling us there will be massive credit losses later this year and into 2010 and beyond. So the market has largely marked down the security for expected credit losses.

This helps but the holder would have to navigate the following hurdles to be able to take advantage of this second proposal:

1. The holder needs to be substantially capitalized to easily support they can hold a security for 10 to 30 years. We know many of our largest banks are insolvent as I posted yesterday, so it will be difficult for banks that fail the stress test to follow this proposal. It will also be hard for other institutions as well. This makes sense and it is a needed "face guard" to avoid further abuses.
2. The larger portion of the discount relates to credit losses. Credit losses would continue to be recorded in the P&L. It may take a few more quarters to a year or more for the credit losses to more substantially materialize but they are coming so the $30 holding value could soon be $20. If home prices continue to decline none of this will matter. We will look back on this and recall we were spending valuable time rearranging deck chairs on the Titanic.
3. There is no retroactivity in the applications of these proposals. So this means the permanent write-downs taken in 2008 are fixed. FASB has a clear precedent of not recasting prior financial statements for refinements like this one.
4. No reversal of permanent impairments. Only if the holder sells the security could a higher amount be recorded. So if the $70 discount was previously recorded as a permanent or OTTI impairment in 2008, the "cement has been poured" around this accounting. There is no write-up potential. Only if the markets recover and the holder is able to sell at a higher price would a gain be recognized. Makes sense and another "face guard".
5. In order for the holder to have the intent to not sell the security there can be no capital constraints that would encourage the holder to sell the heavily discounted security to either reduce Level III assets or meet some other regulatory requirement. This is like holding a stock in your margin account and the share value declines below $5 such that you receive less margin leverage on the security. If you were capital constrained and received less leverage off such a security it would be difficult to say you had the intent to hold the security to maturity when selling it would effectively produce capital.

This second proposal would provide some help on securities that have only had temporary impairments but these are not the securities that have been marked down by more than 20% generally. Temporary impairments are recorded in OCI and may be changed up or down. This will help equity but not earnings.

The net of this second proposal is it will help the healthy on a part of their losses but it is certainly no silver bullet and it should not be. It does not provide a pass for the unhealthy. MTMA is here to stay.

I suspect the FASB approval celebration party will be short lived.

Disclosure: The author is short financials.

Comments

[Bill S. Friend:]

It would seem the market is trading on sentiment rather than the facts. That sentiment is further bolstered by TV personalities spouting off about the boon "mark to model" will be to financials. I would bet they were already "in" on Monday when they advised buying financials.
How in the world can all the pundits be calling bottoms so early in the cycle? It seems ill advised (if not illeagal) for certain CEOs to claim to be profitable two out of three months! Arent there proper forums for disseminating financial statements? Doesnt the release of financial information on a television program give unfair advantage to those particular veiwers? It certainly smacks of insider trading to me. At what point will the Government provide a stable economic environment for the public to invest in with confidence?
I call for the enforcement of regulations NOW!! The market more closely resembles a circus than anything else right now.

Apr 02 07:03 AM

[Ishortyou:]

well if i have an asset and put it for sale in no one buys it, that means the market is already saying that my asset is worthless, so it would be ridicoulus for me to say that my asset is worth a million dollars when there is not buyers, so if they abolish the market to market rule this will create a lot of Enrons!!!!!!!!!!!!!!!!...

Apr 02 07:32 AM

[CautiousInv...:]

Nice article.

Until we know the details and the implementation guidelines that will follow from the prposed changes it's not immmediately clear what the net effects of revisions to M2M will be.

At the margin, though, I would expect the change to result in fewer writedowns than than would occur absent the change.

And depending upon the revised guidelines, this may allow larger, well capitalized banks to hold on to legacy assets longer than otherwise. Based upon the author's comments, banks on the edges of insolvency may not benefit to the same extent from the proposed changes.

In the context of the Geithner proposal to rid banks of legacy assets and securities, changes in M2M should allow the larger, better capitalized banks the opportunity to be more selective in which assets are submitted for sale. A related possibility is a greater gap between bid and ask.

Again, and relying upon the author's commentary, the weaker banks may become weaker as they will be most vulnerable to yield to pressures to rid themselves of any and all assets..........incurring losses as they do.

Apr 02 07:34 AM

[Ishortyou:]

well i guess you can make the balance sheets look good with any trick you want to implement, but i think is the market the one that dictates the price.

Apr 02 07:38 AM

[kelm:]

I am very glad to read this analysis as this seemed like exactly the wrong time to allow financial institutions to increase opacity by using internal models to price assets. Their credibility is rather low. Some of what the market is trading on is sentiment and if this improves the perception that another improvement has been put in place that may be a benefit. But it does seem much ado about nothing.

Apr 02 10:15 AM

[chris james:]

the intent was never to use a distressed sale price as the determining factor of fair value. sfas no 157 even states "7. A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale). The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or
paid to transfer the liability at the measurement date (an exit price)."

the use of a distressed value has been a misapplication of the standard by practitioners and not a requirement of the standard itself.

Apr 02 10:16 AM

[PainfullyAware:]

Chris James - "the use of a distressed value has been a misapplication of the standard by practitioners and not a requirement of the standard itself."

Agreed; but the issue is that everyone played "Fantasy Evaluation" and skimmed fees while there was an abundant supply of "Greater Fools".

Unfortunately, the "Idiot Pricing" has been recognized and thus no one in there right mind would pay the crazy valuations any more; resulting in "Baked In Losses" that no one wants to "Realize" because of the magnitude of the ramifications.

"Pretend" and "Because I Say So" valuations still are the order of the day to keep the circus going.

If we pretend long enough the Tax Payer will cover the losses and the "Fools" will be allowed to begin the silliness again.

Sell The Future To Preserve The Now - What A Bunch Of Crap !!!

Apr 02 02:07 PM

[Ronald Pires:]

This rule change will end up artificially inflating the value of thinly-traded assets. Their new values will now include a premium for the luxury of being able to play with their booked values when things get rough.

Of course, honest bankers would never do this.

Apr 02 02:18 PM

[ANDRE HAEFF:]

PROPOSAL :FIFTY (50) % Transition of Mark to Market Change retroactive for 1st Q 2009 4-02-09

Lets assume that today's (4-02-09) change in Mark to Market Accounting is a positive influence on the value of financial stocks:banks, private equity and others. A way to implement this smoothly would be to retroactively apply 50 % of the impact of the new rules to the 1st Quarter 2009. Thus, there is a partial (50 %)
postiive impact on their balance sheets in the 1st Q 2009 and the full force and effect of the modification would be felt (at 100%) in the 2nd Quarter 2009 and thereafter. This smoothes out the transition.

How to do this would be simply to A) account in the old way
(full mark to market) for the 1st Quarter 2009 and B) account in the new way (new FASB Mark to Market Rules) for the 1st Quarter of 2009 as well. Then add the results of every item A+B and divide by 2.

Example : for Corporation XYZ a typical item on a balance sheet would be liquid assets. Under A) liquid assets come out as
1 Billion USD ($) for Q1 2009. Under B) liquid assets come out as 5 Billion USD ($) for Q1 2009 .

Liquid Assets under this proposed 50 % rule for Quarter 1 2009
would be:

1 Billion USD ( Liquid Assets under A) + 5 Billions USD (Liquid Assets under B) divided by 2 = (-1Billion + 5 Billion)/2 = 6 Billion/2 =
3 Billion USD.

Under the 50 % rule the Company would report for Q1 2009 liquid assets of 3 Billion USD instead of liquid assets of only 1 Billion USD.

The following 2nd Quarter 2009 and thereafter the new rule would apply and the liquid assetts would continue to show more favorably.

Andre Haeff
La Habra Heights, California April 02, 2009

Apr 02 11:32 PM

[imnotadoofus:]

Benchmarks such as ABX and CMBX in all circumstances, especially in a panic situations and irrational times such as these, give a false impression of the value of assets when there is overall fear and loathing. Example: a portfolio of $50 mm other MBS securities that are not agency backed mortgages that are valued at 20% of par when the FICO score of the whole is 728 and there is only a few defaults in the portfolio should only have to record a provision for the losses, not mark down the whole portfolio to 20% of par. Adjusting for this insanity will increase the capital of banks and insurance companies and allow them to then further raise additional capital in the private market instead of paying 5-8% to the Fed for the preferred shares it invests.

Apr 05 10:14 AM

[imnotadoofus:]

Further, adopting a more realistic model, or in effect going back to the method--FAS 115--that existed before January 1, 2008 would have helped offset the irrational pricing of assets at values less than their value after provisions for credit losses. Also, OTTI modification helps in these circumstances as well. Historically, banks that did not intend to use securitization for these assets kept them on the balance sheet at book value and used provisions when losses were expected. In 1986 changes in how banks make provisions did not allow them to anticipate losses more liberally and as a result can only make provisions when losses were obvious. This led to lower provisions that critics now say are understated in the allowances on the balance sheet; hence the mark-to-market model corrects for this understatement. Both are guesstimates and not realistic.

Apr 05 10:33 AM

[Carousel:]

The San Francisco Chronicle had an article on Sunday about the lack of prosecutions and an assertion that this credit crisis is not real. The writer said that it's a deep recession from too much debt and too much debt-financed consumption but that the idea that it's because consumers and businesses can't borrow more is a lie devised by the banks to justify handing them a lot of money that they aren't going to lend to consumers and businesses anyway.

Check it out: www.sfgate.com/cgi-bin...

Apr 06 02:40 PM