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

Includes: BAC, C, COF, WFC, XLF
by: Gary Townsend

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 (NYSE: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?