Tuesday, March 18, 2008

The problem with mark to market accounting when there is no market

In 1993 the SEC ruled that all tradeable securities at public companies be marked to market. A boon to the accounting profession and a bane to the stability of earnings, there has been ongoing debate about the wisdom of the requirement but generally it has been seen as positive. In normal working markets, where price variations are a result of interest rate moves or credit rating changes, most observers concede that the rule makes sense even if they have issues with it. In the financial markets that exist today, there is a big problem.

For many securities today, and almost uniformly any with or backed by mortgage related assets, the markets are thin even for highly rated securities and almost non existent for others. The syndicated loan markets trading mechanism is working well only for the credit of companies who don't need loans. More complex securities like credit derivatives or the various short traded long maturity products may have no observable market trades of any consequence. In some markets the only sellers are distressed sellers, those that must take almost any price as a result of their own liquidity issues. They are not selling based on any calculation of the economic value of the security, only on their need for cash now. To mark to market on prices derived from this type of market is, to repeat, a big problem. It can lead to a downward spiral of reported values that is unrelated to economic value. While that may be just accounting as finance folks might say, that "just accounting" depletes capital such that regulators, counterparties and investors get anxious and therefore has real implications.

That gets back to the accountants. Their job is to follow the rules. If the rules are rigid and lead to overly conservative outcomes, that is not their call. To the extent there is some subjectivity there is always the question "Where is Arthur Anderson?" hanging over their heads, a reminder that a leading firm in their industry was wiped off the map over their approval of one firm's books(Enron). They are inclined to be as risk averse as humanly possible.

A number of financial firms that have reported significant writedowns have suggested that they expect, over time, to recover a large portion of these accounting losses. AIG made such comments, and has raised the issue again today. It is a legitimate issue. In markets that are not functioning normally, mark to market accounting as enforced today by regulators and implemented by accounting firms is creating more dysfunction than transparency.

Let's take a step back in time for a comparison. In 1990 a recession was underway and the commercial real estate market had fallen apart, impacting the balance sheets of many banks. The Fed regulated most large money center banks while the OCC was the regulator for regional banks. The Fed took a rational approach to balance sheet valuation. The OCC, on the other hand, took a draconian approach to writedowns required by banks against non-performing loans, real estate repossessed and held for sale, and lower graded loans that were still performing. Their actions most notably caused the bankruptcy of Bank of New England and, while the management there was far from stellar, many viewed the failure as something that could have been avoided. At banks like First Interstate and Wells Fargo huge reserves, or provisions, were required as well. First Interstate had a middling management and a franchise that was too spread out to have much competitive advantage and it barely averted bankruptcy. Wells Fargo had both excellent management and a strong franchise, and got through it with just a few very bad quarters. In both cases, however(and this is finally the point here), they had huge recoveries that lasted three to four years. The OCC had gone so overboard on the required writedowns that both firms had no, that's zero, credit costs until 1994 or 1995. Running a credit business, which was primarily what banks were doing 15 years ago, with no losses leads to significant earnings. Again that's just accounting the finance guys would say, but those high accounting earnings led to increased regulatory capital which allowed meaningful increases in cash dividends to investors and lower borrowing costs on the interbank market and with counterparties.

Today it's the accounting regs and the accountants that are forcing writedowns that are unlikely to be realistic. When the turn comes in this market, the stage could be set for a rapid return to material earnings growth for the surviving financial institutions.

(Addendum: and what could be the solution while maintaining mark to market in normal markets---no mathematician or accountant here, but in markets without a critical mass of trades, definition needed, there could be writedowns from historical prices, say prices over one year or any recent period. The write downs could be a deviation from the historic price of x for two months, y for four months, and z for six months and after six months just the observable price. This is not the answer, just an example of what an answer designed to alleviate this problem could look like)

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