FASB Roundup: Mark-to-Market, Or Cash for Trash?

In recent years, accounting has gone from occupying a drab back-office function in investment banking to claiming center-stage presence.

Today it was right in the eye of the headlines again, as the Financial Accounting Standards Board, which sets U.S. accounting rules, met to approve changes in accounting rules aimed at reducing losses banks have been forced to report in the wake of the subprime crisis.

FASB (pronounced fas-bee) ruled that banks can now use “significant” judgment in valuing assets to reduce writedowns on certain investments, including mortgage-backed securities. In other words, banks that hold the toxic derivatives can now ascribe their own price to them, and report those self-assessed valuations in their financial statements when it comes to reporting time. Previously, they had to report the value of the assets as the best price a buyer in the market was willing to pay for them.

The key proponents of the changes have, unsurprisingly, been the banks themselves. Citigroup, Bank of America, and Wells Fargo have been the loudest of the lobbiers. As a result, they now stand to receive a surprise first quarter earnings boost — as much as a 20 percent mark-up in Citigroup’s case.

The banks’ argument for the change centered on the premise that mark-to-market accounting makes no sense if there are no buyers. Instead, they should be able to use proprietary financial models to ascribe their own valuations to such assets, they claimed. Thursday, FASB acknowledged its deference.

Volatile Market Reactions

Like all accounting issues in the past few years, the move generated huge controversy. “Back to Square One?” asked BusinessWeek, referring to the pre-2007 rules where banks had much more internal discretion about what stayed on and off their balance sheets. The article puts the pros and cons succinctly:

The move may make life easier for financial institutions, letting them ride the markets’ gyrations with less risk that regulators will demand they raise funds or face foreclosure. But at the same time, it could well cloud investors’ insight into how well the banks are really doing.

Other market participants concur. “We still know the ’stuff’ is on the balance sheets and if the financials are actually allowed to adjust capital based on unreal marks then who will ever buy financials again,” writes Tim Backshall, chief strategist at research firm Credit Derivatives Research, according to Reuters.

Former SEC Chairman Arthur Levitt (pictured), now a senior advisor at Carlyle Group, told Bloomberg: “What disturbs me most about the FASB action is they appear to be bowing to outrageous threats from members of Congress who are beholden to corporate supporters.” Levitt was one of those mainly responsible for the introduction of mark-to-market accounting.

“I really can’t believe this will bring liquidity back into the market or confidence back into the banks,” wrote Martin Marnick, director of Japanese and Asian trading specialist Helmsman Global Trading, in a note to the firms’ hedge fund clients Thursday morning.

But others are equally in favor of the new ruling.

“This is something that should have been done 18 months ago, and it would have saved taxpayers around a trillion dollars. Our view is that the mark-to-market rules are one of underlying causes of the crisis,” says Paul Mendelsohn, chief investment strategist at Windham Financial in Vermont.

“By changing the rules it gives the banks the ability to mark [the assets] to what is a reasonable market: these securities have intrinsic value,” adds Mendelsohn.

For & Against

The cases for and against both have merits. The new accounting rules do put the burden of responsibility to accurately report the values of mortgage-backed assets on the banks themselves, creating a potential conflict of interest. And it’s questionable how much of real income financial institutions will be declaring as “profit” come first quarter earnings.

Then again, that’s what regulators are for: to make sure that such reports are “accurate.” Furthermore, no matter what their various intrinsic values, the assets on the balance sheets of the big banks are unlikely to find much of a market unless they have at least some perceived value to potential buyers.

One solution may be to dispense with mark-to-market accounting, as FASB has, up until the point where a market forms for the assets — and then revert back to it. But just try getting that proposal through Congress.

Update: My BNET Finance colleague Marine Cole thinks the whole FASB thing has been overblown.