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Mark-to-Market Rule

THE mark-to-market accounting rules are being brought a little closer to economic reality — accompanied by misplaced howls of outrage. True, the ostensibly independent Financial Accounting Standards Board agreed to alter a portion of the rules only under extreme pressure. Still, the standards have forced many financial institutions to overstate losses on trillions of dollars worth of assets, intensifying the global financial crisis.


Defenders of the rules say they protect bank investors and changing them will allow institutions to hide future losses. To the contrary, they have helped drive down the value of bank stocks, made shorting the shares much easier and caused bank stockholders to lost hundreds of billions of dollars in such companies as Citigroup Inc. and Bank of America Corp. William M. Isaac, a former chairman of the Federal Deposit Insurance Corp., told a House Financial Services subcommittee “MTM accounting has destroyed well over $500 billion of capital in our financial system.”


Since capital can be leveraged about 10 times in making loans, the rules have destroyed over $5 trillion of lending capacity.


The problem with mark-to-market accounting is that it officially has presumed there’s a functioning market in whatever asset is being valued — and that means a deal between a willing buyer and seller that isn’t being forced to sell. Actually, no such market exists for many mortgage-backed securities.

DISTRESS SALE

Nevertheless, according to testimony, accountants have required many banks to calculate values based on distressed sale prices. That has meant large write downs even on mortgage-backed securities that the institutions intend to hold to maturity.


Take the case of the Federal Home Loan Bank of Atlanta. Following the mark-to-market rules, it wrote down the value of its portfolio of mortgage backed securities by $87.4 million in last year’s third quarter. Its actual projected loss on the securities: $44,000. For the fourth quarter the bank recorded a further $98.7 million loss on the securities.


That result makes no sense when the bank doesn’t trade such assets. However, if the current market value declines significantly and stays down for an extended period of time — a condition known as other-than-temporarily-impaired — mark-to- market has been required, a bank spokesman said.


A writedown might still be required under the changes FASB approved yesterday. Yet auditors can now use “significant professional judgment” when valuing illiquid securities. That’s what they should have been allowed to do all along.

CASH FLOW

The change will make it harder for accountants to continue to protect themselves from lawsuits by using some trade, no matter at what low price, to determine a security’s value. With the new leeway, the Atlanta bank should be able to value its mortgage-backed securities by calculating the expected cash flow — the monthly mortgage payments from homeowners — and applying an appropriate discount. That’s the approach the bank used to determine the $44,000 third-quarter loss.


The key points in this example are that almost all the mortgages involved are still performing and the bank plans to hold the securities to maturity — and yet large writedowns were required.
Think of it this way. There are millions of U.S. homeowners who are “underwater” with their mortgages. That is, they owe more than the value of the home in today’s depressed housing market.

PUTTING UP MONEY

That’s hardly good news, and it might make it impossible to refinance the mortgage because of the lack of equity. On the other hand, the house hasn’t changed. It’s still providing the same shelter and other amenities to the household, and if the family’s financial circumstances haven’t gone into a tailspin, the monthly mortgage payments can still be made.


The family doesn’t have to put up money to cover the difference between the mortgage and the lower market value. Nor should the Atlanta bank have to take a big hit on its reported income because some other mortgage-backed securities owner sold in a depressed market.


FASB wisely backed away from a tentative proposal to allow auditors to assume that limited trades in an inactive market were always distressed sales. That would have gone too far.


Now accountants are supposed to use their judgment in assessing the meaning of such trades. That’s a big improvement over just using the last transaction price, as many auditors have been doing.

RECOVERING WRITEDOWNS

Now FASB has to deal with how banks deal with recoveries of previous write downs due to other than-temporary-impairment losses when there’s evidence that loss is no longer there.


A March 27 letter sent jointly by the five federal regulators of financial institutions — the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corp., the National Credit Union Association and the Office of Thrift Supervision — urged FASB to add such a recovery to current earnings.


Since the losses were subtracted from earnings, that would be an equitable way for FASB to go — and soon.

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