Disappointing “Tweak” for Mark-to-Market Rules?

The equity markets have responded dramatically to any prospect of change in mark-to-market rules.  The reason is the perceived need to restore normal and sensible lending.  Current weakness in the financials is linked to questions about capital adequacy.

Regardless of one’s opinion about mark-to-market, it is an issue demanding the attention of all investors and traders.

Background

There are several key considerations.

1. Writing down existing assets diminishes regulatory capital for financial institutions.  This creates the need to raise more capital in adverse situations and/or seek more government funds.
2. The pressure on capital hurts the ability to do normal lending, increasing requirements on borrowers.
3. Geithner’s announcement of limited TARP funds for banks — $135 B or so — an amount which seems inadequate to many observers.
4. Many skeptics believe that the PPIP will not succeed in leveraging these funds for a satisfactory solution to the distressed assets problem.

The FASB Tweak

Under pressure from Congress, FASB is offering a belated and partial solution, the latest in a series of clarifications.  The public comment period ends Wednesday, with a vote on Thursday.

Bob McTeer, in yet another excellent article on the topic points out the shortcoming in the FASB relief, limited to future accounting periods and ignoring those of the recent past.  He writes as follows:

Banks have lost billions of dollars of capital unnecessarily and unfairly from accounting rules that never should have applied to commercial banks in the first place. It would have been easy and only fair to allow them to correct the last few quarters. Instead, FASB offers no relief to banks near the brink because of faulty accounting rules.

It makes no sense to me for FASB to “fix” the accounting rules, but limit the fix to future applications only. What can possibly be the argument against correcting the mistakes of the recent past?

If a cure for cancer is discovered, should it apply only to those who get cancer in the future even though the cure is readily available now? If DNA evidence proved the innocence of a wrongly imprisoned inmate, I expect the court would not wait until the “next quarter” to release him. Is the same too much to ask of the high court of accounting?

The McTeer question is excellent.  The decision seems inconsistent.

McTeer also cites supporting testimony from former FDIC Chair William Isaac, a strong and articulate supporter of modification in these rules.  Isaac writes as follows:

2. The OTTI proposal applies only to new OTTI incurred in 2009 rather than to assets held on the books against which OTTI charges were taken in prior years. This is an extremely important issue. Prior to 2009, many entities took large MTM losses based on accounting practices that even the SEC acknowledged were wrong (see SEC letter to FASB dated October 14, 2008, requesting that FASB address this expeditiously). If the FASB had acted quickly as requested by the SEC, then these MTM paper losses would not have been recorded in earnings. The final rule on OTTI should apply to any OTTI assets on the books of the bank, which will restore capital improperly destroyed by MTM accounting rules in earlier periods.

3. Finally, the OTTI proposal does not allow reversal of the mark-downs if asset quality or market value improves. The proposal requires the MTM losses to be accreted back to the asset value over the life of the security. Instead of using the correct value upfront, capital is destroyed massively upfront and then corrected over time. This makes no sense and is exceptionally harmful to the banking system and the economy.

Conclusion

Even the “best case” decision by FASB is not going to address the basic problem.  The Treasury Department under Geithner shows no inclination to grant regulatory capital relief.  The SEC under Schapiro is deferring to FASB.

The failure of the Obama Administration to recognize the ebb and flow of assets based upon these marks imperils all of their other programs.

It is difficult to make progress on housing and the economy when credit markets are strangled.