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Fools Rush in to Ease Mark-to-Market Rules

University of Kentucky finance professor Joe Peek filed this guest blog post:

As financial commentator Abraham Briloff famously noted, financial statements are like fine perfume: To be sniffed, but not swallowed.

Such advice is even more relevant today with the recent easing of mark-to-market rules for banks. A quick look shows that the market is not fooled by the accounting numbers on bank balance sheets. For example, even after the recent run-up in bank stock prices, Citigroup and Bank of America have price-to-book ratios of only about 0.25 and 0.30, respectively. In other words, even though balance sheet values are evidently now in the eye of the holder, investors are not swallowing it.

Given that accounting gimmicks magnified the ultimate losses from our savings and loan crisis and, more recently, Japan’s banking crisis is there any reason to believe that this time will be different? My guess: Third time's a harm, too.

So why did bankers lobby for, and accounting standard-setters acquiesce to, the easing of mark-to-market rules that give banks much more discretion in valuing assets and liabilities on their balance sheets?

One justification for the accounting changes is that the complicated financial instruments on bank balance sheets are too difficult to value. Further, the argument runs, current transaction prices are well below “fundamental” values for these instruments due to illiquidity in their markets. But what is really changed by allowing banks to carry their “toxic” assets on their balance sheets at higher prices? After all, banking organizations already are being marked to market every day by investors, a task much more complicated than valuing individual “difficult to value” financial instruments.

While marking, or not marking, a bank’s balance sheet to market will not directly change the economic values of its assets and liabilities, indirect effects may arise. First, easing mark-to-market rules reduces transparency. Bank market values may be reduced as investors use a higher discount rate to value banks due to the increased uncertainty surrounding asset and liability values. In fact, hasn’t much of the problem of illiquidity in credit markets emanated from opaqueness and the associated uncertainty?

Another cost arises because allowing banks to delay or avoid marking down the values of their toxic assets will impede the federal government’s recently announced Public-Private Investment Program.

Already, many banks are reluctant to sell their impaired assets because doing so would force them to acknowledge losses hidden (albeit in plain sight) on their balance sheets. Marking assets to market would actually provide banks with an incentive to sell toxic assets through the government program, which would then produce capital gains for the sellers by generating above-market prices. Bank assets sold through the program will command higher prices because the value will be based on a package that includes the toxic assets, favorable government financing, and the ability to shift most of the risk to taxpayers, each of which contributes to the price an investor is willing to pay.

A third cost is the loss in confidence by investors who might fear that policy makers are not taking appropriate steps to address the underlying problems as the seriousness of the crisis (artificially) recedes. During the “Lost Decade” in Japan, banks and bank regulators insisted on announcing numbers for bank capital and problem loans that had little, if any, attachment to reality. More than a decade of malaise resulted as policy makers continually delayed addressing the real problems.

So why would bank regulators go along with allowing banks to “Enronize” their balance sheets? Following our last financial debacle, Congress passed Prompt Corrective Action legislation precisely to limit regulatory discretion and force regulators to do their job. But easing mark-to-market rules provides regulatory cover because these regulations are based on balance sheet numbers.

Are there other winners, such as bank stockholders and creditors? Possibly.

Bank values may rise if the perceived likelihood that bank regulators will close or nationalize “problem banks” has declined, thereby reducing uncertainties, and thus counter-party risk. Troubled banks would now be perceived as having an increased probability of receiving a taxpayer-funded bailout.

But if the real source of any increase in value is a signal about the extent to which bank supervisors will refrain from stringently applying regulatory conditions, is there another, perhaps better, way? Perhaps mark-to-market accounting in combination with an explicit statement by regulators about their forbearance policies might actually increase the market values of banks. By reducing uncertainty about both the market value of bank assets and liabilities and about government policies, bank stocks may rise as investors view them as less risky.

Policy makers now have an opportunity to increase transparency and rebuild credibility, both of which have been damaged as policy makers have had to focus on a series of immediate crises without the luxury to think through all of the implications. Now is the time for clarity.

Much like in Japan, U.S. policy makers have made efforts to avoid distinguishing among banks, for example, forcing all of the largest banks to accept billions of dollars of Troubled Assets Relief Program funds. The stress tests for the 19 largest banks provide policy makers with an opportunity for a “do over.” The results of the stress tests must be based on market values and whether the banks are truly economically viable. Government capital should not be injected into banks indiscriminately; only the strong should survive. We need disclosure, as well as closure, if a bank either is not viable or cannot raise sufficient private-sector capital to become viable.

The time has come for transparency to replace the “parency” of government support of non-viable firms, financial or non-financial. The “convoy system” did not work in Japan during their “Lost Decade,” and should not be expected to work here.

--Joe Peek, professor of finance, University of Kentucky School of Management

By Sara Goo  |  April 28, 2009; 12:10 PM ET
Categories:  TARP  
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Comments

Professor, arguing mark-to-market accounting yields transparency; what’s next, arguing the tooth fairy should leave more money under pillows since the government is partially funding this endeavor. Bring 10 of your best M.B.A.s in a room, 10 well known financial gurus a la Cramer and Motley Fool, give them a public company’s financial statement and let them answer a series of questions about the balance sheet and income statement. You will see how difficult it is for a sophisticated person to analyze a financial statement properly. It is almost impossible for a lay person to do so. Mark-to-market is not an answer, or a means of replacing the “parency” you reference. For additional insight into this and other financial matters see www.bobgreenfest.wordpress.com.

Posted by: thefest | April 28, 2009 2:44 PM | Report abuse

An interesting thought just occurred to me after reviewing today's release of the Feb. '09 Case-Shiler house-price data.

What if the tremendous discounts demanded by buyers of MBS from the day the market "failed to clear" to today turn out to have been in the right ballpark all along? What if there was no "market failure" on the buyer's side, but merely a failure to face reality and write down losses on the seller's side? What would the implication be for the policies that are being enacted today?

In the CS data there are some signs of stability in cities that never experienced stratospheric bubbles, but there are still some amazing declines. Here are the most pronounced declines from Jan 09 to Feb 09, at an annualized rate.

Atlanta: -38%
San Fran: -38%
Phoenix: -35%
Las Vegas: -29%
Detroit: -26%
San Diego: -26%
LA: -26%

Now I don't think that house prices will actually decline that much in those cities over the next 12 months or until "the bottom" (except, perhaps, in poor Detroit). However, and for the sake of argument, let's assume that they will.

Wouldn't that mean that PPIP is completely unnecessary - because there are already plenty of buyers for the "toxic legacy assets" - they are just demanding a fair rate of return on a risky and likely loss-heavy investment? What are your thoughts?

Posted by: Indy2009 | April 28, 2009 5:42 PM | Report abuse

So if companies don't mark to market, what do they mark to--their dreams? Steve Forbes advocates abandoning mark-to-market, and who does he cite as an authority? FDR of all people. When was the last time Steve Forbes (or anyone at Forbes) used FDR as an authority on how to run the economy? Of course, mark-to-market may be imperfect, but what is the alternative? If the banks used purchase price, we all know that the asset values on the books would be wildly overstated. If they used some form of mark-to-model, they could essentially use whatever model would give them the values they wanted. It seems the banks love the free mark--except when it doesn't give them the the numbers they want it to give them.

Posted by: blindgren6 | April 29, 2009 3:40 PM | Report abuse

It seems like many people are assuming that a portion of the assets on bank balance sheets are "toxic" and the rest are not "toxic." Many even seem to imply that only assets based on sub-prime loans or only those that are CDOs are toxic.

Are those good assumptions? Is it knowable? I am asking because I do not know the answer.

But what if ALL mortgage related assets, including individual loans originated and held by the same bank are in most cases severely over-valued on banks balance sheets? That would certainly explain a lot of the recent behavior of the banks and of Treasury and the FED.

Has this already been answered and I missed it?

Posted by: LMM1 | May 3, 2009 7:00 AM | Report abuse

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