The credit meltdown has spawned a few false villains, and one is "mark-to-market" accounting. Too many observers wrongly thought if we just suspend the accounting rule that requires financial firms to report certain investments at fair market value, then the crisis will go away.
What is mark-to-market accounting? The people who write and enforce our national accounting standards mandate that publicly traded financial companies must report some of their assets (things like mortgage-backed securities) and liabilities (like money they've borrowed from other institutions) at marked-to-market values.
That is, if you bought a certain security at $100 last year, but you can't find anyone to buy it this year for more than $40, you've got to report its worth as $40. Unless you plan to build a time machine, that's the fair-value market price it would command.
Financial institutions have reported many financial instruments this way for decades, usually because they wanted to. If much of your business is borrowing huge amounts of money and then buying and selling securities to exploit and magnify small price changes in those securities, then you've got to have a way of telling the world how much money you've made this quarter doing just that.
What's It Worth?
But no financial firm has to report all of its assets at fair value. What must be reported that way are things like derivative securities, securities purchased temporarilyor what an institution hoped was temporarilythrough constant trading techniques, and securities that companies have designated as "available for sale."
If a bank always planned to sell a particular security pretty fast and was, in fact, depending on the money from that sale to continue funding its operations and churning out profits, it should value that security at what it's worth right now.
When it comes to long-term investments, financial firms have more discretion. In most cases, if a bank had always planned to hold a security to maturity, it doesn't have to pay much attention to those fair values.
There is a big exception, though: If the bank believes that that long-term investment is permanently impaired, it must subtract that impairment from the long-term value. But even then, an institution doesn't have to write these long-term securities down to immediate market values; it only has to write them down to, say, the expected value of the remaining good mortgages in the security.
So what's all this talk about fair-value rules being new and somehow precipitating or at least exacerbating the current crisis? In truth, the only new wrinkle came last November, when the accounting-standards people issued new guidelines for how to measure fair value. They didn't issue a new fair-value requirement.
Around the same time, the markets for the most opaque, complex securities were seizing up. Whereas once you could instantly find hundreds of thousands of buyers for mortgage-backed securities close to the prices at which the securities were issued, nobody wants them anymoreat least not without weeks of scrutiny, and certainly not at the price the banks want to sell them.
In demonizing fair-value rules, critics say that the standards have spawned write-down after write-down, causing yet more losses at financial institutions that use their peers' values as guidelines, and causing more investors to flee, escalating the losses and causing big firms to fail.
No one doubts that we're experiencing a crisis in confidence in asset values, but fair-value accounting didn't cause it. It could have been stopped only by the banks themselves. They could have chosen, starting more than two decades ago, to be in the long-term investment business rather than in the short-term, exotic-security creation and trading business.
People who say that it's not proper to value a long-term asset at today's value miss the point. Most such assets were never meant to be long-term investments for the banks that had just issued them or still held them when the credit crisis struck.
Suspending the rules won't slow this crisis. With or without the rules, nobody knows what certain securities are worth. Investors didn't short Lehman Brothers' stock because the company had written its opaque securities down to zero (it hadn't). They shorted Lehman partly because they didn't think that it had written such securities down far enough.
As for the charge that it's ridiculous to value some mortgages at 22% on the dollar, as a buyer for Merrill Lynch securities did, and that fair-value accounting helps to create the absurdity: maybe, maybe not.
The stark truth is that when you consider that banks wrote mortgages against houses that may have been more than 100% overvalued, and when you consider how much it costs such institutions to foreclose on a house and maintain it for a few months or longer before sale in a tough market, it's easy to see how values get down to less than half. Subtract some more money for uncertaintywhich markets do all the timeand you're down to 22%.
Finally, even if standard bearers and regulators suspended fair-market rules today, banks would still be wedded to fair-market principles, at least until all of today's complex securities are unwound. Consider credit-derivative securities, a form of insurance against debt default.
No Risk-Free Trades
AIG, which holds half a trillion dollars in such obligations, would have gone bankrupt last week without government help. But AIG's problem wasn't some accounting rules. Even without them, AIG's trading partners would have demanded higher cash collateral from the firm as ratings agencies downgraded the firm, due in part to their own private assessments of the chance that AIG would actually have to pay out on those claims.
The same was true at firm after firm: Risks increased and counterparties demanded more cash, as called for in private contracts.
The only thing that was wrong with "fair value" accounting was that it was a mirror of the modern financial industry. Financial institutions thought that they could trade anything, anywhere, at anytime, safely and virtually risk-free and for an instant profit. They couldn't.
But the anti-"mark-to-market" crowd may well get its wish, because investors will regard the business behind such rules more carefully. Financial institutions needed money from the outside world to create all of those fair-value investments. It's unlikely they'll replenish their now-depleted coffers to do the same thing in the future, because investors now understand what complex securities and assets structured to trade instantaneously donot only on their way up, but on their way down.
Original Source: http://www.investors.com/editorial/editorialcontent.asp?secid=1502&status=article&id=307234083390870