Don't Shoot the Messenger

10/23/2008 2:36 pm EST


Howard Gold

Founder & President, GoldenEgg Investing

There are many, many culprits in the financial crisis that has engulfed the world. But some people have honed in on a most unlikely candidate-fair value or "mark to market" accounting.

Their claim: by requiring financial institutions to mark down loans and derivatives to their current market value, auditors and regulators are forcing them to record artificially low values for these assets.

They argue that this drives down the value of these companies, prompting rating downgrades, runs on their stock prices, and perhaps bankruptcy or government seizure.

Banking lobbyists are working overtime in Washington, DC and Brussels to hammer home that point. While taxpayers lavish hundreds of billions of dollars on teetering financial institutions, the banks are asking for more forbearance, more flexibility, more time, to work out the problems they created.

And that's despite some moves regulators have already made to relax standards during the current crisis.

Meanwhile, big accounting firms, institutional investors, and financial analysts have come out strongly against any watering down of the rule.

The battle is pretty fierce for such an arcane issue-and it's important. This is about how much these banks and the toxic paper they hold are worth, and how much we, the taxpayers, will have to pay to save the financial system from catastrophe.

But let me first explain briefly what the issues are.

The Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB) have adopted standards for measuring the "fair value" of various financial instruments.

It required financial institutions to adjust the value of assets and liabilities regularly to reflect changing market prices, rather than carry them on their books at historic cost-the traditional, but flawed, method of valuing them.

When asset values were rising, mark-to-market accounting boosted book values and earnings (when banks sold assets at a profit), and everybody was happy.

But that all changed when the financial crisis hit. Banks had to write down the value of some financial instruments on their books, and as institutions like Lehman Brothers failed, some of those assets took a big hit, reducing capital to dangerously low levels.

The lack of liquidity made pricing these instruments difficult, if not impossible. Valuing some of these complex derivatives was basically guesswork.

That's why the bankers asked for-and got-some flexibility in carrying out the rule.

"When you're dealing with an illiquid market that's in distress, fair value throws gasoline on the problem," says Jonathan Snowling, spokesman for the American Bankers Association, which has pushed to include other things, like cash flow, in valuing assets.

Some experts have even recommended letting banks declare they're holding these assets to maturity and amortize them (write them off) over several years, so some of the value can be recovered when markets rebound.

But there are lots of problems with that. 

Credit default swaps (CDSs), collateralized debt obligations (CDOs), and the whole alphabet soup of convoluted derivatives Wall Street's geniuses cooked up were never meant to be held to maturity the way savings & loans held home mortgages or banks hold commercial real estate loans in their portfolios.

They were trading instruments, parts of complex hedging strategies, fee-generating vehicles, and much of the time they were buried in small-print footnotes that nobody reads but that always seem to come back to haunt us.

Also, we are beginning to see a market for subprime mortgage-backed securities and other derivatives. A couple of months ago, Merrill Lynch (NYSE: MER) sold a slug of them for 22 cents on the dollar, and a recent auction of bankrupt Lehman's CDSs netted 8.625 cents on the dollar.

Shockingly, painfully low? Yes. But at least it is a market, so we know roughly what they're worth now. 

And sure, these may be fire-sale prices, but if we held the wrong side of a credit default swap on Lehman, would it really be worth more in three to five years? No way.

Or how about a package of securities featuring subprime mortgages on homes in Merced, Calif., Las Vegas, or Fort Myers, Florida? As foreclosure rates rise and projected future cash flows on those mortgages sink, don't expect the value of these securities to increase much when the acute phase of the crisis ends.

And now that the governments of most of the big industrialized countries have basically nationalized their financial institutions to save them, it's kind of moot anyway.

The US Treasury, the Federal Reserve, the Bank of England, and the finance ministries and central banks of major European countries now have the authority and the cash to bail out any major bank that has taken a hit on the bad assets on its books. The US government has already injected $250 billion into some of the biggest US banks. So, for all intents and purposes, the current market value of certain assets doesn't really matter, because the government is backing the institutions that own them.

Which gets us to the final point: now that the government is preparing to buy up hundreds of billions of dollars of toxic debt under the Troubled Asset Relief Program (TARP), US taxpayers have a vested interest in getting the best possible price for them.

And shouldn't banks that are now partially owned by US taxpayers have to carry these assets at their true value so we know how much we're getting for our money?

Because ultimately financial statements are meant for the users-investors and analysts-not the managements that issue them.

We've been through two decades in which corporations have lobbied extensively for weaker financial reporting-from technology companies trying to prevent the expensing of stock options; to Enron's various shenanigans, to the current financial crisis, caused by the very toxic paper Wall Street struggled to keep off its balance sheets.

How did those efforts end up? Not so well. Maybe this time we should try telling the truth for a change.

Howard R. Gold is executive editor of The opinions expressed here are his own and do not necessarily reflect the views of InterShow or