Accounting our way out of the mess..

The SEC is slowly waking up to what has been going on and moving another inch. This time on an accounting rule that according to some, has played an important role in the current financial malaise (we’ve written before on this). Mark-to-market, the requirement to mark even the most arcane and illiquid assets at market price, which leads to capital shortages and big problems in many financial institutions.

The essence of the Paulson plan is that the frozen markets trading the arcane, mortgage related securities can be slapped back out of their irrational stupor by the Treasury acting as a big buyer. That would market participants realize that these prices (if they trade at all), are way too low, and ‘normal’ market conditions would prevail again. The Treasury essentially helps the markets in ‘price discovery‘ and that discovery will lead that prices are too low, they will rise, and so will the book values of financial institutions.

Ending the ‘mark-to-market’ rule would offer something of a short-cut. Financial institutions are in such problems because they are forced by this rule to value these securities at these irrationally low prices. Just change the rule, and voilà, books will be restored.

There is some logic to this. markets for financial products are prone to cycles of irrational exuberance and gloom. Books of financial institutions should not necessarily follow every twist and turn, especially if that leads to real consequences (irrationally ballooned books in times of exuberance, and shrinking books in depressed times, reinforcing the process as exuberance leads to more risk taking and depression to less and forced asset sales, depressing values even more).

The SEC now seems a little bit receptive to these arguments:

SEC gives banks more leeway on mark-to-market

  • WASHINGTON (Reuters) – U.S. securities regulators on Tuesday gave the financial industry a reprieve from marking hard-to-value assets down to fire sale prices, throwing a lifeline to an industry beset by strained credit markets and the latest round of bank failures.
  • The U.S. stock market added to gains on the news, in hopes that regulators’ new interpretation of fair value, or mark-to-market, accounting rules, will slow or reverse the heavy flow of mortgage-related losses on banks’ balance sheets.
  • In the new guidance, first reported by Reuters, the U.S. Securities and Exchange Commission reminded financial services firms that they don’t need to use fire sale prices when evaluating their hard to price assets.
  • This is a significant first step and adds stability, confidence, and liquidity within the capital markets,” said Steve Bartlett, president and chief executive of The Financial Services Roundtable. “By clarifying how to treat assets in an uncertain market, the SEC is continuing to provide transparency to investors and helping institutions to provide credit in periods of market stress.”
  • U.S. accounting rule maker, the Financial Accounting Standards Board said on its Web site on Tuesday that it would change the agenda for its Wednesday meeting to focus on fair value accounting. The board is contemplating issuing additional guidance through a FASB staff position as soon as Wednesday, according to a person familiar with the matter.
  • The SEC’s guidance on Tuesday, came on the last day of the third quarter for most U.S. companies, allowing them to incorporate the changes in their next round of financial statements.
  • In a document on the matter, the SEC reaffirmed that management’s internal assumptions can be used to measure fair value when relevant market evidence does not exist.
  • U.S. accounting rule makers assume that the factors used to come up with fair values are based on an orderly transaction between willing market participants. The SEC document said that “distressed or forced liquidation sales are not orderly transactions.”
  • “This guidance will help auditors more accurately price assets that are difficult to value under current market conditions,” said Edward Yingling, president and chief executive of the American Bankers Association, whose group has been among several pressuring the SEC to clarify the rules for months.
  • Under U.S. accounting rules, assets can be valued based on a simple price quote in an active market. But the hardest to value assets are often based entirely on management’s best estimate derived from mathematical models.
  • However, as credit markets seized up this year, many banks were forced to rely on models to value complex mortgage securities that used to trade in more active markets. Critics have complained that accountants forced banks to base their values on fire sale prices in illiquid markets instead of the so-called level 3 input, or unobservable factors, such as the mathematical models used to evaluate their securities.
  • The SEC’s guidance says that sometimes the level 3 inputs may be more appropriate than the so-called level 2, or observable factors.
  • In essence, the SEC wants to stop the avalanche of declining prices,” said Tom Sowanick, chief investment officer at Clearbrook Financial. Sowanick said that the new guidance should allow banks to rely more on their own assumptions when they determine fair value rather than the distressed sale prices occurring in the markets.
  • But fair value accounting has been popular with many investors who said it greatly increased transparency about the risks banks are facing.
  • This letter (SEC document) could be titled, pick a number, any number, as it gives bankers great leeway in choosing what numbers they will give to investors,” said Lynn Turner, who served as chief accountant at the SEC from 1998 through 2001.
  • Others, however, said that the changes have not gone far enough.
  • In a letter to SEC Chairman Christopher Cox on Tuesday a bipartisan group of more than 60 U.S. lawmakers urged the SEC to suspend the fair value accounting rule immediately.
  • “Fair value accounting is a utopian dream that ran into the reality of business and litigation,” said Chris Whalen, co-founder of Institutional Risk Analytics, which provides ratings and analytical tools to investors.
  • “Equating an opinion with a market price is crazy,” he continued. “It doesn’t matter who gives the opinion — the auditor is still going to say to the client, ‘Why don’t you write it down?'”
  • Under U.S. accounting rules, a “Level 1” asset can be marked-to-market based on a simple price quote in an active market. However, the price of a “Level 2” asset is “mark-to-model” and is estimated based on observable market prices and inputs. A “Level 3” asset is so illiquid that its value is based entirely on management’s best estimate derived from complex mathematical models.

It sure did help the markets today though!