Mar

7

Most of us have heard the proposal that we should temporarily ban "mark to market" rules as a quick fix to the current crisis. But FASB, the accounting rule making body, is opposed to this. Further, many agree in principle, rightfully in my opinion, saying company accounting should fully recognize the reality of the market place. However, many conclude this by saying this means use "mark to market" accounting. It is obvious to all that deal with many of these markets that the securities have a very thin or frozen market. I would argue this just as real and even more obvious that what the "market" price is…

Many have blamed the new accounting rule FAS 157, for these frozen markets. I blame the implementation of FAS 157, not the rule. While a subtle difference, this suggest a fairly simple but decisive solution to the problem.

The problem with FAS 157 is that we don't have any disinterested party determining what is an "Active Market" or what is an "Inactive Market". By the current guidelines, a company "marks to market" any security in an "active market"… And is required to use a "mark to model" approach for a security in an "Inactive Market" . The "market to market" approach uses similar securities that traded to determine a price. A "mark to model" uses an expected cash flow, with an interest discount that incorporates an appropriate risk premium for those cash flows.

Theoretically the difference between these values is the liquidity premium.

The financial companies would like to mark-to-a-model everything that has an implied Market Value they do not like…One that is lower than their model's valuation.

The auditors would like to declare anything that has a poor market value active, no matter how thin the actual trading is on these securities and how big a "fire sale" that similar traded security was.

The auditors will win this argument.

The consequence is that what should in a reality based world be "marked to models" becomes "marked to market". This inability to quickly recognize "Inactive Market" in the accounting world makes market liquidity premiums grow quickly in any market beginning to freeze. Further, the frozen market hogs capital and makes it  more difficult for institutions to keep trading in other markets. This quickly makes frozen markets spread like a contagious disease in the real world.

This suggest a simple response: make the accounting world more quickly recognize an "inactive market" before it spreads.

The obvious solution is enable financial companies to have a swift and responsive arbiter of these conflicts. They should have a disinterested third party organization with authority to declare securities as being in "active" or "inactive" markets. This organization would swiftly determine and issue updated rulings for what securities should be "marked to market" or "marked to model".

Who should do this ? The rating agencies would be the obvious choice. The SEC gave the rating agencies power by creating the "Nationally Recognized Statistical Rating Organization for this very reason (needing a 3rd party to legally determine credit worthiness) in 1975 for capital requirement ratings. This prevents them from being sued by either party, i.e. the investor or the company being rated.

This is a simple proposal, that could quickly to be implemented without either side admitting a mistake or revising what guidance they already provided. Now if the SEC, the rating agencies and financial regulators of the financial industry are up to the task of implementing this quickly and with the needed responsiveness, there is another battle of redesigning their incentive structure that is best left to another day.

The current default alternative, of leaving everything as is, will destroy many if not most of the financial companies and require us to start anew. But this new financial market will be one with little money available for illiquid assets. Nor will it have a stomach for assets that are liquid but can become illiquid in a matter of months… like home loans.


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2 Comments so far

  1. michael webster on March 7, 2009 3:22 pm

    Wouldn’t the correct approach be, similar to what was done in the Savings and Loan industry, to employ regulatory capital? Require that banks with diminishing capital borrow from the Fed sufficient regulatory capital, or notational capital, to meet their margin requirements. These loans would have to be paid back, and the regulatory capital would not be an asset on their books. (At least that is how I recollect how the Savings and Loan Bailout worked.)

  2. steve on March 7, 2009 3:26 pm

    If I could give one piece of advice to the SEC or any other government agency, it is do you job to the best of your ability and with the resources you are currently given. Come to work every day prepared to enforce laws already on the books, chase down the bad guys and girls and prosecute to the full extent of the law.

    If you do that many of the challenges and problems we face today would not happen in the future.

    But who in Washington ever cared what a schnook like me ever had to say.

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