Debate: Mark-to-Market Accounting
We have once again eavesdropped on what our Zacks Equity Research senior analysts have been discussing with one another lately. The most recent topic? The proposed suspension of "mark-to-market" accounting (that is, the assigning of value based on an item's current market price):
Dirk van Dijk, CFA, Director of Zacks Equity Research: I'm not sure how many accounting principals are more fundamental than "lower of cost or market." There are some transactions being done between willing buyers and sellers. That is the best way of finding out what the "true" value of something is. Suspending mark-to-market is just an attempt to hide the real condition of the banks -- it allows them to pretend that the garbage on their books is really gold.
Isn't misrepresenting the values on your books the very core of the idea of securities fraud? That is all that doing away with mark to market would be, legalizing and legitimatizing securities fraud.
Jason Napodano, CFA, senior drug industry analyst: I'm not sure what transactions you're talking about, Dirk, but from what I've heard the market for these types of securities is completely illiquid.
It's impossible to mark-to-market when you have absolutely no idea what the market is. There's got to be a better option than, "No one is buying it, so it must be worth zero" mentality. Bernanke and Paulson both stated they would probably buy many of these securities at prices above what is being marked on banks' balance sheets right now. If we can come up with a reasonable pricing mechanism for the value of stock options, then a similar formula should be able to be put into place to calculate the value of mortgage-backed securities.
Prices are artificially low due to a combination of fear and illiquidity. I suspect that if all these funds were held to maturity, they would return far greater value then their current mark-to-market price.
Sean P. Smith, senior travel & leisure industry analyst: There has been a market for these securities, just not one to which the banks have been willing to mark their assets.
At the end of July, Merrill (MER) agreed to sell $30.6 billion gross notional amount of CDOs [collateralized debt obligations] to Lone Star Funds for $6.7 billion. That would equate to roughly $0.22 on the dollar. However, to complete the deal, Merrill had to provide financing to Lone Star for 75% of the purchase (approximately $5 billion).
The loan was non-recourse, meaning Lone Star could put the CDOs back to Merrill should the CDOs deteriorate, and Lone Star would only be out the $1.7 billion in equity it put up. In essence, Lone Star paid about $0.055 on the dollar.
I doubt things have improved in the last two months.
Ann Northrop, CFA, senior communications and restaurant industries analyst: I thought Jeff Diermeier, CEO of the CFA Institute, summed it up well in his September 23rd letter to legislators and regulators. He argued for mark-to-market accounting with optional disclosure of alternative valuation criteria, such as companies that report certain cash flow metrics or EBITDA do now.
He went on to posit that it is capital adequacy and not reporting requirements that should be flexible in chaotic financial times. Here is an excerpt and the link to the letter follows:
"Complaints about fair value arise largely in the context of their impact on capital adequacy. Rather than suspending fair value and thereby the transparency and relevance of financial information, perhaps the focus should instead be on flexibility in capital adequacy requirements in times of distress. This is a much more direct and transparent means of dealing with the capital issues."
http://www.cfainstitute.org/centre/topics/comment/2008/080923.html
Eric Rothmann, senior financials and insurance industries analyst: The one place that we should never be "flexible" is capital adequacy. If there was more emphasis on the quality and quantity of capital, the taxpayers would in all likelihood be on the hood for a lot less.
Ann Northrop: Looks like the SEC has eased mark-to-market accounting.
http://news.yahoo.com/s/nm/20081001/bs_nm/us_usa_accounting_sec
Dirk van Dijk: "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."
Yeah, the best way to provide transparency is to paint over the windows with black paint and then hang heavy curtains in front of them.
Ann Northrop: Looks like they're paving the road to the next disaster. In the meantime, I would imagine this will greatly reduce the multiple investors are willing to pay for bank stocks. How can anyone know what they are really buying? (Thanks, Ann, for passing this along to all of us.)