Dear Minyan Peter,

Why won't the government just change the accounting from mark-to-market to cost and accrual? Wouldn't this avoid the huge writedowns and federal fundings? Why aren't they doing this in lieu of spending more and more?

Any help on this would be greatly appreciated,
Minyan Greg


Dear Minyan Greg,

My guess is that it has a lot to do with the accounting industry.

For a long time, marked-to-market accounting was used by a very limited number of participants - largely brokerage firms and investment managers. The accounting industry generally felt no reserves were required for marked-to-market assets, because securities were liquid, and there were readily available prices. Furthermore, the holding enterprise sought to sell or trade the securities prior to maturity.

So, for prospective investors in the enterprise, the market price represented the best price for evaluating the company's financial condition.

With the consolidation of banks and brokerages -- and, more importantly, the advent of securitization -- more and more loans and other financial assets were transformed into "securities."

Financial firms argued that, since they intended to sell and trade these new kinds of securities, the securities should enjoy the marked-to-market accounting treatment. And the fact that firms did not need to hold reserves on all these securities only made firms argue louder for the highly capital efficient treatment.

The result, not surprisingly, was a huge increase in not just the percentage of assets marked-to-market, but an increase in the overall size of balance sheets, as well.

Now the accounting industry feels like they were taken for patsies - especially when firms stepped up and guaranteed the debt of "off-balance sheet" SPVs. Liquidity was a mirage, and the intention to sell was suspect at best.

And if you look at the rush of firms moving assets (particularly instruments like Fannie (FNM) and Freddie (FRE) preferreds) out of marked-to-market accounting into held-to-maturity hoping to outlast the storm, you can see why the accountants might be more than a little peeved.

My sense is that the accounting industry is telling the banking regulators and the SEC that it's fine if the government wants to suspend marked-to-market accounting - but firms had better set up adequate reserves for the entire remaining life of these heretofore-marked securities and loans, and be prepared to add to those reserves if the economy worsens. Otherwise, the accountants won't sign clean audit opinions.

And this is where the rubber meets the road. The regulators know the assets (particularly the funky tranches of CDOs, CLOs, etc.) aren't adequately reserved for tough times (if they were, would you really need to stress-test the banks?).

So the stand-off continues. And unless the government is prepared to hold accounting firms blameless from lawsuits, I think the stand-off is likely to continue indefinitely.

Sincerely,
Minyan Peter