Thursday, April 2, 2009

Mark to Market Relaxation

In other news the Financial Accounting Standards Board today voted to grant more freedom to financial institions to use fair value accounting for marking assets whos markets are thinly traded. Congress and some financial institutions have been asking for something like this for a long time.

The rules will be applied for the second quarter of 2009 but can be applied to the first quarter as well as long as both are done together. It allows the banks to ignore "distressed" sales of assets when considering their value. What precisely is a "distressed" sale is somewhat in the eye of the beholder.

The logical question to ask is, "Is this a good thing?" The answer to that depends on who you are.

If you are an executive or a current shareholder of a large financial institution with a lot of difficult to value assets....

...this is a good thing. It may not help you with the writedowns you have already done but it means that the pace with which you have to take losses in the future will be slower. This will allow the market to focus on the actual earnings of your bank. Given the fact that most banks are funding at the risk free rate and only making loans to the best possible credits at market distress rates it's probably a safe bet that they are pretty profitable.

If you are a hedge fund shark hoping to lever up with TARP II money and scoop the bottom make billions and retire to the Carribean...

...this is a bad thing. It means that the banks will be able to keep their better assets on the books longer rather than sell them to you at rock bottom prices. They may well be willing to sell you things which actually are worth zero however but you won't really know until several years after you bought them. It's not the end of the world though because the taxpayers take 85% of the loss but only 50% of the gains.

If you are an ordinary American who lends money to banks by depositing your money in them and therefore have a long term interest in the solvency of the banking system...'s a mixed bag. Changing the way in which something is valued on a day by day basis does not change the probability that the person will pay you back. It just means that banks are free to ignore or at least discount what the market believes that probability to be.

This is the heart of the matter. If you put your money in a bank either as a depositor or a shareholder the most important thing for you to know is whether or not the bank is going to ultimately be paid back the money it is lending out. The way market to market accounting works is that people use the markets to estimae the probability that a debtor will honor his debts to the bank.

The idea being that a market where a large number of people make decisions is kind of like a poll taken about the solvency of the debtor. If a loan for $100 to company XYZ is trading at $50 the market thinks there is a 50/50 chance that XYZ will default on the loan. If this happens to a client of a bank then the bank has to mark down the loans to reflect the lower chance that it will be paid back rather than wait until the loan defaults in the future.

The argument behind the FASB rule change today is that in times like these markets reflect the fact that people have to sell good securities to cover losses elsewhere rather than being a rational estimate of default proabilities. There is a case to be made for this but it begs the question: what is a better determinant of an assets value? A panicked market or a person with a material interest in the asset and who will suffer immiediately from having to mark it down.

Today FASB says the person with the has the material interest. Time will tell.

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