Keep Marking to Market

Changes to current accounting rules governing “toxic assets” held by banks are ill timed and could well be ill considered, argues David Min.

The foes and champions of “mark-to-market” accounting have until the end of today to present their final arguments to the Financial Accounting Standards Board, the independent standard setter for accounting rules, which include the rules governing how our nation’s troubled financial institutions should value any “toxic assets” on their balance sheets. Under heavy political pressure, FASB recently issued two proposed rules that would make it much easier for financial institutions to avoid the recognition of losses that might be tied to market-based valuation. The vote is scheduled for tomorrow.

So much has been made of the allegedly pernicious effects of mark-to-market accounting on financial institutions’ overall health that FASB faces a daunting task. Should it change the rules amid the continuing financial crisis, as it is being pressured to do by many members of Congress and financial institutions? Or should it stick to its guns, as most investors and financial regulators urge it to do? There are no easy answers, not least because the debate over mark-to-market accounting is marred by many misunderstandings. So before making our own recommendations to FASB—hint, we don’t think the rules should change—we first need to define the terms of the debate.

Mark-to-market rules, the story goes, force financial institutions to record excessively low values for their troubled assets such as mortgage-backed securities—values that are supposedly not reflective of inherent economic value but instead based on prices resulting from illiquid and panicked markets. Marking to market supposedly drives banks’ balance sheets into peril by causing the recognition of artificial losses, which then force them to raise more capital, a difficult task in the current market. Much of this criticism, however, grossly overstates the consequences of mark-to-market accounting.

First of all, FASB’s existing accounting guidelines give companies considerable flexibility in avoiding so-called fair-value accounting, of which mark-to-market valuation is a subset. Fair-value accounting rules expressly state that illiquid or distressed transactions, such as are now occurring, cannot be the basis for mark-to-market valuation. Under FASB’s guidelines, financial institutions can reclassify many of their troubled assets in ways that allow them to avoid the use of fair-value accounting. That’s why it is difficult to understand the claim that mark-to-market accounting is driving this credit crisis.

In fact, the attack on fair-value accounting may be best understood as an attempt to resolve the furious debate over an issue known as regulatory forbearance, wherein regulators allow embattled banks to delay recognizing their losses in the hope that over time they can raise enough capital to offset the eventual recognition of those losses. By recasting this issue as one of overly burdensome accounting, proponents of regulatory forbearance can achieve their desired result without having to convince regulators of the merits of their position.

So let’s step back for a minute. In general, there are two schools of thought on how to handle a banking crisis. The first is regulatory forbearance and the other is immediate loss recognition—forcing the banks to more swiftly recognize their losses and raise capital to offset those losses in the hopes of cleaning up bank balance sheets and quickly restoring the confidence of depositors and investors. There has been significant and heated debate over which of these methods is preferable in addressing the current financial crisis, but in the end it is up to bank regulators to ultimately make this decision, irrespective of what the results produced by the accounting rules say—a point acknowledged recently by Federal Deposit Insurance Corporation Chairman Sheila Bair.

Indeed, accounting rules are intended to guide investment decisions—not necessarily regulatory decisions. If fair-value accounting were suspended or eliminated, then the issue of regulatory forbearance could be definitively resolved as banks might be able to avoid recognizing losses on their toxic assets for the foreseeable future. But taking the issue out of the hands of regulators, who are delicately navigating a path out of the current mess in the broader interests of the nation—not just bank shareholders—would be a huge mistake.

Another problem with these attacks is that they threaten to politicize the historically independent process of setting accounting standards. This would set the troubling precedent that political pressure can result in short-term changes to the rules by which companies are supposed to present their financial results to investors. At the same time, even if one accepts the criticisms of fair-value accounting on their merits, it’s not clear that alternative measures of asset valuation would be any better. Indeed, there is reason to believe they could be far worse, obscuring the transparency of bank balance sheets and undermining what’s left of investor confidence in U.S. financial institutions, thus exacerbating and prolonging the current credit crisis.

So who are the critics of fair-value accounting? They are led by commercial banks and other home mortgage lenders, many of whom have leaned on their representatives in Congress to argue their cause. But they also include some prominent former regulators such as the former head of the Office of the Comptroller of the Currency Gene Ludwig, and former FDIC Chairman William Isaac, both of whom argue that fair-value accounting is driving otherwise healthy businesses into insolvency by forcing them to recognize artificial mark-to-market losses on valuable assets.

According to this argument, these assets (mostly credit instruments such as mortgage-backed securities and credit derivatives such as collateralized debt obligations) are still performing well, but their market value has been driven down to artificially low levels as a result of the panicked market illiquidity we are now experiencing. Under fair-value accounting, these artificially depressed market prices must be used as the basis for valuing similar assets, which forces companies to recognize huge losses that don’t reflect economic reality.

Because regulatory bank capital requirements are tied to accounting standards, these critics claim, banks are then forced to raise capital to offset these paper losses, which they can only do in this environment by selling their own assets into an illiquid market. These sales then create further downward pressure on asset values by lowering the market prices.

On the other side of this argument are the defenders of fair-value accounting, composed primarily of the investor community, the accounting profession, and most regulators, including Treasury Secretary Timothy Geithner, FDIC Chairman Bair, Federal Reserve Chairman Ben Bernanke, and Securities and Exchange Commission Chairman Mary Schapiro. Their argument is basically two pronged.

First, they argue that the consequences of fair-value accounting are greatly misunderstood and vastly overstated. Second, they note that fair-value accounting is necessary insofar as it promotes transparency—suspending fair-value accounting would create opacity and uncertainty as to the veracity of bank balance sheets, thus deteriorating investor confidence and prolonging and intensifying the credit freeze. But their defense of fair-value accounting begs the question: What are these assets actually worth?

There is considerable debate over what the actual value of these so-called “toxic” or “troubled” or “legacy” assets. Because of the considerable opacity surrounding these assets, including the fact that many of these assets are highly complex structured financial products, there is a great degree of uncertainty as to what the “real” values of these assets are. Perhaps as a result, there is a considerable disparity between the values at which the banks have recorded these assets, and the values the markets have determined they are worth.

On the one hand, the banks and their allies argue that the markets aren’t currently functioning because they are effectively illiquid except for fire sales by distressed companies. On the other hand, supporters of fair-value accounting contend that the market is roughly pricing these assets correctly, and that the markets are illiquid only because the banks refuse to sell these assets at low enough prices to attract demand.

This debate over whether the low-market prices for these troubled assets is reflective of their actual economic value or artificially distressed by market illiquidity may be resolved to some degree by the Obama administration’s new Public-Private Investment Program, which is designed to provide the market for these troubled assets with abundant debt liquidity. Under this plan, the government will provide financing to private investors willing to co-invest with the government in buying these toxic assets from banks, allowing private-sector players to negotiate the prices to be paid for these assets. This process in theory will enable the buyers and sellers to settle on market-based prices for these assets.

If we accept the claim that the market values of these troubled assets understates their actual value to some degree, then the next question is whether and to what extent fair-value accounting forces financial institutions to recognize artificial losses—losses that are driven purely by accounting for temporary market movements and which do not reflect the actual long-term economic value of these assets. This is clearly a very important topic, and one that has unfortunately been greatly misunderstood by the general public, as well as misreported by the mass media. The impact of fair-value accounting is not nearly as broad as many commentators appear to believe due to its flexibility in application.

What is fair-value accounting?

Fair-value accounting is part of a larger set of U.S. generally accepted accounting principles, or GAAP, which provide guidelines for how public companies report their financial statements. These guidelines are developed by the Financial Accounting Standards Board, a nongovernmental group of accounting and other professionals, and are binding insofar as the reporting requirements in U.S. securities law are tied to GAAP.

One of the key elements of GAAP, and the crux of the fair-value accounting debate, is how to properly value a company’s assets and liabilities. Based on the nature of an asset, GAAP prescribes different methods for recording its value. Generally, nonfinancial assets such as buildings and equipment are valued based on what was paid for them (less depreciation). Financial assets such as stocks, bonds, or derivatives are valued based on what would be received for them today. Sometimes this process is as simple as obtaining a market quote for the price of a share of stock, but sometimes it requires substantial judgment in estimating the present value of discounted future cash flows from the assets. As a general rule, GAAP aims to ensure that investors receive a fair and accurate assessment of a company’s assets and liabilities, while acknowledging that sometimes this requires estimates to be made.

In the case of so-called “troubled assets”—the derivative and debt instruments whose ultimate value is at the heart of the current debate—there are generally two sets of rules that apply. For financial derivatives—assets with values derived from other assets, such as collateralized debt obligations composed of pools of mortgage-backed securities and other asset-backed debt bundled with other derivatives such as credit default swaps—fair-value accounting must be used. The reason: There is no other meaningful way to value something that has no historical cost basis and is such a complex financial instrument.

For debt instruments, GAAP provides companies with the option, but not the requirement, of using fair-value accounting. Financial institutions can designate their assets as either “trading securities,” “available for sale,” or “held to maturity,” the last of which is sometimes also called “held for investment.” For assets that are categorized as “trading securities,” fair-value accounting applies. But for assets categorized as “held to maturity” or “available for sale,” fair-value accounting writedowns do not apply—unless there is deemed to be a permanent loss on the asset, known as an “other than temporary impairment.”

What is mark-to-market accounting and when does it apply?

Mark-to-market accounting is a subset of fair-value accounting, although the two are frequently conflated. Under fair-value accounting rules, a mark-to-market valuation—the use of the latest market prices to value an asset or liability—is used only when there is an active and liquid market for an identical asset or liability to the one being valued. Otherwise, a “mark-to-model” valuation is required, wherein the company uses the best available inputs (such as prices for similar instruments or, if those are not available, internal assumptions about the asset or liability) to value the asset or liability.

So when a company uses fair-value accounting for an asset when (as is the case today) there is no liquid or active market for an identical asset, then the firm shifts to a “mark-to-model” valuation, and does not use mark-to-market accounting. As a result, a relatively low proportion of debt instruments held by banks are actually “marked to market.”

How does fair-value accounting tie into the credit crisis?

Critics of fair-value accounting claim that it exacerbates the credit crisis by pulling down the values of credit assets and thus creating artificial accounting losses on bank balance sheets. This forces banks to hoard capital and prevents lending from occurring. Yet there is considerable disagreement about this point, particularly from the investment community. As Jeffrey Mahoney, General Counsel for the Council of Institutional Investors, stated:

When I receive my quarterly 401(k) statement, I see current economic reality. Those who invest in U.S. financial institutions and other U.S. companies deserve to see the same economic reality. Fair-value accounting for financial instruments gets investors closer to that goal.

But even if we ignore the considerable leeway given banks to avoid the use of mark-to-market standards and accept the argument that fair-value accounting leads to inaccurate valuations, we should note that bank regulators—not accountants—are the ones who ultimately decide whether banks must raise capital based on mark-to-market accounting losses. FASB accounting standards, including fair-value accounting rules, are intended to provide clarity for investors, not for regulators. And so the argument that there should regulatory forbearance on capital requirements because mark-to-market accounting is producing inaccurate valuations should be presented to regulators, not the FASB.

What’s the downside of changing the rules?

So what would happen if FASB or regulators decided to repeal or suspend fair-value accounting rules? Well, any such moves could have severely deleterious effects. First, they would likely undermine investor confidence, decreasing transparency and increasing concerns about the accuracy of bank financial statements. This could have the effect of prolonging or worsening the credit crisis.

Second, the temporary or permanent cessation of fair-value accounting would set an unbelievably bad precedent—one that could wreak major damage to the integrity of U.S. securities markets. The setting of U.S. accounting standards has long been an independent nonpartisan process, free from political pressure. This is no small part of the success of the U.S. capital markets as it has created strong investor confidence that the rules of the game—the standards by which U.S. reporting companies disclose their financial results—are fair and will not change suddenly and arbitrarily.

Unfortunately, after a more than year-long drumbeat of criticism that mark-to-market accounting was causing the credit crisis, FASB acquiesced, offering two proposals for comment that would provide additional flexibility in avoiding the recognition of losses related to fair-value accounting. The first proposal would provide additional guidance on when it is acceptable to use “mark-to-model” accounting instead of “mark-to-market” accounting. The second proposal would provide companies more leeway in avoiding the recognition of losses that would be required under fair-value accounting.

These proposals are extremely troubling insofar as they appear to represent capitulation to political pressure, even though they are fairly innocuous on their own terms absent the political pressure. As former SEC Chairman Arthur Levitt put it in a recent Washington Post editorial:

Investors once believed that U.S. markets were sufficiently protected from political pressure and manipulation by a system of interlocking independent agencies and rule-making bodies—some government-run, some not. That system is being dismantled, piece by piece, by political jawboning and rushed rule rewrites. Now, investors find themselves with fewer protections and weakened protectors.

Given the feckless financial supervision of our financial markets under President George W. Bush that led to today’s financial crisis, now is certainly not the time for FASB to be seen playing politics. But if the accounting board does adopt its two new proposals, then it will be up to the Obama administration’s financial regulators to ensure that these new twists to fair-value accounting are not abused by financial institutions—to the detriment of our financial markets.

David Min is Associate Director for Financial Markets Policy at the Center. For more on the Center’s economic policy analysis and recommendations, please go to the Economy page on our website.

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