1. Investors and regulators are not idiots. They know what the accounting rules are. If banks claim they were forced to mark their assets down to “fire-sale” prices, investors can look at the facts themselves and apply any upward corrections they want. Now that banks will be able to mark their assets up to prices based solely on their own models, investors will the downward corrections they want. It’s a little like what happened when companies were forced to account for stock option compensation as expenses; nothing happened to stock prices, because anyone who wanted to could already read the footnotes and do the calculations himself.
However, the situation is not symmetrical, and the change is bad for two reasons. First, fair market value (”mark to market”) has the benefit of being a clear rule that everyone has to conform to. So from the investor’s perspective, you have one fact to go on. The new rule makes asset prices dependent on banks’ internal judgment, and each bank may apply different criteria. So from the investor’s perspective, now you have zero facts to go on. It’s as if auto companies were allowed to replace EPA fuel efficiency estimates with their own estimates using their own tests. We all know the EPA estimates are not realistic, but we can find out exactly how they were obtained and make whatever adjustments we want. If each auto company can use its own criteria, then we have no information at all.
Second, this takes away the bank’s incentive to disclose information. Under the old rule, if a bank had to show market prices but thought they were unfairly low, it would have to show some evidence in order to convince investors of its position. Under the new rule, a bank can simply report the results of its internal models and has no incentive to provide any more information.
So what we get is less information and more uncertainty. That was all reason number one.
2. Between the two options, this is the unsafe choice. Accounting in general is supposed to embody a principle of conservatism. Given plausible optimistic and pessimistic rules, you are supposed to choose the pessimistic one. But think about what happens here. Let’s say the bank has to mark to market, but it turns out the economy recovers and the asset increases in value. In this scenario, the writedown reduced the bank’s capital, so it had to get more. When the asset recovers, the bank is profitable and can buy back the shares it sold.
In the opposite scenario, the bank marks to its own imagination, but in reality the market price was the long-term price. At some point in the future, the bank will have to write down that asset, but it may not have the capital to absorb that writedown, in which case it will fail.
The choice is between the risk of raising too much capital and the risk of not raising enough capital. FASB chose the latter.
3. Mark-to-market is a red herring to begin with. Accounting rules are much more complex than “all assets must be marked to market” and “all assets can be marked to model.” There are different types of assets (Level 1, 2, and 3); different types of impairments to asset values (temporary and other-than-temporary); different accounting impacts (some writedowns on the balance sheet affect income statement profitability, some don’t); and, most importantly, different ways of holding assets. How a bank accounts for an asset depends in part on whether it says that asset is held for trading purposes, is available for sale, or will be held to maturity. Wharton has a high-level discussion of some of these issues, but if you really want to understand them you should read Sections 1.B-D of the SEC’s study of mark-to-market accounting, which I helpfully summarized for you in an earlier post.
The SEC’s conclusions were, in short:
- Most bank assets are not marked to market to begin with, and half of the ones that are marked to market are the type that don’t affect the income statement.
- Marking assets to market had only a very small impact on bank capital through September 2008.
- The bank failures of 2008, including Washington Mutual, were not caused by marking assets to market (increasing loan loss provisions were a bigger culprit). In each case, stock prices started falling before the banks took writedowns, implying that investors already knew something was fishy before the accountants did anything.
I don’t know any of the back-room dealing, but it seems like the banking industry is taking advantage of the confusion to push through a change it wants, because it will make it easier for banks to massage their balance sheets and harder for investors to see what is really going on.
Originally published at the Baseline Scenario and reproduced here with the author’s permission.