Think Flat

FAS 157 has been a bigger WMD in this credit catastrophe than the credit derivative instruments. Fair value accounting, as it stands under FAS 157, has given enough sleepless night to accounting executives and now it has started affecting the govt led investment under TARP program to bail out institutions under financial duress- here is the story. FAS 157 has taken away the very concept of future "intrinsic value" of assets in financial theory and here we are in a situation for a bank where evenif the bank is garnering steady cash flow on its MBS investment, still it is forced to write-down losses due to mark-to-market value of those instruments in present southward market.This WSJ blog explains that in more detail.

Well, it must be kept in mind that mark-to-market was used by these geniuses to give themselves billion dollr paydays, so may be they should give them back as well? In any case the point is no matter what accounting you want to use, in fact almost 90% of all MBS held by Wall Street banks are worthless or will be worthless in the near future. Why? Well, it's going to be quite a long explanation, but suffice to say that if you closely analyze US financial system, it resembles a Ponzi Scheme to a T.

A possible alternative may be to make stringent the credit guidelines by the central bank. There should be a complete halt on selling complex financial products. If bankers agree to this suggestion, the regulator may reduce proportion of provision to be held against these losses with a pre-defined time frame,suitable at this stage.

Suspending mark-to-market accounting is turning your eyes away from the elephant in the room, nevertheless, the elephant remains in the room and somebody has to address him.

The value of the underline asset may not have turned zero and there is a possibility of the market improving in the future and the MBS and similar like instruments fetching the near real price- but that should not change the accounting methods and its implications on balance sheet reporting. If the market rebounds again the same banks can book profit and show positives on their balance sheet using the same accounting methods. The question is more of governance and actual valuation of the underline. There are so many theories in place but surprisingly all of them including those famous credit models failed for unknown reasons. Even in areas like Islamic Bonds (Sukuks) which are pure real asste based transactions, we are expecting defaults and no pays. That will create one more level of turmoil in the ME Market where large banks have huge exposures on Islamic Sukuks. The same reason- unparalleled growth in property prices in certain places like Dubai which cannot be sustained for long which were used to create these MBS like securities. I wonder now- whether Islamic or Conventional - the governance model has failed for all- what is the reason? Can we just blame the doctor or better look for the cause of the disease.

As some one said mark-to-market is a great tool, but for that work you need a market.

In the absence of a market, mark-to-market can kill the financial institution, as it is driven by the exit price of the underlying financial instrument.

This is not an argument against fair-value accounting, however a point to highlight an effective & practical approach is somewhere in between absolute fair-value accounting and none at all.

Though old fashioned Internal combustion engines provides an analogy, you have one power producing stroke for three power consuming strokes and a flywheel produces the constant output that we all have come to enjoy.

What I believe can help is providing a flywheel like component to fair-value accounting, I choose to call it a dampener to fair-value accounting.

One way it can work is to use the 10-20-30-40 rule,

a) In a financial year, if a financial institution’s Level 3 asset’s mark-to-market value increases, then it can book only 10% of the increase in the first year. It can book remaining 20% the next year, 30% the year after and hence forth. Please note at the end of every year u will have a new market value and these components will also go into final pricing of the assets.

b) In a financial year, if your Level 3 assets mark-to-market value decreases, allow amortisation of that loss over a period of say 4 years with 40% accounted for that year, 30% for the next year, 20% for the next and hence forth.

What this would prevent is, building up of a massive balance sheet (albeit illiquid) during a boom, using the +ve mark-to-market accounting. I believe that this is one of the critical contributors to the current problem.

Also when markets go down, allowing amortisation will provide the banks a much required breathing space to pick themselves up when things turn around.

Most of the Level 3 assets are financial instruments created using underlying assets that are illiquid and trying to account them at fair-value will allow banks to hurt themselves both when a market booms(by building a bigger illiquid balance sheet) and goes bust( requiring to raise more and more capital).

I believe the solution is about enabling the doctor to provide the right level of treatment without side effects that kill.

As we debate this topic, I came across a nice perspective from ex FDIC chairman,William Issac, who has strongly criticized SEC for prolonging the mark-to-market accounting standard. Here goes the
story.