The odd mandate that ate Wall St.

The Star-Ledger, October 5th, 2008

The Star-Ledger Archive COPYRIGHT © The Star-Ledger 2008

Date: 2008/10/05 Sunday Page: 001 Section: BUSINESS Edition: FINAL Size: 1040 words

SEC urged to abolish mark-to-market rules

By SAM ALI STAR-LEDGER STAFF

Forget Shakespeare's famous declaration about killing the lawyers. These days, Wall Street has set its sights on the accounting profession.

The reason for the uproar is an opaque accounting rule, known as "mark to market," that says companies must value their assets and securities as if they were going to be sold today to calculate profits and losses.

Congressmen, banking lobbyists and companies such as American International Group, devastated by the write-downs they have been forced to take on mortgage assets since the collapse of the housing market, have been urging the Securities and Exchange Commission to suspend mark-to-market, or fair-value, accounting, because it forces firms to report losses they may never actually incur.

The $700 billion rescue plan passed by the Senate on Wednesday and approved by the House on Friday authorizes the SEC to suspend the mark-to-market accounting rule.

Specifically, under mark-to-market accounting rules, assets or securities must be priced based on the last sale price on the day it is being accounted for.

On its face, it's hard to argue with the logic.

Valuing a security based on what the market is willing to pay makes perfect sense. You want to value 100 shares of Apple stock, you simply use the closing price of the stock that day.

The problem arises during times of considerable market and economic turmoil, when the "market" part of this accounting equation starts acting all screwy – like now. As it stands, active trading in most mortgage-backed securities and other structured credit products has virtually come to a halt. Nobody wants to touch any of it.

But, according to accounting rules mandated by the 2002 Sarbanes-Oxley corporate governance law, banks are required to value these securities at whatever price they would fetch on the open market if they had to be sold today – even if there are no takers and they wind up fetching pennies on the dollar.

"When assets are tradable, transparent and liquid, what people are willing to pay is the 'real' value," said Mark Sunshine, president and chief operating officer of West Palm Beach, Fla.-based First Capital.

"But, when assets aren't traded and are illiquid and opaque, like private bonds or loans, market prices are a worthless measure of value because there is no market to establish value. Not all assets that have no trading market are bad assets."

Yet, companies that own lots of these securities have been forced to write down billions of dollars in losses, even if these mark-to-market "paper" losses don't ever materialize. And that, in turn, erodes the firm's capital base.

"There is no market for these bets because nobody wants to buy them," said Gibran Nicholas, chairman and chief executive of the CMPS Institute, an Ann Arbor, Mich.-based organization that certifies and trains mortgage bankers and brokers. "But that doesn't mean the bet itself is worthless, because not all home values are going to zero and not all homeowners are going to default on their loans."

The American Bankers Association, in a letter to the SEC, said current accounting standards "never anticipated the wide variance and price disconnects that we are experiencing today."

Backing the banks, William Isaac, a former chairman of the Federal Deposit Insurance Corp., criticized what he called the SEC's refusal so far "to abandon its very destructive approach of forcing banks to take excessive and unjustified write-downs on their assets."

Let's say a company has a pool of mortgage securities worth $100 million, Nicholas said. And let's say 30 percent of the loans in that pool are going to default on their mortgages, or $30 million worth. Even if lenders are only able to recover half of that $30 million, the entire pool is still not worthless, he said.

That's because the vast majority of the pool – the remaining $70 million worth of mortgages – may be fine and will probably perform in the longer term, he said.

Yet, the markets today are not interested in pricing in the "fine" part, he said.

"If you held an auction and only one guy showed up, you can probably guess the price you would fetch would be low, so you are being held hostage at the worst possible time to mark your assets to the lowest possible price," said Brian Battle, vice president of Performance Trust Capital Partners, a 13-year-old Chicago-based fixed-income firm.

That's why in July, for example, a firm such as Merrill Lynch was forced to sell more than $30 billion in repackaged debt securities to Dallas-based private-equity firm Lone Star Funds for 22 cents on the dollar. Or why Lehman Brothers, shortly before declaring bankruptcy, in September marked down its third-quarter subprime mortgage assets to 34 cents on the dollar, and its asset-backed collateralized debt obligations were marked down to 29 cents on the dollar.

"Wall Street is essentially driven by emotion and the news of the day, so when nobody wants a particular security, the price falls fast and hard," said Jim Ainsworth, an accountant and author based in Texas. "Subprime loans and the securities they are bundled into have plummeted in value, sometimes to zero, because nobody wants to touch that barrel, even if most of the apples are still good."

Federal Reserve chairman Ben Bernanke and other proponents say removing the rule would erode confidence that firms are owning up to losses of mortgage assets that have devastated the balance sheets of banks and securities firms.

But Performance Trust's Battle said the SEC should temporarily suspend fair-value accounting until the markets for these securities start to function properly again.

"Mark-to-market is okay when the markets are fine and transparency is your goal, that way everyone knows what your assets are worth," he said. "But we should not risk/bet the economy based on accounting rules. Let's count the dollars, not be beholden to new accounting principles. Right now, the accountants are ruling the roost."


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