Alert reader James Bianco pinged us about a new SEC release today and Floyd Norris of the New York Times' commentary on it, "If Market Prices Are Too Low, Ignore Them," Norris, who is usually pretty understated, disapproved of one of the items in the SEC letter, as do we.
Most readers probably know that accounting rule FAS 157 became effective as of January 1 of this year. It requires companies, subject to certain restrictions, to classify financial assets as Level 1 (easily valued by reference to market prices), Level 2 (doesn't trade actively, but similar enough to actively traded assets that can be valued in relationship) and Level 3 (known in the trade as "mark to model" or "mark to make believe"). Some financial firms opted to comply with FAS 157 early, which led to quite a few investment banks revealing that the value of their Level 3 assets exceeded their net worth.
In the last couple of months, there has been increased worry that mark-to-market accounting leads to the operation of a destructive "financial accelerator." As prevailing values go down, banks have to lower the value of their holdings. This leads to a direct hit to their net worth, which will lead them to contract their balance sheets, either by withholding credit or selling assets. More sales in a weak market lead to further declines in the prices of financial instruments, leading to more writedowns and sales of inventory.
Funny how no one had a problem with mark-to-market when asset prices were rising. The process in reverse leads to mark-to-market gains, higher net worths fueling balance sheet growth and credit expansion, which led to more demand for financial assets. That gives you higher securities prices which least to more mark-to-market gains. Sounds like a bubble, doesn't it?
The SEC's solution for the contractionary version of this dynamic is simple: ignore those market prices if they are too ugly. From the release:
Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).
Quite a few observers had argued that the windups of SIVs and the failure of hedge funds, and even Bear Stearns, would be a good thing because they would force price discovery of assets that are normally illiquid and/or hard to value. That in turn would resolve a great deal of uncertainty of what bank and hedge fund positions were really worth.
But now the SEC has given banks and brokers a huge out. No matter how small or easily absorbed by the market a forced sale might be (think of a hedge fund hit by a margin call), a financial institution can ignore the price realized. In fact, they get to determine what trades constitute a forced sale. As Norris dryly notes:
Some people on Wall Street think that nearly every sale today is a forced sale. There are entire categories of collateralized debt obligations where most, if not all, of the trades, occur because a holder has received, or expects, a margin call.
Moreover, we've seen plenty of unintended consequences, or worse, backfires, as regulators intervene trying to alleviate the credit crisis. Banks have been reluctant to extend credit to each other precisely because they don't trust their creditworthiness. That's tantamount to saying they already don't trust their public financial statements, since according to their public filings, virtually all major financial institutions have more than the required statutory capital.
So this move, to stem the balance-sheet-shrinking impact of mark-to-market accounting in a falling price environment, may further undermine liquidity. Companies will less able to judge whether their published financials are telling the whole story, And where the numbers are in doubt, rumors are taken more seriously.
Now in fairness, the entire letter wasn't a gimmie to the securities industry. Entities that report Level 3 exposures have to talk about them at great length:
To paraphrase Winston Churchill, it has been said that mark to market accounting is the worst form of financial accounting except for all the others that have been tried. But it looks like we are going to try them anyhow.