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FASB Lets Banks Mark to Myth, Not Mark to Market

Why did the Financial Accounting Standards Board change its rules regarding mark-to-market accounting under pressure from Congress and the financial-services industry?

More to the point, just what is "mark to market" anyway?

When companies buy assets, initially they are "marked to market," or recorded at their actual purchase price on the company's balance sheet. However, as time passes, mark-to-market accounting rules required companies to revalue these assets on a daily basis to reflect their current market value. For example, if ABC Bank purchased a mortgage-backed bond for $1,000 in 2006, the value of that bond may be the same, higher or lower three years hence. In this case, the bond is probably worth at least half the value of what ABC originally paid and maybe even less than that.

The problem occurs when the company in question is a financial institution -- more specifically, a bank that owned a bond backed by pooled mortgages. What if ABC Bank doesn't know the value of the bond today? With few transactions occurring in the distressed bond market, and those that do occur are often at fire sale prices, there is no basis for comparison to price the bond. Under mark to market, it doesn't matter that ABC intends to hold the bond for a number of years -- it must report the value of the bond at the bargain-basement price that it could fetch today.

One more problem: if the value of the bond drops, the bank can't make as many loans because as the value of the balance sheet is reduced, the rules surrounding lending require banks to keep more assets on hand. The end result is that mark to market accounting hurts bank's ability to lend, which is why we are even talking about the issue at all right now.

To put this in perspective, imagine the following scenario.

At the height of the housing boom, Jane purchases a home for $500,000 with a $420,000 mortgage. Today, the house, which Jane doesn't intend to sell for a long time, is valued at approximately $420,000, meaning that Jane has exactly zero equity in her home at the moment.

Jane goes to the bank to seek a small business loan, and when the underwriting committee asks her to prepare a balance sheet, she lists the value of her house as $500,000. After all, she's not about to sell the house today, and it's likely that by the time she would even consider selling it, the value will most assuredly rise to at least $500,000, if not more.
Back to Jane. The friendly banker tells her that she can not extract any money based on the "aspirational value" of her home. "But I plan to use that money to expand my business, hire another employee and help the economy!" The friendly banker responded, "I am sorry but that's just the way it is. We can not allow it." Period -- full stop -- the end.

Do you really blame the bank? What if Jane is forced to sell her house before it recoups its value? What if something happens to Jane and she's unable to service the two loans? It's true that if everything were to go smoothly, Jane may help herself and the economy, but the risk doesn't seem appropriate.

Funny how the rules can change when we replace Jane with a big bank.

So why did FASB, whose stated mission is "to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information," change the rules? I guess the board thought it would be fun to return to bank la-la land, where computer models guesstimate the value of assets. Since that process worked so well for firms like Bear Sterns and Lehman Brothers, it's obvious why FASB changed its tune.

Sarcasm aside, the bankers say it's not fair to hold them to mark to market because there is essentially no market for these securities. Considering that this rationale didn't help Jane from our scenario, why should it apply to our banks? In the end, it doesn't make sense to extend loans based on a made up figure on a balance sheet.

I don't know about you, but I wouldn't loan a dime to either Jane or the banks until we understand what the real value of the assets are. If the U.S. government believes that the only way to help the beleaguered banking sector is to change the rules, we are in for a long recovery.

Addendum: My colleague Marine Cole over at BNET Finance argues that the FASB rule change wasn't anywhere near as significant as many of us think it is.

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