by Louis Basenese, Advisory Panelist
Senior Analyst, The Oxford Club

Finally, our government has taken to examining the hot-button accounting issue of mark-to-market, formally known as FASB 157.

The SEC's already asserted its stubbornness. An anonymous source told Reuters this week, and I'm editorializing slightly, "There ain't no way we're suspending mark-to-market!"

But there are a lot of good reasons why they need to do exactly that. Unfortunately, the SEC doesn't have a great history of proactive regulation. But as investors and taxpayers, a reform to mark-to-market accounting could bring some much needed stability to finance.

Here's why we better hope our elected representatives see the situation differently.

Mark-to-Market - Increasing Transparency?

Proponents of mark-to-market contend, and rightfully so, that the rule increases transparency. It requires banks to "mark" or price assets based on the current market price. In other words, it forces banks to tell us what their assets would sell for in the current environment on that particular day.

On paper, that's a great principle. Who wouldn't want to know what their investments are worth on a daily basis? If you're like me, you probably mark your stocks to market every day - checking their prices after the closing bell.

So if a bank holds a big pile of assets, they check the final trading price on each, add it all up, and conclude "Today we have $100 million in assets," or whatever the price may be.

With some assets, this is no problem. However, doing the same for mortgage-backed securities - the assets at the center of this debate - is not as simple as punching in a symbol on Yahoo! Finance. You see, while stocks trade daily and by the hundreds of thousands of shares, these mortgage-backed securities might not trade for weeks or months at a time.

And when thousands of these investments exist, and only one trades in a month, can we really say a market exists? Not at all. So under the current conditions, mark-to-market is more like mark-to-make believe. Especially since the prices banks are forced to use are completely out of whack with reality.

Now that $100 million in assets has to be written down to zero, even though they'll continue to pay interest and likely be sold for a profit in the future.

Let me provide some examples to illustrate what I mean...

When FASB 157 Misses the Mark

In the fourth quarter, The Bank of New York Mellon (NYSE: BK) was forced to write down a $5 billion portfolio of Alt-A mortgages by $1.24 billion or (25%). Yet, based on the performance of the underlying loans - the principal and interest payments the bank was receiving - they only expected to lose about $208 million.

Granted the bank's estimates of losses could be wrong. But the difference between the two methods - net realizable value and mark-to-market - is gargantuan. And it proves mark-to-market fails to do its job when virtually no market exists for these assets.

For good measure, here's another example of its shortcomings...

The Federal Home Loan Bank of Atlanta holds three private mortgage-backed securities. But, it has no intention of selling any of them. Again, based on the actual performance of the loans, the bank estimates it will lose $44,000, beginning in 2025.

That's not a typo. It will be another 16 years before any losses are incurred on these loans. Yet because of mark-to-market accounting, the bank was forced to write off a loss of $87.3 million - a figure almost 2,000 times greater than the actual losses.

One could argue that over time - as a market returns for these assets - the huge price differences would correct themselves. That's true. Over the long run the differences in accounting practices will even out...but banks can't simply wait that long.

Due to Mark-to-Market, Banks Out of Compliance

The write-downs required by mark-to-market put many banks out of compliance with capital requirements - the amount of cash and easily liquidated assets they need to hold to offset their liabilities (i.e. - loans to others). And the only way to become compliant again is to raise capital by either issuing more stock or selling off assets.

You see, banks have a reserve requirement set forth in Regulation D of by the Federal Reserve. It limits how much money banks can lend depending on the capital they have available. According to current regulations, banks have to keep 10% in reserve. (If they loan out $10 million, they have to have $1 million to back it up.) The current requirements are available here.

Banks have kept the mortgage backed securities we mentioned earlier as part of their capital reserves. But with mark-to-market causing unexplainable write-downs in value, keeping up with reserve requirements is near impossible.

This is the exact reason banks are begging for bailout money. The "paper losses" from mark-to-market accounting has left them out of compliance, even if the assets are perfectly fine.

Bottom line - the current application of mark-to-market forces banks to raise billions upon billions in real capital to offset losses that are never going to occur. And that makes absolutely no sense.

As for questioning the authority of the Financial Accounting Standards Board, their track record warrants it. Remember, their rules on special purpose entities allowed Enron to pull-off its accounting shenanigans and later required revisions to adjust for the deficiencies.

• Mark-to-market rules were supposed to fix problems from Enron. Unfortunately, they created a large batch of new problems.


• Mark-to-market is simply another one of FASB's rules that's good in principle, bad in practice, in desperate need of a revision.

But instead of complaining about mark-to-market, we look for ways to profit.

Since mark-to-market losses will eventually turn into gains, whether the standards are fixed or not, there is opportunity to profit by concentrating on the banks with the strongest balance sheets.

There is an important caveat: this situation may take a long time to correct itself, so these investments need at least a 3 to 5 year time horizon to ensure success.

That said, a these banks do stand out above the rest. Bank of New York Mellon (NYSE: BK), Well Fargo & Company (NYSE: WFC), and JP Morgan Chase (NYSE: JPM) all have balance sheets that will look healthy once assets can be counted at their true value.

For a more diversified investment. The exchange-traded-fund Financial Select Sector SPDR (NYSE: XLF) is a quick an easy way to invest in a basket of eighty financial companies.

As an Investment U reader, you'll be kept up to date on all the latest in the banking crisis and other opportunities in the market.

Good investing,

Lou Basenese

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