Blaming Accounting Rules for the Crisis? Whatever…

Wow…I thought that the Democrats who forced companies to peddle questionable loans were guilty of the credit crisis. Apparently, there are some who blame a relatively new accounting rule, FAS 157. This argument seems, at best, far-fetched. FAS 157 refers to the ‘Mark to Market’ rule that’s getting tossed around the news.

Under this relatively new accounting rule, companies classify their assets into 3 categories (Level 1, 2, and 3). Simple, right?

Level 1 Assets are the easiest to value…these would include stocks & bonds (i.e. any asset with a readily determinable market value). Riskier Level 3 assets don’t have a readily known market value and are thus more difficult to determine a price. You guessed it, mortgage-backed securities based on sub-prime mortgages are Level 3…nobody knows what these suckers are worth! Level 2 Assets are somewhere in the middle.

Guess what…management gets to decide the value of Level 3 assets! Good for them, right? Maybe, maybe not. At the moment, this rule doesn’t seem to be helping the financials one bit…many of these entities are burdened with bad sub-prime paper and there’s no current market in which to sell this stuff. As such, management at banks who hold this toxic paper have recently taken massive write-downs on these assets…these write-downs are magnified with FAS 157, as many institutions have written down their subprime to a level WAY BELOW what some believe this paper will be worth in the future. These write-downs cause all kinds of problems for banks (increased losses and asset devaluation)…as such, bank’s debt/asset ratios get screwed up, which lowers their credit rating and limits their ability to borrow from other banks. To make things worse, investors jump ship when things like this occur, magnifying the bank’s problems further.

Some believe that the dollar values of these questionable Level 3 assets have been written down so much by management that these losses have been over-done. Folks in this camp would argue that the sub-prime slime WILL be worth something some day...maybe they’re right. This is the type of argument Paulson has been trying to make all along (i.e., the taxpayer will eventually make some money on these undervalued mortgage securities, EVEN IF we pay above current market price). By purchasing a ton of sub-prime securities, the government would essentially create a new market for this paper, with the hope that other buyers would eventually jump in once the paper had more concrete value.

All of this may not seem important at first glance, but the different methods of valuing assets is EXTREMELY important, especially for banks…as you know, bank’s credit ratings are determined by the soundness of their financial statements. As such, the credit ratings banks receive are a direct reflection of the entities’ overall financial health. Bottom line: a bank’s credit rating helps to determine how much one bank is willing to lend to another bank…this is pretty straightforward stuff when you think about it.

While the means in which a bank’s assets are valued is important, I’m not sure how suspending the ‘Mark to Market’ rule would remedy the current crisis. Investment bankers don’t enter into stupid transactions unless they're forced to do so by the government (this is why the crisis happened, btw). If we suspended FAS 157 and the values of sub-prime securities suddenly shot up on paper, wouldn’t rating agencies have to adjust their models to reflect these higher valuations? In a nutshell, wouldn’t credit rating agencies have to take these higher valuations post-FAS 157 with a grain of salt?? Not every bank will be able to unload their sub-prime and take advantage of Paulson's higher asking price.

Even with a sudden improvement to some bank’s financial statements through the suspension of the mark-to-market rule, I don’t believe most banks would start lending more money to one another. It seems like credit rating agencies would STILL have to take into account the fact that there’s NO MARKET for subprime...duh.

Do you believe that banks will magically start lending more money to one another simply because an accounting rule has changed and sub-prime mortgages are suddenly recorded at higher valuations? Maybe some banks will…I honestly don’t know. It probably depends on an individual bank’s overall financial health, and how the financial industry collectively views the rule change.

At first blush, it seems that changing this accounting rule might (and I stress, might) positively impact a few banks, but most banks would still be in big doo-doo.

FMC