Mark-to-market or fair value accounting refers to the accounting standards of assigning a value to a position held in a financial instrument based on the current fair market price for the instrument or similar instruments.
Fair value accounting has been a part of US Generally Accepted Accounting Principles (GAAP) since the early 1990s. The use of fair value measurements has increased steadily over the past decade, primarily in response to investor demand for relevant and timely financial statements that will aid in making better informed decisions.
"Legislators and regulators fear that marking banks’ assets down to fair-value estimates will trigger automatic actions as capital ratios deteriorate. But using accounting rules to mislead regulators with inaccurate information is a poor policy. If capital calculations are based on inaccurate values of assets, the ratios are already lower than they appear. Banks should provide regulators with the best information about their assets and liabilities and, separately, allow them the flexibility and discretion to adjust capital adequacy ratios based on the economic situation. Regulators can lower capital ratios during downturns and raise them during good economic times." Financial Times, August 17, 2009
Possible "patch-up" solution for M2M convergence
- Source: INTERVIEW-Plan B may keep accounting convergence on track – IASBFinancial Regulatory Forum by Reuters Staff, January 18, 2010
"A patch-up solution to keep the goal of a single global accounting system on track may be needed due to differences over how standard setters are reforming a rule blamed for amplifying the credit crunch.
Two rival accounting systems could feature extra disclosures allowing analysts to make comparisons between different fair value rules, the chairman of the International Accounting Standards Board (IASB), David Tweedie, told Reuters Insider.
The G20 group of leading countries has set a mid-2011 deadline for converging the world’s main accounting rules.
It is a long-time goal of multinational companies which want to cut red tape and would also make it easier for international investors to compare companies from different countries.
Two of the world’s top standard setters are reforming their fair value or mark-to-market rule which requires banks to value some assets at the going rate. It led to huge writedowns at the height of the credit crunch, sparking calls in Europe to curb its scope.
The IASB has begun changing its fair value rule in a move which UBS analysts say will reduce its use. The U.S. Financial Accounting Standards Board (FASB), however, has signalled it wants to broaden the scope of its fair value rule.
“The U.S. believes we should have more at fair value. We have not found that,” Tweedie said.
“What we can do? Plan B. If we can’t get the same answer, can we at least get the income statements the same. We should be able to do that.”
“At least we could get net profit the same… It’s not all lost if we can’t agree.”
Plan B would be to provide sufficient information in the disclosures so that analysts could compare banks reporting under both accounting systems on a like-for-like basis.
“The world wants one standard but we can’t force them and nor can they force us. We have to look at what our constituents said and they are pretty clear they don’t want to go to fair value, that’s why we have come up with plan B,” Tweedie said.
The European Union has yet to endorse changes made by the IASB to curb fair value, a step needed to make it mandatory in the 27-nation bloc which applies IASB rules.
Some EU countries feel the scope of fair value should be cut further but Tweedie is reluctant as some non-EU countries are already implementing the change on a voluntary basis.
“They are accepted by quite a large proportion of people we have talked to. We knew what the issues were and we dealt with pretty much most of them,” Tweedie said.
The reform simplified the rule, as the G20 requested, so that assets are either valued at cost or at the going rate.
“It’s all right to say ‘oh well, we would like other things at cost’. The question is ‘what exactly do you want?’,” he added.
“We will discuss it but that does not mean to say we are going to reopen it,” Tweedie said.
Meanwhile, the IASB is waiting to see FASB’s draft reform of fair value, due this year, to gauge its impact on convergence.
“If they go to full fair value, I can imagine people will say ‘forget it’. If they are pretty close but with a little bit more fair value then there is a debate to be had. It depends what they come out with,” Tweedie said.
The IASB is also consulting on how to reform the way bank loan losses are accounted for as the G20 wants banks to recognise losses much earlier to lessen the need for more huge taxpayer bailouts.
Tweedie said the draft reform is likely to change before final adoption later this year.
“We have said OK this may be too complicated. See the direction we are trying to go. How do we operationalise this and make it simpler,” Tweedie said.
- Financial Statement Presentation International Accounting Standards Board, July, 2010
- To FASB or not to FASB? The Economist, June 10, 2010
IASB affirms need for transparency/independence for standard setting
- Source: Statement of the Monitoring Board for the International Accounting Standards Committee Foundation on Principles for Accounting Standards and Standard Setting IASB Foundation Monitoring Board, September 22, 2009
Principles underpinning accounting standard setting In addition to the principles guiding the standards themselves, the process by which accounting standards are set must embody certain attributes. Confidence in the quality and integrity of the standards depends upon independence and transparency in the standard setter’s due process.
Independence: Deliberations and, in particular, conclusion on positions in an independent fashion rely on a number of factors. First, the individuals composing the standard setting body must demonstrate professional competency in matters of financial reporting. Further, members with a decision-making role in the standard setting organisation should collectively be reasonably representative of the constituents whose interests the standards seek to address. Finally, the process should remain free of undue pressures from political and corporate interests.
Transparency: Visibility into the standard setting process should be sufficient to enable users to trace the evolution of the standard from thoughtful consideration of alternatives to final positions. Interested parties must be afforded the opportunity to provide input to inform the standard setter’s evaluation of pertinent issues.
The IASB and FASB have benefitted from informative input into their financial instruments and fair value measurement standard setting initiatives from a broad range of stakeholders.
The recommendations of some constituencies often contradict the strongly held views of others, reflecting the diversity of uses for and desired outcomes of financial reporting. As above, robust participation of interested parties is an essential element of a standard setter’s transparent due process.
Equipped with this input, it is the responsibility of the standard setters to evaluate the knowledge they have gained against the overarching objectives of financial reporting and the principles that reinforce those objectives, in a manner engendering independent decision-making.
While it is useful to consider the intersection of banking supervision and financial reporting in light of the recent banking crisis, accounting standards should not be allowed to become a surrogate for robust bank risk management or effective bank supervision.
Accessing public capital markets is a choice issuers make, and but one of many choices open to financial institutions.
As securities market regulators, we believe it would be a mistake to attempt to rectify today’s banking crisis by placing a burden on the investors in our public capital markets.
Accounting standards must be designed to provide investors with information to assist them in efficiently allocating their hard-earned investment money. It is in this context that accounting standards are designed to contribute to a sound, prosperous and more stable financial standard of living.
Independent standard setting and adherence to the fundamental objectives of financial reporting remain essential components in the development of high quality, global accounting standards.
The Monitoring Board is strongly committed to guarding the independence and accountability of the standard setting process.
European Commission on fair value and the IASB
- Source: Brussels warning on fair value shake-up Financial Times, November 10, 2009
"Brussels has warned that a radical overhaul of rules on how banks value their assets could lead to greater volatility in their accounts, undermining broader financial stability.
European Commission officials have sent a letter to the International Accounting Standards Board criticising the rule-setting body’s proposals for financial institutions, the first stage of which is scheduled to be published this week.
The IASB’s standards are used or are being adopted by more than 110 countries, including India, Japan, South Korea, Canada and those of the European Union. The IASB rule proposals could provide a blueprint for its US counterpart which is considering amending its own rules. IASB and US officials are aiming for convergence of their standards by June 2011.
The IASB overhaul is aimed at addressing criticism of so-called “fair value” accounting, the system of valuing assets at market prices which some banks and policy makers believe exacerbated the credit crisis by increasing volatility in banks’ accounts. When markets fell sharply, banks were forced to mark down the value of their assets, leading to heavy losses.
The IASB reforms will allow more flexibility in determining which bank assets must be marked to market and which can be valued according to so-called amortised cost accounting, which smooths out market volatility. But Commission officials believe the overhaul does not go far enough to limit the use of fair value accounting. Analysts say some European banks with large investment banking activities would be hit disproportionately.
In the letter to the IASB, Jörgen Holmquist, director general of Internal Markets at the European Commission, said more assets might be marked to market under the new system than even under existing rules. He urged the IASB “urgently” to consider further changes.
“It would seem that the current draft may not yet have struck the right balance between ‘fair value’ accounting and ‘amortised cost’ accounting,” he says. The letter, dated November 4, comes as a Brussels committee is expected to meet on Wednesday to discuss its response to the overhaul. The near final draft already includes a number of changes demanded by Brussels in September.
Those changes include applying fair value more flexibly than in earlier proposals.
Initially, the IASB proposed that if an asset earned predictable cash flow such as a loan, then it could be valued by amortised cost accounting. If it delivered an unpredictable return such as a share portfolio or derivative, then it had to be marked to market.
Under the new proposals, accounting experts say the IASB has given banks and insurers more flexibility on some specific financial instruments.
The IASB also unexpectedly decided to delay a rethink of how banks account for liabilities until next year, allowing financial institutions to continue the disputed practice of marking debt to market. This allowed banks to book gains when the value of their debt traded in the market fell sharply on concerns over their financial health."
FASB Chairman calls for separation of M2M from banking regulation
- Source: FASB Chairman Defends Fair Value, Calls for Separation From Banking Regulation Journal of Accountancy, December 8, 2009
on criticism of the role of accounting standards in the financial crisis and called for GAAP to be “decoupled” from bank regulation.
Herz, speaking at an AICPA conference, contended that many of FASB’s critics simply do not understand its mission. “There seems to be some confusion in the media and elsewhere about the relationship between the accounting standards we set and regulation of financial institutions,” said Herz. He explained that FASB does not determine the capital levels banks are required to maintain, but under laws enacted in the wake of the savings and loan crisis, bank regulators determine regulatory capital starting with GAAP numbers. But bank regulators can adjust the GAAP figures, and they also have other tools to address capital adequacy, liquidity issues, and concentrations of risk at regulated institutions, Herz said.
He said that while FASB has a deep interest in the strength and stability of the financial system and the economy, its public policy mission and focus is designed to be different from that of banking regulators. “Our focus as accounting standard setters is on the communication of relevant, reliable, transparent, timely, and unbiased financial information on corporate performance and financial condition to investors and the capital markets,” he said. “The transparency provided by external financial reports contributes to financial stability by reducing the level of uncertainty in the system—and a lack of transparency can hide the extent of risks facing financial institutions from both investors and regulators.”
The mandate of the Federal Reserve and other banking regulators, according to Herz, differs in that it relates to ensuring the soundness of banks and the overall stability of the financial system. He says most of the time FASB and banking regulators can find common ground, but in some situations they’re actually in conflict. “In dire situations, bank regulators may be appropriately concerned that public release of data on severe losses and asset impairments could spark a run on a bank,” said Herz. “But investors would likely want to know the extent of the problems on a timely basis.”
The answer to this problem, according to Herz, is to “decouple” bank regulation from U.S. GAAP reporting requirements. “Doing so could enhance the ability of both the FASB and the regulators to fulfill our critical mandates,” he said.
And Herz, citing a 1991 GAO report following the S&L crisis, seemed to indicate that he believes that although GAAP and specifically much-criticized fair-value accounting did not cause the financial crisis, a GAAP unencumbered by pressure from banking interests would have done a better job of alerting investors and other stakeholders of an impending crisis. “The  GAO report found that regulatory call reports significantly overstated the values of loans and debt securities (and hence the financial condition and capital) of failed banks,” he said.
He pointed out that the stress tests banking regulators recently conducted of the 19 major U.S. bank holding companies also found that the bulk of the $600 billion of potential additional losses revealed under the more adverse scenario related to loans and other receivables carried on a historical cost basis such as that used in the 1980s and not to items carried on a mark-to-market or fair value basis. In other words, fair value accounting, which is currently applied to only some financial assets, has done a better job of indicating the true financial condition of those assets than the cost basis.
Addressing another criticism of fair-value accounting, Herz admitted that reporting fair values can have procyclical effects on behavior. But he contends that “timely recognition of problems at financial institutions can have countercyclical effects through lessening the impact of financial downturns by providing an early warning of developing problems.”
This year both FASB and the IASB, under pressure from political influences, have struggled to agree on changes to accounting for financial instruments, which involves the fair value applications that have been most widely criticized. Herz provided assurances that FASB and the IASB would continue to work together on these issues, while acknowledging that the two boards have recently had differences in approach and timing. “Next year, once we have received comments and other input on our proposal, we will redeliberate at public board meetings all the key issues identified including discussing them with the IASB and making changes as appropriate,” he said. “Only after having completed this very extensive and thorough public due process will we issue a final standard carefully considering effective dates and transition.”
On Monday, the AICPA’s Accounting Standards Executive Committee (AcSEC) issued a comment letter to FASB in which the committee indicated that it favors an approach that would measure “many but not all” financial instruments at fair value. The AcSEC letter cited a 30-year fixed rate mortgage loan held to maturity as an example of a financial instrument that should not be measured and recorded on the balance sheet at fair value.
FASB to tighten mark-to-market==
- Source: Banks Face Mark-to-Market Challenge Wall Street Journal, March 15, 2010
"...But that argument ignores the fact that banks clearly didn't pay enough heed of market values in the run up to the crisis, and their own estimates of potential losses were woefully inadequate. This left bank balance sheets, and investors, unprepared for the credit crunch. If banks had focused on market values as well as internal models, many may have acted sooner to raise equity.
If anything, FASB's proposals may not go far enough. Many swings in the market value of loans, for example, still likely won't hit net profit. Even so, the potential changes are far reaching.
First, under the proposals, banks would show loans on their balance sheets at historical cost, and then adjust them for both loan-loss reserves and market values. That would allow investors to see the difference between what management has provisioned against losses and what investors think the loans are actually worth.
Second, banks' financial holdings would be divided between those they trade and those they hold. Changes in the value of tradable assets would hit profit as today. Non-trading assets would be also be marked to market but those changes would go to a portion of shareholders' equity called other comprehensive income.
Third, income statements would show more than just net profit. After that line would be added an "other-comprehensive-income" category reflecting changes in the market value of loans and securities. That would be added to net income to create a new bottom-line figure called comprehensive income. Earnings per share would still be based on net profit.
While FASB will likely come under fire for these approaches, it may have found an ally last week in House Financial Services Chairman Barney Frank. In a letter to the big four banks, Mr. Frank said banks were refusing to accept reality when it came to the value of second-lien mortgages such as home-equity loans.
"Because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans," Mr. Frank wrote.
Marking such loans to market values, and making the impact more prominent in accounts would be a step toward forcing banks to take the more-realistic view—as Mr. Frank and many investors want."
FASB proposes new valuation method to begin in 2013
- FASB Issues Exposure Draft on Accounting for Financial Instruments Alston & Bird, May 27, 2010
- Source: FASB Exposure Draft Alarms Bank CFOs CFO.com, June 2, 2010
The Financial Accounting Standards Board's new exposure draft on accounting for financial instruments, if adopted, could have adverse consequences for commercial banks, according to lobbyists and bank CFOs who are assessing its ramifications. Almost immediately after the proposal was published last Thursday, bankers began questioning its logic, particularly the requirement that even plain-vanilla loans held for collection be marked to market. Bankers say the ripple effects are numerous and include damping origination of long-term, variable-rate loans; spooking bank investors; and increasing procyclicality in the financial system.
"This is really a jaw-dropping proposal," says Donna Fisher, senior vice president of tax and accounting at the American Bankers Association.
The proposed accounting changes, which would take effect in 2013 for banks with assets of more than $1 billion, would force companies to use market prices to value almost all financial instruments, including loans to corporations and consumer loans like credit-card debt, and record any changes on the balance sheet. That's a significant departure from current accounting practice for banks, which record held-to-maturity loans on the balance sheet at amortized, or historical, cost. The changes to fair value will not flow to net income, FASB says.
Changes in fair value would appear as a separate line on the balance sheet and in the statement of comprehensive income alongside amortized cost. Currently, components of other comprehensive income (OCI) are usually displayed in notes to financial statements. The proposal would also require banks to be more forward-looking in their estimation of credit losses.
"The objective . . . is to provide financial statement uses with a more timely, transparent, and representative depiction of an entity's exposure to risk from financial instruments," FASB says.
But commercial bankers say the rules are antithetical to the business model of holding on to a loan and collecting the payments rather than selling it to a third party. "Our business is not buy and sell," says Fisher. "If the cash flows are from the customer, there's no reason to have those market fluctuations. You don't want that craziness in your financial statements."
How banks would perform such valuations is also under question. "We have a $5 billion investment portfolio and we can value it using Bloomberg," says Michael Hagedorn, CFO of UMB Financial, a $12 billion (in assets) commercial bank. "But we would have to fair-value our loans using different discount rates and various assumptions, and I don't see how that improves transparency."
"[FASB] is trying to get to where any user can pull up a balance sheet and truly see on a mark-to-market basis the value of a company's equity," says Mike Rossi, finance chief at Dallas-based NexBank. "But what they will end up with is a situation where there is a ton of judgment involved."
In an extreme situation, fair-value accounting might force a bank to take a market loss on the day it makes some loans, says Fisher. "Bankers know the borrower's credit history better than the market does," she comments. Even if a loan is fully performing, the loan will be worth more to the originator than to the market, she says. "They're going to discount it."
While bank CFOs don't think overall lending volume would be directly reduced, the fair-value rules could steer banks away from making long-term, fixed-rate loans. Such credits would have more variability in a mark-to-market scenario. And, indirectly, any negative adjustments in OCI from falling loan values would reduce a bank's total equity, which would potentially force a bank to cut back lending if the amount is large, Hagedorn says. In a tumbling financial market, hits to OCI could accelerate bank failures.
Having to mark loans to market would also increase the accounting burden on banks, says CFO Rossi. "As long as a loan is performing, there is no accounting that needs to be done," he says. "The [new FASB rule] will require us to hire another couple of people on an accounting staff of three. That would ultimately manifest itself in higher rates or fees."
According to a member survey by the CFA Institute last November, 52% of investment professionals said it was appropriate to record loans at fair value based on the notion of an exit price. The FASB proposal, however, diverges from the International Accounting Standards Board's recommended loan-loss rules, which would have non-U.S. companies carry loans held for collection at amortized cost. The difference could add another roadblock to global accounting convergence, say experts.
One aspect of the exposure draft is being greeted with a modicum of acceptance by banks. In trying to get banks to provide more-timely information on credit impairments, FASB aims to change the model banks use for accounting for credit losses. Fisher says this part of the exposure draft is a good thing. The traditional "incurred loss" model — in which banks have to accrue losses if they are probable and reasonably estimable as of the date of the financial statement — would be replaced by an "expected loss" model, in which banks would look forward and extrapolate their level of potential bad debts. The change might prevent banks from relying too much on historical data from previous economic cycles.
FASB loosens mark-to-market
- Source:Mark-to-Market Lobby Buoys Bank Profits 20% as FASB May Say Yes Bloomberg, March 30, 2009
"Four days after U.S. lawmakers berated Financial Accounting Standards Board Chairman Robert Herz and threatened to take rulemaking out of his hands, FASB proposed an overhaul of fair-value accounting that may improve profits at banks such as Citigroup Inc. by more than 20 percent.
The changes proposed on March 16 to fair-value, also known as mark-to-market accounting, would allow companies to use “significant judgment” in valuing assets and reduce the amount of writedowns they must take on so-called impaired investments, including mortgage-backed securities. A final vote on the resolutions, which would apply to first-quarter financial statements, is scheduled for April 2.
FASB’s acquiescence followed lobbying efforts by the U.S. Chamber of Commerce, the American Bankers Association and companies ranging from Bank of New York Mellon Corp., the world’s largest custodian of financial assets, to community lender Brentwood Bank in Pennsylvania. Former regulators and accounting analysts say the new rules would hurt investors who need more transparency, not less, in financial statements.
Officials at Norwalk, Connecticut-based FASB were under “tremendous pressure” and “more or less eviscerated mark-to- market accounting,” said Robert Willens, a former managing director at Lehman Brothers Holdings Inc. who runs his own tax and accounting advisory firm in New York. “I’d say there was a pretty close cause and effect.”
Willens, investor-advocate groups including the CFA Institute in Charlottesville, Virginia, and former U.S. Securities and Exchange Commission Chairman Arthur Levitt oppose changes that would enable banks to put off reporting losses.
“What disturbs me most about the FASB action is they appear to be bowing to outrageous threats from members of Congress who are beholden to corporate supporters,” said Levitt, now a senior adviser at buyout firm Carlyle Group and a board member at Bloomberg LP, the parent of Bloomberg News.
FASB spokesman Neal McGarity said the proposal allowing significant judgment was “in the works prior to the Washington hearing and was merely accelerated for the first quarter, instead of the second quarter.” The plan on impaired investments “was an attempt to address an important financial reporting issue that has emerged from the financial crisis,” he said.
Mary Schapiro, sworn in as SEC chairman in January, testified to Congress on March 11 that the agency recommends “more judgment in the application, so that assets are not being written down to fire-sale prices.”
- Source: Fair-Value Accounting Is ‘Horror Flick Monster’: Chart of Day Bloomberg, August 14 2009
"Investors should beware the Financial Accounting Standards Board’s decision yesterday to consider expanding fair-value rules, said Brian Wesbury, chief economist at First Trust Advisors LP in Wheaton, Illinois.
“Like a horror flick monster that just won’t stay dead, FASB’s accountants are proposing to expand the application of mark-to-market accounting rules across the board to include all financial assets, including regular loans,” Wesbury said.
The CHART OF THE DAY, fashioned from one Wesbury is presenting to investors, tracks the performance of the Standard & Poor’s 500 Index since the Securities and Exchange Commission and FASB clarified the meaning of the rules in September 2008.
“Twice the market was teased with a sense of potential changes for mark-to-market accounting. Twice those hopes were dashed and twice the market fell to new lows,” Wesbury said.
The biggest reason that stocks have rallied since March, Wesbury said, is that the House Financial Services Committee forced FASB to loosen its mark-to-market rules. Other reasons for the rally are the easiest monetary policy in the Federal Reserve Board’s 96-year history and the end of panic selling, he said."
CFA Institute webinar on M2M
- Source: Financial Instrument Accounting: IFRS after the Crisis A CFA Institute Centre for Financial Market Integrity Live Event, November 3, 2009
The financial crisis has sharpened focus on accounting treatment of financial instruments. The accounting approach can influence investor appreciation of risk exposures associated with complex financial instruments. Treatment of the accounting for financial instruments also represents an area of potential differences between U.S. GAAP and IFRS, and investment professionals should understand the potential consequences of these toward the ongoing convergence of global financial reporting.
IASB representatives Patrick Finnegan, CFA, (IASB Board Member) and Sue Lloyd (IASB Senior Technical Adviser) give a presentation moderated by J.P. Morgan’s Dane Mott, CFA, in which the IASB’s approach to financial instrument accounting is reviewed.
This is a recording of a live event that occurred on Tuesday, 3 November 2009.
The development of "mark-to-market"
The practice of mark to market as an accounting device first developed among traders on futures exchanges in the 20th century. It was not until the 1980s that the practice spread to big banks and corporations far from the traditional exchange trading pits, and beginning in the 1990s, mark-to-market accounting began to give rise to scandals.
To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if the market price of his contract has declined, the exchange charges his account that holds the deposited margin. If the balance of this accounts falls below the deposit required to maintain the position, the trader must immediately pay additional margin into the account to maintain his position (a "margin call"). As an example, the Chicago Mercantile Exchange, taking the process one step further, marks positions to market twice a day, at 10:00 am and 2:00 pm. SEC Info - Chicago Mercantile Exchange Inc - S-4/A
OTC Derivatives on the other hand are formula-based financial contracts between buyers and sellers, and are not traded on exchanges, so their market prices are not established by any active, regulated market trading. Market values are, therefore, not objectively determined or readily available (purchasers of derivative contracts are customarily furnished computer programs which compute market values based upon data input from the active markets and the provided formulas). During their early development, OTC derivatives such as interest rate swaps were not marked to market frequently. Deals were monitored on a quarterly or annual basis, when gains or losses would be acknowledged or payments exchanged.
As the practice of marking to market caught on in corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be objectively determined (because there was no real day-to-day market available or the asset value was derived from other traded commodities, such as crude oil futures), so assets were being 'marked to model' in a hypothetical or synthetic manner using estimated valuations derived from financial modeling, and sometimes marked in a manipulative way to achieve spurious valuations.
Internal Revenue Code Section 475 contains the mark to market accounting method rule for taxation. Section 475 provides that qualified securities dealers that elect mark to market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account in that year. The section also provides that dealers in commodities can elect mark to market treatment for any commodity (or their derivatives) which is actively traded (i.e., for which there is an established financial market that provides a reasonable basis to determine fair market value by disseminating price quotes from broker/dealers or actual prices from recent transactions).
Example: If an investor owns 10 shares of a stock purchased for $4 per share, and that stock now trades at $6, the "mark-to-market" value of the shares is equal to (10 shares × $6), or $60, whereas the book value might (depending on the accounting principles used) only equal $40.
Similarly, if the stock falls to $3, the mark-to-market value is $30 and the investor has lost $10 of the original investment. If the stock was purchased on margin, this might trigger a margin call and the investor would have to come up with an amount sufficient to meet the margin requirements for his account.
US regulators express voice concerns over broad use of M2M
- US Regulators Voice Concerns Over Broad Applicatn MTM Accounting IMarketNews.com, September 13, 2010
Chief accountants of key U.S. bank regulators Monday voiced their concerns over a broad application of fair value accounting as proposed by the Financial Accounting Standards Board.
It's not that regulators do not like mark-to-market, but, "We like fair value when it's relevant," summarized Arthur Lindo, chief accountant at the Board of Governors of the Federal Reserve System.
Fair value on the asset side would make sense if we had fair value on the liability side, he said, adding that for liabilities, in particular, looking at fair value as the main measurement is somewhat "troubling."
"Amortized cost is generally the most representative measurement attribute for instruments used in credit intermediation," Lindo said during the first day of the AICPA National Banks & Institutions Conference that ends Wednesday.
He said that using fair value for instruments held for collection or payment purposes would not only "distort performance" and the financial position of the reporting institution, but it may also create a "false sense of precision."
Instead, "we support improved disclosure of fair value information in the footnotes to financial statements," he said.
On credit impairment, he stressed that "accounting should not place artificial constraints on an entity's ability to form its best estimate of credit losses."
In fact, Kathy Murphy, Lindo's peer at the Office of the Comptroller of the Currency noted that the proposed impairment model "is not clearly stated."
In particular, she reiterated that regulators support "efforts to reduce the procyclical effect of accounting," something FASB's proposal to apply fair value to all financial instruments, including loans held to maturity, would instead increase.
For now, the cycle seems to be turning around, which might come handy for FASB when defending its proposal issued in May, and for which comments are still due until September 30.
According to the OCC's Official 2010 Shared National Credits Review
with a "significant reduction in volume of critized loans from levels reported in 2009."
The survey, according to the highlights presented by the accountant, attributes this improvement to borrowers better operating performance and access to bond and equity markets, debt restructurings and bankruptcy resolutions.
Still,"Despite the improvement," Murphy said in previewing the survey, "the volume of poorly underwritten credit originated in 2006 and 2007 continued to adversely affect the overall credit quality of the SNC portfolio."
FASB to improve reporting for financial instruments -- FAS 157 becomes Topic 820
Source: Fair Value Measurements and Disclosures (Topic 820) August 28, 2009,Exposure Draft, Proposed Accounting Standards FASB
From page 5:
- The disclosure of the use of "reasonably possible alternative inputs" for valuing "level 3" assets.
- Transfers in and out of Level 1 and 2
- Activity in Level 3 fair value measurements. In the reconciliation for fair value measurements using unobservable inputs information about purchases, sales, issuances and settlements would be required on a gross basis than one net number.
- Source: July 15, 2009 FASB Board Meeting
"Financial instruments: improvements to recognition and measurement. The Board agreed to propose a model to improve financial reporting for financial instruments.
- Accountants Gain Courage to Stand Up to Bankers: Jonathan Weil July 23, 2009 (Bloomberg)
"Turns out America’s accounting poobahs have some fight in them after all.
Call them crazy, or maybe just brave. The Financial Accounting Standards Board is girding for another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out swinging.
It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance companies could keep long-term losses from crummy debt securities off their income statements.
Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month."
"Mark to market" rules exonerated
- Source: Accounting rules exonerated Financial Times, July 27 2009
"Accounting rules probably understated, not overstated, the losses embedded in the financial system, according to a report on Tuesday from an influential group of policymakers. The report concludes, controversially, that the rules did not add to the pro-cyclical nature of the financial system.
It is widely assumed that the practice of marking assets to market prices and not reserving for expected losses on loan portfolios added to the woes of the financial system by deepening losses at a point when banks and other institutions could least afford it.
However, the report by the Financial Crisis Advisory Group concludes that because in most countries the majority of bank assets are not marked to market, but kept at their historic value, those values probably underestimated the losses now being exposed by the crisis.
The FCAG is a high-ranking group set up by the International Accounting Standards Board and its US counterpart to discuss issues arising from the credit crisis. These include fair value accounting, reserving for expected losses, and off-balance sheet accounting."
- Source: Politicians Accused of Meddling in Bank Rules Floyd Norris, New York Times, July 28, 2009
"Accounting rules did not cause the financial crisis, and they still allow banks to overstate the value of their assets, an international group composed of current and former regulators and corporate officials said in a report to be released Tuesday.
The report, from the Financial Crisis Advisory Group, also deplored successful efforts by politicians to force changes in accounting rules and said that accounting standards should be kept separate from regulatory standards, contrary to the desire of large banks.
“The message to political bodies of ‘Don’t threaten, Don’t coerce’ flies in the face of some of what has been coming from the European Commission and from members of Congress,” said Harvey Goldschmid, a co-chairman of the group and a former member of the Securities and Exchange Commission..."
- FASB Financial Crisis Advisory Group homepage
- [http://www.cfo.com/article.cfm/14511711/?f=rsspage Without Hoopla, Fair-Value Rule Is Readied CFO.com, July 20, 2010
- FASB Looks to Expand Mark Rules WSJ, Aug. 13, 2009
GAAP can be disregarded for regulatory capital purposes
Source: Will Bank Regulators Diverge from GAAP? CFO.com August 20, 2009
"Bank regulators are set to discuss accounting standards next week, with an aim toward determining the potential affects that off-balance-sheet rules may have on some financial institutions. During the past year, bankers have fretted about new accounting rules that would force them to bring back on their balance sheets billions of dollars worth of assets — a move bankers have argued will throw regulatory capital ratios into chaos.
As a result, the Federal Deposit Insurance Corp., the federal agency that insures bank deposits, announced it would discuss "the impact of modifications to generally accepted accounting principles" during its August 26 board meeting. What that likely means is board members will debate the practical implications of the rules known as FAS 166 and FAS 167, which beginning in January 2010 will change the way banks and other financial institutions account for securitizations and special-purpose entities (SPEs)...
...The impact of the accounting rules on banks came to a head in May, when the Federal Reserve Board released the results of its so-called stress tests, which were performed on the 19 largest bank holding companies in the United States. The unprecedented stress testing, officially dubbed the Supervisory Capital Assessment Program, incorporated several accounting changes into its modeling, including the potential effects of FAS 166 and FAS 167. In its summary report, the Fed concluded that the new FASB rules would require banks to reconsolidate off-balance-sheet assets tied to securitizations and SPEs.
So far, the estimates of how many billions of dollars would have to be reconsolidated vary, with the Fed guessing that an aggregate $700 billion worth of assets would be brought back on the balance sheets of the largest bank holding companies. News reports have estimated the impact to be closer to $1 trillion worth of assets.
The problem for banks is that as they consolidate the assets, they also will be required by law to increase their capital cushion, something that could prove undoable during a credit crisis.
Banks do have reason to hope, however. While banking regulators usually require GAAP-based reporting from financial institutions, which would include the use of FAS 166 and FAS 167, they can ignore GAAP for regulatory capital purposes. Indeed, that is exactly what happened when banks protested an earlier effort to improve securitization accounting. In 2005, to help quell a bank backlash against FASB's FIN 46, the Fed announced that accounting rules need not apply to banks.
"Although [generally accepted accounting principles inform] the definition of regulatory capital, the Board is not bound to use GAAP accounting concepts in its definition of tier 1 or tier 2 because regulatory capital requirements are regulatory constructs designed to ensure the safety and soundness of banking organizations, not accounting designations established to ensure the transparency of financial statements," said the Fed. "In this regard, the definition of tier 1 capital since the Board adopted its risk-based capital rule in 1989 has differed from GAAP equity in a number of ways."
Source: Mark-to-Market Update: Barney Frank on Regulatory Discretion and Pro-cyclicity Encima Global, March 31, 2009
"Appearing on CNBC this morning, Arianna Huffington quizzed House Financial Services Chairman Barney Frank on mark-to-market. His answers generally made sense to us but didn’t show a timeline or urgency in moving to repair the problems. Asked whether FASB would relax mark-to-market, he said (per our notes):
- “My major point has been not that we should change mark-to-market (though there’s some flexibility there). We want regulators to show some discretion in how they react to it. If a bank has to write down its capital because of a drop in the value of the assets it holds, nobody’s trying to stop that. Regulators shouldn’t have to react immediately because the Frank continued: “If you’re hold-to-maturity, we’ve discussed that with SEC and FASB. We’re not watering down mark-to-market. It is to give regulators discretion in how they react. Regulators should not automatically say you’ve got to cut your lending right away. There should be some discretion to the regulators.”
- Frank cited an example: “The Federal Home Loan Banks are holding mortgages to maturity, mortgages that are making payments. We don’t think they should have to have substantial markdowns as long as these mortgage are still paying because it makes no real difference in their economic position. If you force the FHLB banks to take these enormous writedowns that they’ve been forced to take by an overly rigid mark-to-market and no regulatory discretion, you cut back on mortgage lending. and we think that’s a mistake. “ consequence would be pro-cyclicity and banks would immediately have to stop their lending.”
House Financial Services Committee hearing, March 12, 2009
Mark-to-Market Accounting: Practices and Implications, March 12, 2009
Chairman Kanjorski Convenes Hearing to Address Problems Facing Mark-to-Market Accounting
Washington, DC – Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, today announced that the Subcommittee will hold a hearing to examine the mark-to-market accounting rules that many contend have exacerbated the current troubles in the financial industry and in the broader economy. The standard requires companies to value assets they hold at current market values. For assets that are frozen and have a diminished current market value but may recover value in the future, the standard has proven problematic. Companies are then forced to write-down billions in assets, which can lead to further write-downs elsewhere.
“Illiquid markets have resulted in great difficulty in valuing sizable assets. Some have therefore complained about fair value accounting and sought to eliminate it. While companies need stability, investors still need accurate information. We therefore cannot allow for fantasy accounting that wishes away bad assets by merely concealing them,” said Chairman Kanjorski. “As a result, we will seek at this hearing to engage in a constructive, thoughtful conversation with a diverse range of viewpoints aimed at identifying fair-minded, incremental, and achievable fixes to this problem. In short, I want to find a way – within the existing independent standard-setting structure – to still provide investors with the information needed to make effective decisions without continuing to impose undue burdens on financial institutions. Each of our anticipated witnesses will have the opportunity to contribute as we all pursue consensus solutions together to this thorny, contentious issue.”
- Mr. James Kroeker, Acting Chief Accountant, U.S. Securities and Exchange Commission
- Mr. Robert Herz, Chairman, Financial Accounting Standards Board
- Mr. Kevin Bailey, Deputy Comptroller for Regulatory Policy, Office of the Comptroller of the Currency
- Mr. Jeff Mahoney, General Counsel, Council of Institutional Investors
- Ms. Cindy Fornelli, Executive Director, Center for Audit Quality
- Mr. Thomas Bailey, Chairman, Pennsylvania Association of Community Bankers, and President and Chief Executive Officer, Brentwood Bank
- Mr. Lee Cotton, Past President, Commercial Mortgage Securities Association
- Ms. Tanya Beder, Chairman, SBCC Group
- Mr. Robert D. McTeer, Distinguished Fellow, National Center for Policy Analysis
- The Honorable William Isaac, Chairman, The Secura Group of LECG
SEC 2008 study on mark-to-market
On December 30, 2008, the Securities and Exchange Commission (the "SEC") issued its study (1) on fair value accounting.(2)
The study recommends that existing fair value accounting and mark-to-market standards, including Financial Accounting Statement 157 ("FAS 157"), should not be suspended. The report recommends improvements to existing accounting practices, including reconsidering the accounting for impairments and the development of additional guidance for determining fair value of investments in inactive markets, including situations where market prices are not readily available.
FAS 157 provides a uniform definition across accounting principles and a common framework for the application of fair value, as well as requiring additional disclosures relating to fair value measurements. Fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."
As the subprime mortgage crisis grew into an international financial crisis, preparers and auditors of financial statements became concerned with the impact of the application of FAS 157. Some asserted that fair value accounting, along with the accompanying guidance on measuring fair value under FAS 157, contributed to instability in the financial markets by requiring potentially inappropriate write-downs in the value of investments held by financial institutions, most notably due to concerns that such write-downs were the result solely of market prices established in inactive, illiquid, or irrational markets creating values that did not reflect the underlying economics, or ongoing cash flows, of the securities.
Others, particularly investors, argued that fair value accounting served to enhance the transparency of financial information and was vital in times of stress, suggesting that suspending FAS 157 would weaken investor confidence and result in further market instability.
For a more detailed discussion on FAS 157 and its impact on the financial crisis, see our client alert "Fair Value Accounting and the Recent Market Turmoil".
As mandated by the Emergency Economic Stabilization Act, the report addresses the following six key issues:
- The effects of such accounting standards on a financial institution's balance sheet;
- The impact of such accounting on bank failures in 2008;
- The impact of such standards on the quality of financial information available to investors;
- The process used by the Financial Accounting Standards Board (the "FASB") in developing accounting standards;
- The advisability and feasibility of modifications to such standards; and
- Alternative accounting standards to those provided in FAS 157.
The study makes eight recommendations:
Please see SEC's study on mark-to-market for additional information of the SEC study and the eight recommendations.
Federal Reserve Bank of Boston study of M2M impact on large banks
- Source: Fair Value Accounting: Villain or Innocent Victim? Exploring the Links Between Fair Value Accounting, Bank Regulatory Capital, and the Recent Financial Crisis QAU Working Paper No. QAU10-1, Sanders Shaffer, Federal Reserve Bank of Boston, January 31, 2010
There is a popular belief that the confluence of bank capital rules and fair value accounting helped trigger the recent financial crisis. The claim is that questionable valuations of long term investments based on prices obtained from illiquid markets created a pro-cyclical effect whereby mark to market adjustments reduced regulatory capital forcing banks to sell off investments which further depressed prices. This ultimately led to bank instability and the credit effects that reached a peak late in 2008. This paper analyzes a sample of large banks to attempt to measure the strength of the link between fair value accounting, regulatory capital rules, pro-cyclicality and financial contagion. The focus is on large banks because they value a significant portion of their balance sheets using fair value. They also hold investment portfolios that contain illiquid assets in large enough volumes to possibly affect the market in a pro-cyclical fashion. The analysis is based on a review of recent historical financial data. The analysis does not reveal a clear link for most banks in the sample, but rather suggests that there may have been other more significant factors putting stress on bank regulatory capital.
Accounting for Certain Investments in Debt and Equity Securities (Issued May 1993)
This Statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows:
- Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost less impairment.
- Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.
- Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity (Other Comprehensive Income).
Fair Value Measurements
Related to the entire discussion is the effect of the issuance of Financial Accounting Standards Board's (FASB) Statement No. 157 “Fair Value Measurements”, which became effective for entities with fiscal years beginning after November 15, 2007.
FAS Statement 157 includes the following:
- Clarity on the definition of fair value;
- A fair value hierarchy used to classify the source of information used in fair value measurements (i.e. market based or non-market based);
- Expanded disclosure requirements for assets and liabilities measured at fair value; and
- A modification of the long-standing accounting presumption that a measurement date-specific transaction price of an asset or liability equals its same measurement date-specific fair value.
- Clarification that changes in credit risk (both that of the counterparty and the company's own credit rating) must be included in the valuation.
FAS 157 defines "fair value" as:
“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
FAS 157 only applies when another accounting rule requires or permits a fair value measure for that item. While FAS 157 does not introduce any new requirements mandating the use of fair value, the definition as outlined does introduce certain key differences.
First, it is based on the exit price (for an asset, the price at which it would be sold (bid price)) rather than an entry price (for an asset, the price at which it would be bought (ask price)), regardless of whether the entity plans to hold the asset for investment or resell it later.
Second, FAS 157 emphasizes that fair value is market-based rather than entity-specific. Thus, the optimism that often characterizes an asset acquirer must be replaced with the skepticism that typically characterizes a dispassionate, risk-averse buyer.
FAS 157’s fair value hierarchy underpins the concepts of the standard. The hierarchy ranks the quality and reliability of information used to determine fair values – quoted prices are the most reliable valuation inputs, whereas model values that include inputs based on unobservable data are the least reliable. A typical example of the latter is shares of a privately held company whose value is based on projected cash flows.
Although FAS 157 does not require fair value to be used on any new classes of assets, it does apply to assets and liabilities that are carried at fair value in accordance with other applicable rules. The accounting rules for which assets and liabilities are held at fair value are complex.
Mutual funds and securities firms have carried their assets and some liabilities at fair value for decades in accordance with securities regulations and other accounting guidance.
For commercial banks and other types of financial services firms, some asset classes are required to be carried at fair value, such as derivatives and marketable equity securities.
For other types of assets, such as loan receivables and debt securities, it depends on whether the assets are held for trading (active buying and selling) or for investment.
All trading assets are carried at fair value.
Loans and debt securities that are held for investment or to maturity are carried at amortized cost, unless they are deemed to be impaired (in which case, a loss is recognized).
However, if they are available for sale or held for sale, they are required to be carried at fair value or the lower of cost or fair value, respectively. (FAS 65 and FAS 114 cover the accounting for loans, and FAS 115 covers the accounting for securities.)
Notwithstanding the above, companies are permitted to account for almost any financial instrument at fair value, which they might elect to do in lieu of hedge accounting (see FAS 159, "The Fair Value Option").
Thus, FAS 157 applies in the cases above where a company is required or elects to carry an asset or liability at fair value.
The rule requires a mark to "market," rather than to some theoretical price calculated by a computer — a system often criticized as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model)
Sometimes, there is a thin market for assets, which trade relatively infrequently - often during an economic crisis. In these periods, there are few, if any buyers for such products. This complicates the marking process. In the absence of market information, an entity is allowed to use its own assumptions, but the objective is still the same: what would be the current value in a sale to a willing buyer. In developing its own assumptions, the entity can not ignore any available market data, such as interest rates, default rates, prepayment speeds, etc.
FAS 157 makes no distinction between non cash-generating assets, i.e., broken equipment, which can theoretically have zero value if nobody will buy them in the market – and cash-generating assets, like securities, which are still worth something for as long as they earn some income from their underlying assets.
The latter cannot be marked down indefinitely, or at some point, can create incentives for company insiders to buy them out from the company at the under-valued prices.
Insiders are in the best position to determine the creditworthiness of such securities going forward. In theory, this price pressure should balance market prices to accurately reflect the "fair value" of a particular asset. Purchasers of distressed assets should step in to buy undervalued securities, thus moving prices higher, allowing other companies to consequently mark up their similar holdings.
Also new in FAS 157 is the idea of nonperformance risk.
FAS 157 requires that in valuing a liability, an entity should consider the nonperformance risk. If FAS 157 simply required that fair value be recorded as an exit price, then nonperformance risk would be extinguished upon exit.
However, FAS 157 defines fair value as the price at which you would transfer a liability. In other words, the nonperformance that must be valued should incorporate the correct discount rate for an ongoing contract. An example would be to apply higher discount rate to the future cash flows to account for the credit risk above the stated interest rate. The Basis for Conclusions section has an extensive explanation of what was intended by the original statement with regards to nonperformance risk (paragrpahs C40-C49).
In response to the rapid developments of the financial crisis of 2007–2008, the FASB is fast tracking the issuance of the proposed FAS 157-d, Determining the Fair Value of a Financial Asset in a Market That Is Not Active. 
FAS 166 and 167
- Source: The FASB today published Financial Accounting Statements No. 166 Reuters, June 12, 2009
"The FASB today published Financial Accounting Statements No. 166, Accounting for Transfers of Financial Assets, and No. 167, Amendments to FASB Interpretation No. 46(R), which change the way entities account for securitizations and special-purpose entities. The new standards will impact financial institution balance sheets beginning in 2010. The impact of both new standards has been taken into account by regulators in the recent "stress tests."
These projects were initiated at the request of investors, the SEC, and The President`s Working Group on Financial Markets. Copies of the new standards are available at the FASB`s website, along with a concise briefing document.
Statement 166 is a revision to Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a "qualifying special-purpose entity," changes the requirements for derecognizing financial assets, and requires additional disclosures.
Statement 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated.
The determination of whether a company is required to consolidate an entity is based on, among other things, an entity`s purpose and design and a company`s ability to direct the activities of the entity that most significantly impact the entity`s economic performance.
Marking-to-market a derivatives position
In marking-to-market a derivatives position, at pre-determined periodic intervals, each counterparty exchanges the change in the market value of their position in cash. For OTC derivatives, when one counterparty defaults, the sequence of events that follows is governed by an ISDA contract. When using models to calculate the ongoing exposure, FAS 157 requires that the entity consider the default risk ("nonperformance risk") of the counterparty and make a necessary adjustment to its calculations.
For exchange traded derivatives, if one of the counterparties defaults in this periodic exchange, that counterparty's position is immediately closed by the exchange and the clearing house is substituted for that counterparty's position.
Marking-to-market virtually eliminates credit risk, but it requires the use of monitoring systems that usually only large institutions can afford. ( Michel Crouhy, Risk Management, McGraw-Hill, 2001, ISBN 0-07-135731-9)
Use by brokers
Stock brokers allow their clients to access credit via margin accounts. These accounts allow clients to borrow funds to buy securities. Therefore, the amount of funds available is more than the value of cash (or equivalents). The credit is provided by charging a rate of interest, in a similar way as banks provide loans.
Even though the value of securities (stocks or other financial instruments such as options fluctuates in the market, the value of accounts is not calculated in real time. Marking-to-market is performed typically at the end of the trading day, and if the account value falls below a given threshold, (typically a predefined ratio by the broker), the broker issues a margin call that requires the client to deposit more funds or liquidate his account.
Effect on subprime crisis and Emergency Economic Stabilization Act of 2008
Former FDIC Chair William Isaac placed much of the blame for the subprime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to "mark-to-market" their assets, particularly mortgage-backed securities. Whether or not this is true has been the subject of ongoing debate. 
The debate arises because this accounting rule requires companies to adjust the value of marketable securities (such as the mortgage-backed securities (MBS) at the center of the crisis) to their market value. The intent of the standard is to help investors understand the value of these assets at a point in time, rather than just their historical purchase price. Because the market for these assets is distressed, it is difficult to sell many MBS at other than prices which may (or may not) be reflective of market stresses, which may be below the value that the mortgage cash flow related to the MBS would merit.
As initially interpreted by companies and their auditors, the typically lower sale value was used as the market value rather than the cash flow value. Many large financial institutions recognized significant losses during 2007 and 2008 as a result of marking-down MBS asset prices to market value.
For some institutions, this also triggered a margin call, where lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back.] This resulted in further forced sales of MBS and emergency efforts to obtain cash (liquidity) to pay off the margin call. Markdowns may also reduce the value of bank regulatory capital, requiring additional capital raising and creating uncertainty regarding the health of the bank.
It is the combination of the extensive use of financial leverage (i.e., borrowing to invest, leaving limited room in the event of a downturn), margin calls and large reported losses that may have exacerbated the crisis.
If cash flow-derived value, which excludes market judgment as to default risk, but which may also more accurately reflect 'actual' value if the market is sufficiently distressed (rather than sale value) is used, the size of market-value adjustments under the accounting standard would typically be reduced. One might question why banks or GSEs (Fannie Mae and Freddie Mac) are allowed to use high-risk, difficult-to-value assets like MBS or deferred tax assets as part of their regulatory capital base. Whether a margin call is involved is not part of the accounting standard itself; it is part of the contracts negotiated between lender and borrower.
Critics charge that claims that this had happened are akin to claiming "the problem, in short, is not that the banks acted irresponsibly in creating financial instruments that blew up, or in making loans that could never be repaid. It is that someone is forcing them to fess up. If only the banks could pretend the assets were valuable, then the system would be safe."
On September 30, 2008, the SEC and the FASB issued a joint clarification regarding the implementation of fair value accounting in cases where a market is disorderly or inactive. This guidance clarifies that forced liquidations are not indicative of fair value, as this is not an "orderly" transaction. Further, it clarifies that estimates of fair value can be made using the expected cash flows from such instruments, provided that the estimates reflect adjustments that a willing buyer would make, such as adjustments for default and liquidity risks. SEC Clarifications
Section 132 of the HR1424|Emergency Economic Stabilization Act of 2008, titled "Authority to Suspend Mark-to-Market Accounting" restates the Securities and Exchange Commission’s authority to suspend the application of FAS 157 if the SEC determines that it is in the public interest and protects investors.
Section 133 of the Act, titled "Study on Mark-to-Market Accounting," requires the SEC, in consultation with the Federal Reserve Board and the Department of the Treasury, to conduct a study on mark-to-market accounting standards as provided in FAS 157, including its effects on balance sheets, impact on the quality of financial information, and other matters, and to report to Congress within 90 days on its findings.
The Emergency Economic Stabilization Act of 2008 was passed and signed into law on October 3, 2008. On October 7, 2008, the SEC began to conduct a study on "mark-to-market" accounting, as authorized by Sec. 133 of the Emergency Economic Stabilization Act of 2008.
On October 10, 2008, the FASB issued further guidance to provide an example of how to estimate fair value in cases where the market for that asset is not active at a reporting date.
On December 30, 2008, the SEC issued its report under Sec. 133 and decided not to suspend mark-to-market accounting.
On March 10, 2009, In remarks made in the Council on Foreign Relations in Washington, Federal Reserve Chairman Ben Bernanke said, "We should review regulatory policies and accounting rules to ensure that they do not induce excessive (swings in the financial system and economy)".
Although he doesn't support the full suspension of basic proposition of Mark to Market principles, he is open to improving it and provide "guidance" on reasonable ways to value assets to reduce their pro- cyclical effects.
On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis.
On April 2, 2009, after a 15-day public comment period, FASB eased the mark-to-market rules. Financial institutions are still required by the rules to mark transactions to market prices but more so in an steady market and less so when the market is inactive. To proponents of the rules, this removes the unnecessary "positive feedback loop" that can result in a deeply weakened economy.
Companies can use the new guidance when issuing their first-quarter financial statements.
Such changes could significantly boost banks' statements of earnings and losses. The FASB changes, however, are for acceptable accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.
Opponents argue that the implications for investors are that the valuation of assets underlying such securities will be increasingly difficult to analyze, not less so.
An example would be determining a company's actual assets, equity and earnings, which will be overstated if the assets are not allowed to be marked down appropriately.
IASB to hold fair value measurement round tables
- Source: IASB to hold fair value measurement round tables IASB, September 15, 2009
In November and December 2009 the IASB will hold round table discussions on its proposals for fair value measurement. Round tables will be held in North America, Asia and Europe. An audio recording of the round table discussions will be made available on the website shortly after each round table.
About the round table topics:
The IASB has a project to define fair value and to provide guidance on measuring fair value in IFRSs. The round tables will discuss the IASB's proposals (as reflected in the exposure draft Fair Value Measurement).
- See also SIV (structured investment vehicles)
- Berkshire Takes Accounting Rules Into Its Own Hands, Tells SEC To Stuff It ZeroHedge, Oct. 25, 2010
- FASB Proposes Semi-MTM Requirement, American Banker Association Goes All "Mutual Assured Destruction" ZeroHedge, Sept 15, 2010
- Goldman Exposes The "Lend To Play" Conflict Scheme Involved In IPO Underwriter Allocation ZeroHedge, September 3, 2010
- U.S. Banks Recruit Investors to Kill FASB Fair-Value Proposal Bloomberg, July 8, 2010
- Financial Statement Presentation Interntional Accounting Standards Board, July, 2010
- Developing Implications on Loan Accounting Law: Mark to Market, Mark to Model, or Mark to Market Crash? ZeroHedge, June 5, 2010
- FASB’s mark-to-mayhem FT Alphaville, May 28, 2010
- Level 2 assets are the new Level 3 FT Alphaville, May 25, 2010
- Richard Koo Says If Banks Marked CRE To Market,It Would "Trigger A Chain Of Bankruptcies" ZeroHedge, April 21, 2010
- Hussman: "The Banking System Is Still Quietly Insolvent" ZeroHedge, April 12, 2010
- Fair Value in Foul Weather Andrew G Haldane, Executive Director, Financial Stability, Bank of England, March 2010
- Deloitte chief reignites debate over accounting for banks' losses Financial Times, February 15, 2010
- Banks Stand to Lose Billions in Value, Face Skeptical Investors if FASB Rule Adopted FinCri Advisor, Jan 17, 2010
- Accountants Misled Us Into Crisis New York Times, September 10, 2009
- Financial Crisis Advisory Group Report to the IASB and FASB re standard setting implications of the global financial crisis, July 28, 2009
- Bank Profits From Accounting Rules Masking Looming Loan Losses Bloomberg, June 5, 2009
- Citi Treasury Analytics Enhances Reporting for Mark-to-Market Accounting August 11, 2009, Wall Street and Tech
- Mark-to-Market Debate Blog of Performance Trust Capital Partners
- Get Ready for the Next Fair-Value Showdown CFO.com, August 18, 2009
- Pension Plans’ Private-Equity Cash Depleted as Profits Shrink Bloomberg, August 20, 2009
- Bankers Craving Bonuses Fudge Loan-Loss Reality Bloomberg, August 21, 2009