Published August 1, 2011

Fox Business

A little understood but very important accounting rule being blamed for the $523 bn in losses and writedowns at financial companies around the globe is now being retooled by market and accounting regulators, in a last-ditch attempt to stop the steam pipes bursting and to get banks lending again.

However, the move matters greatly to taxpayers, because analysts now say that banks who own severely damaged mortgage-backed bonds may be able to use the changed rule to get higher prices for these securities if they auction them off to the government as now planned in the $700 bn rescue bill.

The rule change comes just at the end of the third quarter, which means companies may be spared the pain of big third-quarter losses and writedowns.

And it comes as the Federal Bureau of Investigation is probing Wall Street firms to search for criminal securities fraud in the valuation of these bonds.

Here’s how it works.

When borrowers get loans, the banks typically sell these loans to Wall Street firms, who then repackage them as bonds backed by the value of a house or property. Wall Street then sells these bonds to mutual funds, pension funds and all sorts of investors around the globe.

As house prices drop in value, so, too, do the value of these bonds, which vary in type as mortgage-backed securities, collateralized debt obligations (CDOs), even CDOs of credit default swaps or exotic bonds called CDO-squareds.

The accounting rule says that companies that own these bonds must value these bonds each quarter as if they were going to be sold immediately. That process is called mark to market.

But since these bonds have dropped in value, they are regarded as Kryptonite because no one wants them.

Companies must then book these losses on these bonds even if they did not sell them. Mark to market has since been jokingly called mark to mayhem and mark to madness.

Relaxing the Rules

The Securities and Exchange Commission and the Financial Accounting Standards Board have now clarified existing mark to market accounting rules saying companies have leeway in assessing value, and do not have to use the current market price, which is of course way down.

The SEC and the FASB basically say that companies are not required to book fire sale prices when valuing these illiquid assets, including mortgage-backed bonds. Instead, management can use their own internal assumptions to measure fair value.

Specifically, the accounting regulators said that companies were initially supposed to use fair values based on an orderly transaction between willing market participants. However, distressed or forced liquidation sales are not orderly transactions, the SEC said in a statement. 

Don’t Blame the Rule

It’s important to remember here that no one really knows the value of these bonds and whether they are worth more or less than what the market says they are worth because the cash flow is or is not really there.

It’s important, too, to remember that it’s not just an accounting rule that can be held to blame for record losses, but the fact that banks got themselves into trouble by recklessly giving too many loans to borrowers who either were irresponsible or could not afford them.

It is no small irony that the government’s plan essentially is an attempt to put a floor under these bad securities that were written down according to a governmental accounting body’s rules.

The question now is whether this accounting rule change will reflect the true value of these assets and whether doing so will force Congress to dole out the full $700 bn—or more—to rescue these assets.

Record Losses

The losses have caused banks to be in violation of their statutory capital requirements, forcing them to raise capital to plug balance sheet holes. The losses are also the reason why a growing number of financial companies have shut down, been forced into mergers, or been nationalized.

And the losses are behind the reason why the Federal Reserve and central banks around the world have pumped record amounts of liquidity into markets, and have pushed the US central bank and the US Treasury to let banks dump their illiquid mortgage-backed bonds for more liquid Treasuries.

The decision by the Securities and Exchange Commission and the Financial Accounting Standards comes as the London interbank offered rate, or LIBOR, hits record highs. Many adjustable rate mortgages—including dodgy no income verification loans and interest only loans—in the US are due to reset to higher interest rates because they are tied to LIBOR, which is the rate that banks in Europe charge each other for such loans.

As more loans go belly up due to the higher rates, that means more losses for banks and financial companies.

The financial-services industry has been lobbying the SEC and FASB for months now to alter the rules, a lobbying that picked up speed in the wake of the new $700 bn Congressional rescue bill that would set up a reverse auction mechanism to let banks unload these damaged bonds onto the government. Congress may include the change in its new version of the rescue plan.

The American Bankers Association had complained to the SEC that auditors were forcing banks to value these bonds at unrealistically low fire sale prices, rather than at the higher values the banks believe these bonds should be worth in an orderly market.

There is also some talk in Congress of a temporary or permanent repeal of the mark to market rules to allow for more long-term valuation of assets and loans.

The Problem with the Rule

The problem with this accounting has always been what critics say is its punitive effect.

Companies have to record resulting losses from this mark-to-market exercise, which some say is the equivalent of sticking a finger in the wind, as if they actually lost cash even if they did not actually sell the bonds at all, and even if the cash flows are still coming in higher than what the market says the assets are worth (Fannie Mae and Freddie Mac have said that they are solvent on a cash-flow basis, notes economist Brian Wesbury ).

The writedowns taken by some firms have triggered a cascade of writedowns at other companies, as prices are seen to be set in the marketplace. For example, E*Trade last year priced some mortgage-backed bonds at 27 cents on the dollar, triggering writedowns at other firms. Merrill Lynch (MER) sold assets to the vulture fund Lone Star at 22 cents on the dollar (really 6 cents if you consider that Merrill financed 75% of this sale), also causing other writedowns.

JPMorgan Chase (JPM) bought Washington Mutual (WM) at a garage sale price, triggering fresh new prices for assets on its books that triggered anew mark-downs on the assets at Wachovia. which was shephered by the Federal Deposit Insurance Corp. into the arms of Citigroup (C). 

Risk to Taxpayers

But the $700 bn rescue plan makes the change potentially more damaging to taxpayers because the relaxation of the accounting rule means banks may be able to keep higher prices on these bonds and then unload them at higher prices at auction to the Treasury. 

It is not in the interests of U.S. citizens and taxpayers to abandon mark-to-market accounting for a proposal in which taxpayer funds are being used, says Janet Tavakoli, founder and president of Tavakoli Structured Finance and one of the best market analysts on the dangers of credit derivatives.

Tavakoli adds: If we would have to sell the assets at a loss due to downward moves in market prices, we have a right to know that. If the assets have permanent losses so that even if we hold to maturity we would have losses, we have a right to know that too. At any given time, we have a right to know what our investment’ is worth.

Tavakoli adds that the danger is that the government’s new portfolio managers can claim they are making money while the assets are declining in value due to defaults or permanent value destruction of collateral. This situation can continue for a long time to create the false appearance of profitability.

Tavakoli notes that in other words, U.S. taxpayers can be told they are making money on their $700 bn investment, when in reality they are losing money. I would rather know the market price, even if the news is bad news.

Loophole Dangerous to Taxpayers in the Rescue Bill

And check out this sentence I’ve highlighted in italics in section 101 of the new bill, entitled purchases of troubled assets—it could also mean even higher costs to taxpayers:   

(e) PREVENTING UNJUST ENRICHMENT. In making purchases under the authority of this Act, the Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset. This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in Conservatorship or receivership , or that has initiated bankruptcy proceedings under title 11, United States Code.

This section probably indicates that JPMorgan Chase can sell the troubled assets of WaMu to the US government and make windfall profits, notes market analyst Richard Suttmeier. Same for Citigroup with regard to Wachovia’s troubled assets. Other future deals as well. That is a direct bailout of Wall Street on the back of taxpayers.

Check out what Tavakoli says is a better way than the $700 bn bailout plan:

Rather than adopt any form of the Paulson Plan, which uses billions of taxpayer dollars and forces risk and potential losses on taxpayers—instead of those who enjoyed the gains—I advocate an alternative.

Instead of the Paulson Plan, we can force creditors to accept a restructuring plan (this was done during the Great Depression). Creditors (debt holders) including credit default swap counterparties would be compelled to accept a restructuring plan. That requires partial forgiveness of debt in many cases and/or a debt for equity swap (in which the government takes equity stakes in these companies).

If we are determined to violate personal property rights, I prefer it be done through a forced debt forgiveness and a forced capital restructuring (debt for equity swaps), rather than through a massive bailout (any of the various forms of the Paulson Plan).

The Paulson Plan destroys capitalism (those who stood to gain—and already made off with large gains—should bear the risk) and violates the spirit of democracy established by the Founding Fathers of the United States.

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