Tomorrow Mark-to-Model Returns with a Vengeance

The heat is on in Norwalk, Conn., this week.

The Financial Accounting Standards Board’s headquarters quakes down to its foundation as Congress bullies it toward sweeping rule changes. Those changes govern the balance sheet values of those very pesky loans and derivatives that started us on this road to crisis in the first place. And the rule overhaul could strike as early as this week.

Right now, the FASB recommends a mark-to-market practice for a majority of financial assets. But Congress wants to mark to model — because that’s what ailing banks want. To see what marking to model looks like, let me give an example of how that would work for your 401(k) quarterly report.

Each quarter, instead of finding out your current account value, you’d get a figure derived from a series of equations using various probabilities for what the value of your fund might be at your target date for retirement. In my case, something like 2045.

Of course, I don’t think I’ll be living in the same America in 2045 — even if I never move overseas. And that’s the problem. As the mortgage-back securities blowup taught us, these models — especially those developed by and for the banks — didn’t price things correctly in the first place.

Sure, we all have moments when we think the market’s current valuations are crazy. Maybe because we know the industry better than anyone, or we have a friend who’s found some old land on the books, or we’ve seen the heights of a cycle and expect it to return. If stocks are at the mercy of the market — and its potential for misinformation — shouldn’t we hold other assets to the same standard?

This mark-to-market accounting rule change isn’t the Change the president was after. As a step toward further protectionism of Frankenstein financials, it’s more of the same. Switching over to a mark-to-model system is like a college student who must present her dorm room for inspection. What’s to be done? The floor has a throw rug on it, so she lifts up a corner and swishes all the dust bunnies, dried vomit, spare change, and other detritus under the carpet.

Bloomberg offers the take from former Lehman Bros. managing director, Robert Willens:

“By letting banks use internal models, instead of market prices, and allowing them to take into account the cash flow of securities, FASB’s change could boost bank industry earnings by 20%.”

We note that the April 2 changes will apply to first-quarter financial statements. So I’m assuming that means all the recent earnings announcements will head back to the SEC for restatements in the hopes of attracting new suckers…I mean shareholders. Such a ruling would allow Citigroup to cut losses by 50-70%. Of course, this rule change threat has been afoot since late 2007, but the rush is on as our can-do Congress takes control.

It’s all about swinging those net losses into net gain territory come hell or high water. (Fargo, N.D., for one, is drowning under the Red River as I write).

The industry rhetoric always ends in a rousing “just say no to fire-sale prices.” Funny, I thought Wall Street had an awfully large conflagration going upon which Congress and Treasury are eager to throw more cash. (Well, I’d rather they burn through decimal places than burn books, I guess. But I don’t see the FASB quenching these flames.)

How March 12 Changed Everything

On March 12, the House Financial Services subcommittee called FASB chairman Robert Herz to the stand. His statement blames the underlying financial conditions — and not the standards — for the write-downs banks are having to suck up. He also says that capital adequacy “is beyond the purview of the FASB.” He makes it clear that the FASB exists to protect investors’ right to information.

However, House Financial Services berated him, belittled him, and told Herz he couldn’t make the rules anymore. Last I checked, the FASB was actually an independent private sector organization. But that’s not so important anymore. Check out this exchange:

“Chairman Rep. Paul Kanjorski (D-PA): You do understand the message that we’re sending?

“Herz: Yes, I absolutely do, sir.”

So now Herz has to get a new fair-value rule finished by April 2. Technically, it’s the SEC who has the oversight here, not Congress. But that’s not the worst part.

Herz admitted, after his congressional grilling, that the financial industry and their trade groups are doing the heavy lobbying. Not investors.

Who holds political action committee strings? None other than beleaguered Citigroup, and others like the Bank of New York, Mellon, Bank of America and Wells Fargo.

Take a look at what the Federal Election Commission tracked for just one representative’s, Chairman Kanjorski’s, re-election. Citigroup put up $6,500. Bank of America topped that with $7,000, and Wells Fargo offered the most: $13,000. Of course, it was all chump change to them. And we, the chumps, are already down about 50% this year and don’t have the spare change to dump in the House Financial reps’ pockets. Our only influence comes by selling short more bank stock.

Congress Follows Newton’s Sacred Law

Newton’s Third Law: For every action, there is an equal, opposite reaction. Chances are you heard that an awful lot in grade school, and have seen this reality break up many a marriage.

Well, in the case of the FASB, Congress, and the bold new plans coming out of Timothy the Timid (who stood firm as a lion on his recent Meet the Press junket), we are left with a big naught.

You see, the new age of mark to model that Congress asks the FASB to inaugurate runs directly opposite to what Geithner fixes to do for the banks. Geithner wants to allow banks to sweep this trash from their balance sheets (and onto our Treasury’s and those of “private” investors tempted in yenta-like matches — whose prospects may be read in that famous attempted union of Citi and Wachovia. If you’ll recall, Wachovia fled at the altar for Wells Fargo).

But Congress — with the help of the FASB — wants to let these banks keep the stinking assets…every last one. Mark to model will be left up to the bank’s choice of equations plugged into its internal modeling of future market conditions — and not it being made to write these assets down to below “fair market value.” Thus, they won’t be selling these suckers to the Treasury.

Before you think that means we’re home free, that it’ll keep those dollars in the Treasury (or from being printed in the first place), realize that in five years, 10 years…whatever the fixed term…those assets will actually hit the marketplace.

It could send banks swimming with their favorite enemies — the short sharks — all over again. And those sharp-eyed shorts have every right to signal to the market, “Here are the weak fishes — cut the school down to size.”

What the New and Improved “Fair Value” Could Look Like

Right now, fair value is determined by marking these assets to their market price once a quarter. Is that really so much to ask? The sally from the banks is always the same: Some of the banks will hold these assets to maturity, which could be 10 years down the road.

The model, on the other hand, is only the most mathematical guess where the market will be in 10 years. There’s just one flaw. Even holy Goldman doesn’t know the future, and no matter how many ex-execs it puts in public service, we’ve seen it can’t MAKE the future.

When the math guys, fondly called “quants” — short for “quantitative” — modeled these derivatives the first time around, their calculations indicated what would happen 99% of the time, when there would be some measure of profit, and neglected the other 1% of the time, when losses would be catastrophic.

Obviously, Congress would do better by putting a ban on all “black swan” events. But most important of all, some banks could be freed from tapping the government bailout if mark to model rules the day: Wells Fargo, M&T Bank, U.S. Bancorp, and PNC Financial.

For edification, I leave you with a quote from Wells Fargo’s own CEO, John Stumpf:

“If you’re a pessimist, there’s a lot for you to like about 2009.”

He further says that you should look for more bankruptcies; more borrowers in a bind — hence more loan losses — and, icing on this mud pie: higher unemployment… signaling more borrowers underwater and more loan losses.

However, Stumpf sweetly echoes the best politician (or Mr. Pollyanna, Warren Buffett) when he offers:

“We continue to believe in the spirit, ingenuity, work ethic, creativity, and adaptability of American workers. We’re capitalists and proud of it.”

What he really must believe in is the work ethic of folks like Rep. Paul Kanjorski and friends on the House Financial Services Subcommittee. Stumpf should know he’s the one paying for it.

Samantha Buker

April 1, 2009

The Daily Reckoning