The 'Mark to Market' Accounting Rule: The financial crisis we are in today was not caused by mortgages or housing, although they were both catalysts. The real reason was an accounting rule called "Mark to Market" (also known as FASB 157). Few people have a strong grasp of this rule, and even those who do have a tough time explaining it on air due to time restrictions. So let's take a few minutes to break it down, so you can have the inside track on this very important concept and understand why it represents some great opportunities. Why does 'Mark to Market' exist? Let's go back to the stock market crash, which occurred between 2000 and 2002. With the S&P down 49% and the NASDAQ down 71%, many people lost much of their life savings and they were very angry. Companies like Enron and Arthur Andersen were able to find ways to make their books look more attractive, which was reflected in an artificially inflated stock price. Both the public and Congress had a call for more transparency in business and hastened the passage of "Mark to Market" accounting. This is the notion that all assets should be valued as if they were sold on a daily basis. Under the letter of the law, failure to do this conservatively can now result in jail time. So what's the problem? Before we get into what this means for banks, let me make a quick analogy using a scenario that should make perfect sense to you and your clients. Let's imagine that you own a house in a neighborhood where all of the houses are priced at around $300,000. Unfortunately, your neighbor, who owns his home free and clear, falls ill and needs emergency cash quickly. Because he is under duress, he must sell the home for $200,000 in order to get the cash he needs right away, even though the home is worth considerably more. | ||
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The problem multiplies The problem doesn't stop there. The fire sale we just had on our loans makes things worse - even for the banks that bought them up and thought they were getting a great deal.
Under Mark to Market, the loans we just sold must be included in the comparables that other financial institutions use to value their assets. This is how the problem spread and got so bad so fast. Other good institutions, with good loans, have to mark down. Just like us, they become over-leveraged. It's a chain reaction, all triggered by a well intentioned, but over-reaching accounting rule. Financial institutions fold, sell, or freeze. Credit - the life blood of our economy - is cut off at the source. Because of a lack of available credit, home sales and refinances crawl, auto sales drop and jobs are lost. Additionally, the economy enters a recession. During the last recession in 2001, the economy recovered relatively quickly thanks to $3 Trillion worth of home equity withdrawals. But, more restrictive programs, a lack of available credit, and lower home values will make it difficult for us to use home equity to help pull us out of a recession this time around. Fixing the Problem The Federal Reserve has passed a rescue plan, which, over time, will provide some level of help. Some banks will get money to infuse into their capital accounts. Others can sell some assets to the government in an effort to "de-lever". But, the big thing that is not talked about, not well understood, is the part of the rescue plan that traces this financial crisis back to the source. The US Congress has given the SEC its blessing to modify "Mark to Market" accounting. And by January 2, SEC Chairman, Chris Cox has to get back to Congress with ideas, if any, on how to fix Mark to Market accounting. It won't be eliminated, as we will not want to go back to the Enron days. But he is likely to adjust the Mark to Market provisions. Here's one potential solution - even rental or commercial real estate properties can be valued two ways:
If we see Mark to Market modified to use cash flow to value assets, without requiring a large percentage discounting mechanism - wow! What a shot in the arm that would be. We'd likely see the stock market rally, with financial stocks leading the uphill charge. Consider that, in today's market, fund managers are holding 27% of their assets in cash, compared with just 3% they held in cash when the stock market peaked in October of 2007. That means there is a lot of money on the sidelines that can push stock prices higher. Additionally, think about the redemptions from hedge funds that eventually need to be put back to work. That's another reason to be optimistic about stocks in the first quarter of 2009 - provided that Chairman Cox modifies Mark to Market accounting in a meaningful way. And a good stock market helps individuals feel better about purchasing homes. Additionally, stronger balance sheets for financial institutions will allow them to lend more money. The bottom line With some potentially very good news around the corner, there might be reason for optimism as we head into 2009. | ||
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