Thursday, February 19, 2009

"Mark-to-Market" - More Than You Ever Wanted to Know

From the Desk of Joe Rollins

I have a beautiful, large tree in my backyard that hangs over my deck. I’m not sure what kind of tree it is, but it is an incredibly accurate gauge for spring’s arrival. This tree goes dormant in the winter every year, losing all of its leaves. Throughout winter, it stands starkly naked against the dreary sky. Only in spring does it come to life, first with white petals that quickly fall off to be followed by dark green foliage that canopies the yard. It’s always somewhat exciting when this tree comes to life after being asleep all winter.

We’ve had about two good weeks of warm weather here in Atlanta and my yard is beginning to show its thanks. When I got home from work last night, my back deck was covered with white petals, giving it the illusion of a light dusting of snow. It’s amazing to me that winter’s end is drawing near already, and we’re only a few weeks away from a more moderate temperature. The roses in my yard, which are my pride and joy, along with the azaleas, are on their way to a beautiful unveiling of blooms at the beginning of April.

The metamorphosis from winter to spring typically brings a smile to most faces, but alas, our current economic situation has seemingly put a damper on our happiness. In watching the news this morning, I was overwhelmed by the incredible pessimism being reported by the national news. It’s really going to be hard for the United States to start moving forward unless someone convinces us that the world really isn’t in a tailspin and that we’re only suffering through a correction. Hopefully we will see the news take a more positive tone now that President Obama has signed the stimulus package. Until consumer confidence improves, it is going to be hard for the country to pull itself up by its bootstraps and go to work with a better attitude. Hopefully, like spring, those days aren’t far away.

I got into a lively discussion with a client the other day regarding mark-to-market accounting. I indicated that I had wanted to write a blog on the subject, but that most people were either ambivalent about the topic or that most eyes tended to gloss over out of boredom when I discussed accounting terms. But the more I hear on TV and the more information we receive from the financial press, the more I think I need to take a shot at explaining it. Maybe a rudimental explanation of a complex subject will at least get people thinking.

I continue to be outraged by our elected officials’ inability to understand – or even attempt to understand – complex issues. Two administrative moves have been made over the last two years that have directly led to the poor performance of the financial markets and indirectly, the performance of the U.S. economy. They are so simple and so basic that it’s amazing we continue debating the same subjects ad nauseam. A reversal of these two policies would not only focus the market, but it would also relieve the pressure on our banking community.

The first of these policies that need to be reversed is the very famous uptick rule. On our blog, we have often opined that the uptick rule needs to be reinstated. It was administratively deleted on July 1, 2007, at the height of the strong market, when the SEC indicated it was unnecessary. I will not go into a long-winded explanation of why the uptick rule is necessary because its importance is well documented throughout history.

After the uptick rule was suspended in July of 2007, there were no barriers to the people that short the market (sell before they purchase the stock) or elect to force a company out of business by coercion. They, in concert with others (which is illegal), can essentially sell down a stock until it’s worthless. Notwithstanding the financial performance of that stock, short sellers are not taking on any risk by continuing to short it since there are no administrative means to prevent them from doing so. Look at Fannie Mae and Freddie Mac, Bears Stearns & Company, Lehman Brothers, Wachovia, and (almost) CitiBank and how not having the uptick rule in place has damaged those companies that were once the backbone of American finance.

The uptick rule worked for the first 78 years that the stock market was open, but since it was suspended almost two years ago, investors have been destroyed due to a lack of administrative oversight. A tremendous amount of damage has been done to the financial institutions of our country due to this lack of oversight, and a tremendous amount of assistance could be offered to this group of companies if only someone would take the time to determine what would be in the best interest of the country as a whole.

The stock market opened on October 9, 2007 at its height of 14,163. Today, the Dow Industrial Average stands at 7,500, down a whopping 47% in the intervening 18 months. The accounting profession dictated that the financial instruments held by banks were required to be valued on a mark-to-market basis for publicly traded companies effective November 15, 2007. Therefore, essentially all banks and financial institutions were required to revalue these long-term assets effective January 1, 2008.

If you believe that the decline in the stock market and the implementation of the mark-to-market rules is just an unfortunate and ugly coincidence, then I wonder if you have also purchased beachfront land in Arizona and still believe in the Tooth Fairy. Unfortunately, the suspension of the uptick rule and the implementation of the mark-to-market rules have very much temporarily destroyed the financial security of many investors.

There’s a simple example to illustrate the mark-to-market issue: A company owns a building that leases to a third party and it receives rent on that building. For general accounting rules, this building would be amortized over its available life and the value would be marked down based upon general depreciation rules of 40 years or so since it is a long-term asset. At the end of its depreciation life, its value would be determined based on what it can be sold for in the open market.

Now, assume that next door to that building is another building that’s exactly the same and that is rented out for exactly the same rent amount. The only difference is that the second building is owned by a distressed landlord. Due to financial circumstances beyond the landlord’s control, he is required to sell that building at a 40% discount to the true underlying fair market value of that particular building. Even though the first landlord had nothing whatsoever to do with the actions of the second landlord, what if the first landlord is required under current accounting rules to take a 40% loss on his building, even though the true value of that building has not been diminished and he had done nothing?

Here’s another example using a financial instrument: Let’s say that we have two identical holders of a 30-year bond from the country XYZ. This bond requires that interest be paid on a semi-annual basis, and the financial stability of the debtor is not in question. However, this bond is very rarely traded, and in fact, due to its limited trading activity, it has virtually no market value. The underlying interest rate on this bond is 5%.

During the bond’s life, its value moves up and down dramatically based upon current interest rates in the market. If current market interest rates jump up to 10%, the implicit value of the bond would have to fall to match its 5% coupon rate. However, the owner of this bond has the capacity and the desire to hold the bond until maturity when he will receive the full value of the principal invested along with the annual 5% interest for the entire 30 years.

As with the building example, another holder of this bond gets into financial difficulty and sells his bond on the open market at a 40% discount. Does the first bond owner really incur a loss of 40% of his principal even though he has received all of the interest payments and has good assurances that he will receive his full principal at maturity?

As the two foregoing examples illustrate, valuing long-term assets is an inexact science. For the holder of the stock of a company that holds either of these assets, I would vigorously argue that neither of their values has been diminished by the actions of the other similar holders. However, this is exactly what has happened to the banks in our country since January 1, 2008.

For those in the financial markets who continue to argue that it is important for us to know the exact value of the underlying assets, it is interesting to note that in the first 200 years of our existence, we got along just fine under the old accounting rules. There were almost no banks that went out of business in the United States from 1996 through 2006. However, we are now up to approximately 30 banks that have failed in just an 18-month period. These bank failures correspond almost exactly with the implementation of the mark-to-market rules on November 15, 2007. Coincidence? Unequivocally not.

Beginning January 1, 2008, the banks were under a completely different set of accounting rules. Their cash flow had not been impacted, their liquidity was exactly the same and their financial positions on a long-term basis were just as stable as they were on December 31, 2007. However, beginning on that day, they were required to write-down billions of dollars of assets that they fully intended to hold to maturity. These assets weren’t bad; there was just no market for them. Additionally, the bonds in question continued to perform favorably, but the banks were now required to write them down 30% to 50% based upon an illiquid market where the bonds could not be openly sold.

First, it’s important to realize the impact of this transaction on banking in general. Since the banks can essentially lend 10 times their capital, the lending capabilities of the entire financial structure in the United States were immediately and dramatically diminished. If banks wrote down $500 billion in these assets, the U.S. lost $5 trillion in lending capacity. Nothing had changed, but since their capital had eroded they could no longer lend as much money as they were able to only one year (or even one month) previous. One minor change in the rules essentially made the banks insolvent. I guess that’s the axiom of unintended consequences, and if it were not so serious, it might even be funny.

The financial markets immediately began reeling on the effect of this transaction. Financial commentators throughout the world commented that all the banks were now insolvent and had no ability to carry on. I’m betting they were shorting the stock or did not understanding basic accounting. What is interesting is that nothing had actually happened and then the banks go from having excess financial capital on December 31, 2007 to being insolvent (at least by this definition) at January 1, 2008. One day does not equal insolvency. Many of our banking institutions have been destroyed due to an ill-informed, ill-applied and overly-cautious accounting rule.

There’s a simple solution to this issue, and it’s one that could be signed by Congress, the Chairman of the FDIC or the Federal Reserve Chairman tomorrow. It would require no special legislation, no specific Congressional approval or any type of intuitive thinking. We could allow the accountants to take their pessimistic and gloomy analyses and continue to reflect them on the financial statements for the world to know. This information could be disclosed in massive detail that only the nerdiest of nerds would understand. We could create transparency of information unlike any ever created before, and we could make this information available to each and every person who wanted to evaluate it, understand it, and act on it if anyone actually cared. However, we would not charge these write-downs against their regulatory capital and therefore, not reduce the bank’s lending capacity.

For those of you who continue to argue that it is important to value your assets on a fair market value basis, I want to point out that we have never done so before, so why is it so important now? This solution would solve everyone’s issues. The accountants and financial analysts would still have the information they need to evaluate the specific banks. However, the banks would have the regulatory capital to continue to lend, which ultimately supports the U.S. economy and how they make money. It’s amazing to me that a solution this simple seems so foreign to a government that has become too big to function.

If you think that mark-to-market has not been detrimental, just think about Wachovia and CitiBank. These are two of the most successful banking enterprises of our lifetimes, and they’ve essentially been put out of business due to this simple accounting mistake. I, for one, believe that the banks are little changed from where they were a few years ago. While it’s true that they’ll have bad debts due to the recession, I think these amounts are fully accounted for in their reserves for bad debts. These banks have gone through many recessions before and survived. What’s different now?

In fact, I believe that the banks are little different than they were on December 31, 2007, except the owners of these financial instrument’s common stock have lost 90% of their value due to the combination of bad accounting under the mark-to-market rule and the inability of our government to enforce guidelines on short selling and the uptick rule.

I think that if the simple solutions I’ve suggested are implemented, this big problem would be easily solved. Questions by inept, uneducated and overly political government officials and administrators welcome…