Accountants in the hotseat
Foes of fair-value accounting will try to make their case at SEC hearings this week.
NEW YORK (Fortune) -- Are well-intentioned but misguided accounting rules intensifying the financial crisis?
Those who think so will get a chance to make their case Wednesday, when a Securities and Exchange Commission roundtable explores the role of so-called mark-to-market accounting in the market meltdown of the past year.
Mark-to-market, or fair-value, accounting requires firms to value securities they hold at market prices, rather than the price at which they were purchased or some other value. Regulators put the rules in place to keep companies from hiding losses.
Proponents say only full disclosure will satisfy markets that have gone from skittish to terrified over the course of the past year. "Investors have been clear: they want to see the current fair values of a company's financial assets," Robert Herz, chairman of the Financial Standards Accounting Board, said in a speech last month in New York.
Critics of mark-to-market say that while it is workable in deep, liquid markets such as those for NYSE-listed stocks, it can actually exacerbate problems for firms holding the complex, rarely traded securities at the heart of the current mess.
When markets are thin or buyers hard to find, these critics say, sticking to mark-to-market can force a bank to write down the value of illiquid assets below the actual cash payments those assets stand to produce over time.
The writedowns can deplete capital - the cushion banks hold against possible losses - and force them to raise new money at disadvantageous terms. That action can send their shares down further, creating more turmoil in markets and potentially leading to more writedowns.
"What mark-to-market did was accelerate all the bad stuff," says Vinny Catalano, president of investment strategy firm Blue Marble Research. "It turned a bad situation into a horrible one."
William Isaac, a former chairman of the Federal Deposit Insurance Corp., will be among the participants at the SEC hearings Wednesday. He has been among those calling for the repeal of the mark-to-market rules, saying they have led to a $5 trillion reduction in lending by U.S. financial firms.
Isaac reasons that $500 billion of unnecessary writedowns have wiped out the same amount of capital, which has slashed lending by much more because banks typically lend out $10 for every dollar of capital they hold.
The SEC began studying the accounting matter earlier this month, after Congress called for an investigation of the question as part of its passage of the Emergency Economic Stabilization Act. The agency, which is due to report back to legislators by early January, has opened the issue up for public comments, many of which criticize perceived shortcomings in mark-to-market.
"The impact of mark-to-market accounting during this very illiquid market has caused long-term investors that are focused on fundamentals to become speculators that see asset valuations in a MTM 'death spiral,'" writes Jason Ziegler of Highland Capital Management, a Dallas-based hedge fund that invests in real estate and other assets, in a public comment on the SEC's mark-to-market study Web site.
"The current accounting standards never anticipated the wide variance and price disconnects that we are experiencing today," American Bankers Association President Edward Yingling wrote last month in a letter to SEC chief Chris Cox, "and there needs to be a more appropriate and accurate measure that approximates the fair value."
Of course, many opponents of the fair value rule have an ax to grind: They believe fair value writedowns are making banks they invest in or work with look less healthy than they really are.
And any policy change that seems apt to get banks lending again is naturally a popular one right now, as the U.S. heads for what is shaping up as the worst recession in almost three decades.
"The pressure on the SEC and the FASB is intense," says Catalano. "This thing has become a real political football."
Still, the public comments filed with the SEC show that even some observers who like the mark-to-market concept believe changes are appropriate.
William Waller, an accounting professor at the University of Arizona, suggests in a public comment filed last week with the SEC that the agency suspend mark-to-market when it comes to balance sheet valuations, while forcing companies to continue posting their mark-to-market values in footnotes. Doing so, he writes, will result in satisfactory disclosure while making banks "less prone to take suboptimal steps to meet capital requirements."
Waller says in an interview that he would typically endorse the mark-to-market rules as they exist. But with markets melting down and the economy heading into a recession, the risks that accounting rules are imposing unnecessary capital constraints on lending institutions can't be overlooked, he says.