Mark to Market Laws Finally Changed

The Financial Accounting Standards Board (FASB) met yesterday to discuss, among other things, the now infamous mark-to-market laws (MTM). After much deliberation, the rules have finally been changed. These fair value accounting rules contributed to the downfall of major firms last year such as Lehman, Wachovia, and Washington Mutual. And former FDIC chairman William M. Isaac told a House Financial Services subcommittee last march that “MTM accounting has destroyed well over $500 billion of capital in our financial system.”

Until yesterday, MTM rules required firms to value assets on their balance sheet based on whatever price they could get from them in the market on that day (instead of what they are probably worth in the long-term). Financial firms are also required to hold a certain amount of capital relative to the asset debt they hold. When values on assets linked to mortgage-backed securities (MBSes) dropped last year banks were left scrambling to find additional capital to balance their ratios. Unable to quickly recapitalize, Lehman was forced to declare bankruptcy.

But this has now changed. Yesterday, FASB staff determined they will:

“Affirm that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).”

In English this means that when markets are determined to be frozen or inactive, like when the MBS chaos threw into question their values, then financial firms can set the price of their asset as if they were selling in a stable market. They can project down the road what the value of the asset would be if there was no market volatility. Basically, banks are largely free to use their own judgment in setting asset values.

The FASB provides various rules and recommendations for how to properly do this, and it also emphasizes transparency requirements for firms as they set prices.

Of course this does open the door for fraud, and banks over valuing their assets in order to leverage more cash into investments. This has been a fear in changing the laws. However, that’s why we have regulatory organizations, to enforce the laws and referee the rules of the game.

I said on March 24 that, “Varied opportunity cost and subjective value mean that you can’t effectively mark-to-market an asset in an economic downturn. The market is made up of varying actors with varying perspectives that can’t meaningfully be lumped together.” The new FASB laws reflect that concern and create a more fluid process that doesn’t try to box in market principals.

Of course we do have to look for what unintended consequences might result from this rule change. WSJ wrote yesterday that the new MTM regulations create a disincentive for banks to sell Legacy Assets through the TALF and PPiP initiatives set up be the Fed and Treasury. And Reuters reported Morgan Stanley analysts said the change might reduce potential earnings in a volatile market.

More on MTM from Reason here, here, and here.

Commentary on MTM from Bloomberg, and a primer on MTM from