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Well-Capitalized To Insolvent In One Easy Step
The wonders of mark-to-market accounting

Gary Townsend
Posted 03/05/2009
Hill-Townsend Capital
gary.twnsnd@gmail.com

In last week’s piece on the economic value distortion and havoc caused by FAS 157’s mark-to-market accounting, I cited Capital One’s 2008 10-K to show how a company can be well-capitalized and solvent according to GAAP, but simultaneously insolvent from the point of view of many market participants. Several readers requested the pro forma balance sheet effect. Here goes:

So with full-bore MTM treatment of Capital One’s balance sheet, after net MTM adjustments of just over $12 billion, the company’s tangible book value of $28.24 per share falls to minus -$1.21. There are innumerable other examples.

The point is that the market takes Capital One’s MTM disclosure, does the math, and values Cap One as if the loans were marked to market anyway. That’s how Capital One and many other banks are well-capitalized according to GAAP and regulatory standards, but insolvent in the view of many market participants. GAAP results become irrelevant. And it’s how Roubini and others come up with their huge loss numbers, on their way to declaring the U.S. banking system insolvent.

The problem, of course, is that the MTM results have little to do with the intrinsic value to a bank of a loan or a security that it plans to hold to maturity. In a bank, the decline in a loan’s value is offset with a forward-looking provision for loan losses. The decline in the loan “prices” net of loan loss allowances is not due to credit deterioration; it’s the result of the distortions and speculation in the world’s financial markets. Mark-to-market accounting isn’t improving the transparency of bank accounting. It has reduced it, with enormous and growing damage to our economy and prospects.

The Financial Accounting Standards Board has said that it will issue new guidance on the application of FAS 157. That’s encouraging, but can anyone recall when the FASB has been timely?

The damage from this misguided rule is already huge, widespread, and growing daily. Mark-to-market accounting creates a powerful negative feedback loop. Actual or imputed FAS 157-related losses weaken capital ratios and undermine confidence in the financial system generally, which weakens the economy and adds pressure on loan pricing, causing more FAS 157 losses—and around we go.

This cycle needs to be broken. Mary Schapiro? Tim Geithner? Are you listening?

What do you think? Let me know!

Mark-to-Market Mayhem

A Wise Move By Europe's Accounting Rulemakers

Mark-to-Market Insanity

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Comment:

JimBob Posted On 3/5/2009 12:15:12 PM

With financials down another 10%+ today, I would hope that someone in the gov't would wake up and realize the disaster this is creating before it is too late. That and the uptick rule. My guess is that they are too dumb to realize what the problem is. Thanks again government.

Bob Posted On 3/5/2009 12:46:45 PM

Why would they need to be listening? They know what's going on, but it's what Obama wants - full scale nationalization. Then he can do whatever he wants with mortgage cramdowns and everyone will bow down to him to look to solve their problems. It's how socialism works...

nishitmehta Posted On 3/5/2009 1:27:15 PM

i agree mark to market should be disbanded, but bob, bush could have done so as well, not just leave it to obama. Gary, do you have any idea why they; i.e is the SEC and treasury are resisting that? would be int. to read your thoughts on why the resistance; is it just incompetence' if so that is even scarier; and then you have Goldman andJ.P. Morgan saying MTM is fine and works for them.

Jim C Posted On 3/5/2009 2:02:30 PM

Consider the money (our money) that the government put into the banks. They put this money in and explained that it was an investment that would be repaid with interest. Yet since that investment was made the federal government has done nothing to try to help the banks improve. The slowness to put a meaningful program in place to deal with the mortgage crisis has allowed the damage to continue. The lack of action by FASB or PCAOB to forebear on mark to market has caused larger and larger losses further staining bank capital. The hectoring from Congress has added no value. The stimulus (???) bill etc. doesn't help. And now Sheila Bair comes out and says the FDIC could be insolvent. So it seems like the government is hell bent to make sure that our investment is wortless. It's the equivalent of yelling "fire" in a crowded theatre. Jim C. Lake Forest, IL

bankman1 Posted On 3/5/2009 2:26:22 PM

yea, i wish they wouldnt mark my house to market while i am trying to refi - i payed a lot more for it - thats what they should use to determine LTV....not current value! Its "has little to do with the intrinsic value" of my house. cmon already - an accounting gimmick will fix the fact that the banks are isolvent? get a grip.

bankman1 Posted On 3/5/2009 2:46:56 PM

yea, i wish they wouldnt mark my house to market while i am trying to refi - i payed a lot more for it - thats what they should use to determine LTV....not current value! Its "has little to do with the intrinsic value" of my house. cmon already - an accounting gimmick will fix the fact that the banks are isolvent? get a grip.

Observer Posted On 3/5/2009 3:00:35 PM

So explain to me how the market would change if we shut down FAS 157. Wouldn't investors still be trying to figure out the underlying value of assets on companies' balance sheets? The market doesn't believe the "intrinsic" value companies are putting on their assets (i.e., that the loss reserves are adequate). Right or wrong in their assessment, I'm not sure you can change their mind by having the companies change their reporting of those values. I might be convinced that the accounting rule doesn't offer material help in reading the financial statements, but it seems a red herring in looking for a cause (or even a material contributor) in the current downturn. I've yet so see a persuasive argument on this.

Mark H Posted On 3/5/2009 4:53:53 PM

good info. This is absurd. Stop the insanity!

Little WB Posted On 3/5/2009 5:03:41 PM

Gary -- right on! Doesn't anyone use any common sense anymore when looking at the value of these instruments? I get the feeling that a bunch of folks are just putting the info given to them in a spreadsheet and calling it "good enough". Heck, if the market for these instruments was in totally the opposite situation, would we be complaining about these financial institutions being overcapitalized?

rs Posted On 3/5/2009 7:52:35 PM

Bob is right, Obama loves this. Wait till he hammers the Rx companies...

Dirk Posted On 3/5/2009 10:16:59 PM

What you are saying makes a lot sense because in theory, as regulated entities, banks already mark to market by taking loss reserves. So in essence what you seem to saing is that the mark to market calculation is double counting, on the down side. I think the truth is probably somewhere in the middle, because thus far the banks haven't recognized how weak their loans are, thus the reserves keep going up from quarter to quarter, and a close look at their own numbers suggest this. Thus the market is doing it for them, perhaps to excess, but if the people on the inside, who suppesdly are in the best position, don't face up to reality or don't have clarity, we can't expect the market to be anymore precise.

Mangesh Hirve, SG Analytics Posted On 3/5/2009 11:18:46 PM

The value of both an individual’s and an institution’s holdings are determined by and are subject to the vagaries of market. A portion of the share holder value has eroded due to expected business performance while the rest has eroded due to liquidity and credit crunch. This raises some key issues which the US policymakers have also questioned. These questions revolve around the valuation techniques and the mark to market mechanism used by the accountants as required by the regulations and compliance. Is mark to market fair to the professional investors who do not have the luxury of “picking” and “holding”? Accounting has been conveniently blamed in the past - will it undergo a transformation this time too? The key here is to watch out how investment firms "value" their holdings at the end of the year. Lately, I have been in discussions with some of my clients to reassess the valuation, reporting and auditing aspect for the same. The debates have been largely focussed around the use of an appropriate "valuation" standard. After having looked at traditional options such as DCF, Industry multiples and Assets, it has been noted that investors, in the short run, have been favoring the "Price of Recent Investment" option. This largely involves valuing an investment, if made recently, at the cost of investment and is generally a "good indication of the fair value".

scribe Posted On 3/6/2009 9:10:04 AM

Bankman: Your analogy doesn't work. Your house does not produce cash flow and you don't keep posted (ie transparent) reserves against its fall in value.

Joe Posted On 3/6/2009 9:36:10 AM

If the prices are so "distressed", how come nobody wants to buy the assets? They don't want to take advantage of the bankers? Story just doesn't pass the laugh test to be honest. Citibank sold for a buck a share yesterday. Based on your analysis, it is a great deal. I hope you're buying some.

dmg Posted On 3/6/2009 9:38:55 AM

i think we all get it, but dont you think putting the market back to model will reduce confidence in these institutions. the hand has already been shown and people know the market value, as of now, so really can you use smoke and mirrors to reestablish confidence..........

bankman1 Posted On 3/6/2009 10:45:42 AM

scribe - fine. use a rental property as an example. same holds true - what is value of the home? whatever somone pays for it. in that case you have cash flow - but the value declined. why? the other inputs have changed and so to here. the value of these investments have dropped for a good reason. all these banks are still carrying them at inflated values. can you imagine if the banks marked their loans to market? they'd all be insolvent. just ask PNC where they marked their NCC loans they bought.....

theosbornecoky Posted On 3/6/2009 11:23:20 AM

Mr. Townsend, can you please, as simply as possible, explain how a bank would value a home loan held "in house" under these conditions. house A: $200,000 mtg. / curent value $120,000 / loan is performing. house B: same numbers but loan is not performing How does the bank value these two loans under GAAP and MTM, what loan loss provisions does the bank have to reflect, and how would this hinder the bank from making new loans?

Yelsew Posted On 3/6/2009 1:44:56 PM

Well it would appear that somethings got to give, and with retail pulling out (always the last to leave the party) we might be in for some good upward momentum. And of course retail will get back in near the end of the recovery.

maryangell Posted On 3/6/2009 7:02:16 PM

I agree 100%. MTM has been the principal cause preventing the economy's ability to weather the deep recession and return to reasonable growth wit a healthy financial system. Mark-to-market has become mark-to-liquidation and the balance sheets no longer reflect the Fiar value of the assets.

Michael Fernwood Posted On 3/6/2009 8:52:46 PM

Nice job. And I am sure any investor can make the same comparison on any company with GAAP and MTM. So, either way, Cap One and Citi are still junk stocks.

aGoodBroker Posted On 3/7/2009 11:29:14 AM

Fasb 157 was instituted in 2006. It allowed banks to overstate their loan/asset values in a good market and now under estimates them in bad market. Markets are NOT always efficient. Just consider our recent tech, housing, and hedge fund bubbles. Remember that nearly all banks were "insolvent" in 1990/1991 under similar circumstances ( Oops forgot the Latin bond bubble). One modest proposal would be to mark to market what the banks plan on liquidating in the next 24 months, or some % that had been liquidated over the previous 24 months. Neither mark to market nor model is perfect. Why trust one more than the other.

MikeD Posted On 3/8/2009 6:33:10 PM

BenStein's NYTimes column today is an excellent and simply stated game plan to adress this crisis: Suspend mtm, reinstate the uptick rule and third, restict speculation/manipulation in the thinly traded CDS market through reserve requirements and/or participation limitations. Combined with some postive realistic leadership from our underachieving new administration we have a chance to break this self reinforcing negative feedback loop. Hopefully Barney Frank and friends figure this out pronto and invite you Gary to provide some testimony. This shit show must come to an end.

M2M is more realistic Posted On 3/10/2009 11:20:02 AM

The Market is the true pricing mechanism. Yes, even in these distressed times. Today's market pricing reflects the negative markets outlook. Consider these examples: Can I call my house as more expensive than the market price, just because I plan to hold it for 30 years? Can I call my stock portfolio value as more, because I plan to hold it to the next bull cycle (the bailout super bubble) If I do these, you will not believe my net worth, just as i do not believe a company's GAAP book value. Yes, I agree, when the economy picks up, the markets will assign a better price to these assets based on an improved outlook. That is the fair thing to do, and not assign a crappy value just because it is a generally accepted practice.

Jim retired Posted On 3/13/2009 7:56:37 PM

I see the point of evaluating loans, etc. for their worth. Why nite apply these principles to show their true value. Sounds logical to me

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