Is mark-to-market accounting rule driving financial crisis?

New guidance about how banks should show mortgage assets on their balance sheets will be released shortly. The key rule in question is the mark-to-market rule of the FASB (FAS 157) that became effective in 2007. Those in favor of this rule believe mark-to-market accounting provides vital insight into a companies' financial health. Those who want the mark-to-market rule suspended believe the rules have forced huge writedowns of mortgage-related securities and other financial instruments at a time when there is no market to sell these assets, worsening the current crisis in the financial industry.

Mark-to-market accounting (also known as fair value accounting) requires companies to value the assets on their balance sheets based on the latest market indicators of the price of those assets. Essentially, the asset should be on the balance sheet based on the price at which they currently can be sold. Since the market for mortgage-based securities is almost nonexistent, banks must write down the assets to near zero.

The big question is are these assets really worth nothing? Some contend that these assets do have greater value because there is a cash flow from these assets as mortgage payments are collected. They advocate that some means of recognizing this income flow, not just the current asset price, would be a fairer way to value these assets given current market conditions.

The FASB appears to be moving in that direction. FASB member Lawrence Smith told the U.S Chamber of Commerce conference in Washington that criticism of mark-to-market was overblown, but indicated that guidance would be issued regarding whether a market is active or inactive. In September 2008, the SEC reminded financial firms they did not have to use fire-sale prices when evaluating hard to price assets. If FDIC Chairman Sheila Bair gets her way, she'll create a market for these assets with an "aggregator bank." The Treasury department likes the idea, but prefers to call it "public-private funds." The name doesn't matter as long as it works to stimulate the market.

The mark-to-market rule is defended by investor advocates, but the banking industry wants the rule suspended or modified. The SEC and FASB oppose suspension or elimination of the rule because they say it will hurt the quality and transparency of the financial reports from these entities. They believe that if the rule is suspended investors will have even less trust of financial reporting from banks. Remember much of this crisis started when banks were forced to move these assets onto their balance sheets from off-the-books entities.

For banks, the reason this becomes a bigger problem than other corporate entities is their federal capital requirements, which determine their ability to lend money. William Isaac, chairman of the FDIC in the 1980s under former President Reagan, told Forbes, "When there are temporary impairments of asset values, due to economic and marketplace events, regulators must give institutions an opportunity to survive the temporary impairment. Assets should not be marked to unrealistic fire sale prices."

Even if the rule was suspended, isn't the cat already out of the bag? If all of a sudden banks balanced sheet looked better because of a suspension of the rule, would investors believe the numbers? What do you think?

Lita Epstein has written more than 25 books including "Reading Financial Reports for Dummies."
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