March 8, 2009
A Modest Proposal to The SEC
Most of us have heard the proposal that we should temporarily ban "mark to market" rules as a quick fix to the current crisis. But FASB, the accounting rule making body, is opposed to this. Further, many agree in principle, rightfully in my opinion , saying companies should fully recognize the reality of the market place. However,many conclude this by saying this means use "mark to market" accounting. It is obvious to all that deal with many of these markets and these securities that many have a very thin or frozen market, but are not being recognized. I would argue this is just as real and even more obvious that what the "market" price is..
Many have blamed the new accounting rule FAS 157, for these frozen markets. I blame the implementation of FAS 157, not the rule. While a subtle difference this suggest an fairly simple, but massive solution to this problem.
The problem with FAS 157 is that we don't have any disinterested party determining what is an "Active Market" or what is an "Inactive Market". By the current guidelines, a company "marks to market" any security in an "active market"... And required to uses a "mark to model" approach for a security in an "Inactive Markets" . The "market to market" approach uses similar types securities sold to determine a price. A "mark to model" uses an expected cash flow, with an interest discount that incorporates an appropriate risks premium for those cash flows.
Theoretically the difference between these values is the liquidity premium.
The financial companies would like to mark everything to a model that has an implied "Mark to Market", Market Value, they do not like...One that is lower than their models valuation.
The auditors would like to declare anything that has a poor market value "active", no matter how thin the actual trading is on these securities and how big a "fire sale" that similar traded security was.
The auditors will win this argument.
The consequence is that what should in a reality based world be "marked to models" becomes "marked to market". This inability to quickly recognize "Inactive Markets" in the accounting world makes markets liquidity premiums grow quickly in any market beginning to freeze. Further, the frozen market hogs capital and quickly makes frozen markets spread like a contagious diseases in the real world.
This suggest a simple response, make the accounting world more quickly recognize an "inactive market" before it grows and spreads.
The obvious solution is to enable financial companies to have a swift and responsive arbiter of these conflicts. They should have an disinterested 3rd party organization with authority to declare securities as being in "active" or "inactive" markets. This organization would swiftly determine and make any changes needed for what securities should be "marked to market" or "marked to model".
The rating agencies would be the obvious choice. The SEC gave the rating agencies power by creating the "Nationally Recognized Statistical Rating Organization for this very reason (needing a 3rd party to legally determine credit worthiness) in 1975 for capital requirement ratings. This prevents them by being sued by either party, i.e. the investor or the company being rated.
This is a simple proposal, that could quickly be implemented without either side admitting a mistake or revising what guidance they already provided.
The current default alternative, of leaving everything as is, will destroy many if not most of the financial companies and we will start anew. But this new financial market will be one with little money available for illiquid assets, that must be "marked to market". Nor will it have a stomach for assets that are liquid but can become illquid in a matter of months... like home loans.