Who Benefits from FASB Accounting-rule Changes?

The Financial Accounting Standards Board’s (FASB) mark-to-market rule requires firms to report the fair-market value of their assets on a quarterly basis. The valuation is based on the sales price fair market price of equivalent assets. Opponents of mark-to-market contend that in illiquid markets, mark-to-market unduly penalizes companies by making them write-down their assets, thereby exposing them to more financial risks as a result of the unfavorable valuations that result from the ensuing depressed prices. Proponents on the other hand believe that the fair market price is a true reflection of the value of the asset at the time.

Banks that advocated for the changes to FASB 157-e argued that the absence of a market for collateralized debt obligations, such as mortgage-backed securities significantly impaired their ability to do business, hence making it more difficult for them to recover from the economic slow down. Some banks proposed a replacement of mark-to-market with the traditional discounted cash flow model. This model discounts future cash flows at a risk-adjusted rate of return. Bankers believe this model is better suited for the valuation of assets in an illiquid market. Opponents contend that when the cash flow model is used, bad assets are still depressed as a result of the risk-adjusted discount rate used in the discounted cash flow model. They believe that the current price, determined by mark-to-market, is what a buyer would pay for the assets.

The big U.S. banks stand to gain the most from the changes to FASB 157-e. Many of these banks were forced to write down their assets at a significant cost as the value of their investments in mortgage backed securities declined. As a result of the write-downs in their assets, they had to raise additional capital to maintain their reserve requirements at a time when they would otherwise have benefited from withholding less capital and issuing more loans. These banks also experienced a decline in the market value of their stocks as investors dumped their stocks. The decline in their financial health led to a reduction in their credit rating by the rating agencies. All of these adverse conditions hit the big banks like a Tsunami, making it even more difficult for them to survive. Some banks saw huge withdrawals by customers who were panicking and the Federal Reserve and U.S. Treasury were concerned that there might be a run on these banks by investors who may panic and think that the banks are insolvent.

The banks argued that the changes to FASB would help their capital position by allowing them to value their assets more favorably, reduce their capital requirements, and improve their credit ratings. The banks argued that this measure could only improve their financial position and give them the much-needed opportunity to sell their assets and return to a state of solvency. Opponents content that this change does not address the structural issues in the market and in fact exacerbates the situation by encouraging the same practices that precipitated the current economic crisis.

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The changes in FASB 157-e are retroactive, going in effect the first quarter of 2009. The biggest financial institutions including Citibank (C), Bank of America (BAC) and Wells Fargo (WFC) will benefit the most from the change, since they hold a disproportionate number of toxic assets. Some analysts estimate an upward revision in asset values of these companies by as much as 20%. Others content that the recent plan developed by the Treasury Secretary, will be more difficult to enact if asset prices rise too much, and investors will no longer be induced to buy the toxic assets. Yet others believe there will be less of an incentive at higher prices for the banks to sell their assets. Though the changes to the FASB accounting rules are complex and might prove ineffective in resolving the current banking crisis, the proponents who are almost overwhelmingly the big banks are confident that it is a step in the right direction. Only time will tell if the large banks will indeed benefit from the recent accounting changes.

Taking a stock trading position in a financial company may seem very attractive with the depressed values of the companies, but with the changes to the FASB accounting rules, it becomes more difficult to value the companies. An investor considering a stock trade of a financial company might consider stock options as method to hedge investments. Stock options can provide investors an aid for capital preservation. For example, a put option can be considered “stock insurance“. A put option provides protection in the event the price of a stock investment drops significantly. A married put position, a stock combined with the purchase of a put option, can provide downside protection while also providing an investor upside potential. A married put combined with a covered call investing position can provide downside protection and monthly income.

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[tags] mark-to-market, fair market price, illiquid markets, FASB, 157-e, collateralized debt obligations, mortgage-backed securities, discounted cash flow model, banks, Federal Reserve, U.S. Treasury, Treasury Secretary, BAC, BankAmerica Corp., C, Citigroup Inc., WFC, Wells Fargo & Co. [/tags]