Fahrenheit 157

Story Highlights:

• Today, Fed Chairman Ben Bernanke commented on the status of mark-to-market accounting in a speech to the Council of Foreign Relations in Washington, DC.
• Bernanke expressed support for the accounting rule but hinted changes are in order.
• The unintended negative consequences of mark-to-market accounting can't be undone, but revisions to the rule and a greater understanding of its impact should help speed a recovery in the financial system.

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Stock market volatility continued today, but this time investors received a welcome respite from the selling pressure of the last few weeks as US markets finished the day up a whopping 6.4%. One of many factors contributing to today's gains was relatively sanguine comments from Fed Chairman Ben Bernanke as he addressed the Council of Foreign Relations in Washington, DC. Bernanke discussed a number of topics, including the status of FAS 157 (aka mark-to-market accounting). For those unfamiliar with this accounting rule, FAS 157 requires financial firms to value their assets at the price they could fetch in an immediate sale. In implementing the rule, the Financial Accounting Standards Board (FASB) hoped to improve the transparency of financial firms' balance sheets. But the unfortunate unintended consequence has been write-downs totaling hundreds of billions of dollars, which have seriously impaired financial firms' capital structures.

Bernanke indicated support for mark-to-market accounting, but he didn't say FAS 157 should be left as is. On the contrary, the Fed chairman suggested aspects of mark-to-market accounting should be revisited, such as how the rule is applied to illiquid, hard-to-value assets (e.g. Collateralized Debt Obligations, or CDOs) for which active secondary markets simply do not exist. In doing so, he acknowledged the now obvious fact strictly applying market-to-market accounting to these assets has resulted in severe market "disruptions." Put differently, the only way to sell assets in a market with few if any willing buyers and sellers is to cut prices to levels often far below their long-term values.

Mark-to-market accounting is a perfectly fine approach for valuing many types of assets, so long as they're liquid and trade at least somewhat frequently. For instance, the value of a portfolio of stocks or liquid bonds is generally very easy to determine because prices are available by the day, or even by the minute. But a strict application to exceptionally illiquid assets has forced financial firms to mark them down to extremely depressed levels far lower than the actual value of the loans comprising these instruments.

Bernanke isn't the first to suggest an overhaul of FAS 157 is in order. The original version of the Troubled Asset Relief Program (TARP) required the Securities and Exchange Commission (SEC) to review the application of the rule. And numerous industry groups including the American Bankers Association, American Insurance Association, and the Mortgage Bankers Association have urged the SEC and FASB to provide better clarity on how FAS 157 should be applied.

Despite the turmoil surrounding FAS 157, it's clear mark-to-market accounting isn't going away. Not only are regulators loathe to eliminate such rules once they're in place (after all, the almost universally maligned Sarbanes-Oxley legislation is still around), but this issue has become highly politicized and reversal now would likely be viewed as pandering to banking interests. We can, however, expect additional scrutiny on mark-to-market accounting in the very near future. A House subcommittee will hold a hearing on the issue this week, and House Financial Services Committee Chairman Barney Frank plans to examine the rule as well.

Fortunately, the guidelines for applying the rule have already changed considerably. Financial firms no longer have to reference actual distressed sales when valuing their most illiquid assets. Instead, they can utilize valuation methods that better reflect assets' long-term value (much as they did before FAS 157 was put in place). But current accounting rules don't allow companies to write these assets back up after they've already been written down, so changing FAS 157 doesn't immediately improve banks' capital. But write-downs resulting from FAS 157 and their extraneous impacts are undoubtedly already reflected in equity prices.

To the detriment of investors, the learning curve associated with FAS 157 has been exceedingly steep for both regulators and the firms they regulate. The damage caused by the inappropriate application of this accounting change cannot be immediately undone entirely, but looking forward, revisions to market-to-market and a greater understanding of its impact should help speed a recovery in the financial system. As always, the market is adapting to accounting and regulatory changes, and stock prices can move higher with or without FAS 157.