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Patrick asked:

 

Mike B writes:



....  

The question being asked is whether it makes sense to maintain mark-to-
market accounting if it results in killing firms that are otherwise
profitable and 
who, but for the adoption of SOX, would still be alive and well today?  

 

...

So while I encourage disclosure, there needs to 
be balance so that you don't artificially create a crisis due to price
swings that 
are likely to be temporary.  IOW, I can see both sides of the argument, and
I 
would suggest a middle ground approach."


This is the very question I've been wondering about since the bailout
package was defeated and I stumbled across former FDIC Chairman Isaac's
argument that repealing the mark-to-market provisions of SOX would solve
this crisis.  While it would certainly ease the crisis for now, nobody knows
what the ultimate outcome would be, else the market could properly valuate
MBS.  The banks would start lending, but would still be stuck with some
questionable securitized assets that could become issues over time and
they're stock prices would still look nothing like they did a year ago,
because the assets will surely not be worth what they'd be accoutned as in
this case.  

 

I've been trying for the life of me to figure out what a middle-ground
approach would be in this case.  Does the government come up with a
complicated one-time rule allowing revaluation of MBS as an asset class?
Can't imagine that would restore investor confidence, but it forestalls the
crisis and lets the rest of the economy function, while the mess gets sorted
out.  Of course, sorting the mess out remains the problem.  How would MBS
get reevaluated (e.g., subprime at $0.25 on the $ relative to the paper rate
of return of non-defaulted loans, adjustable rate at $0.50, undocumented
loans at $0.10, fixed rates at $0.75)?  Could even a straight-faced-test
revaluation happen in a time-frame that the market would accept?  Do we
simply repeal the mark-to-market provisions for now and try to work out the
details after the election?  

 

I'm at a loss on this one.  Mike, could you suggest a reasonable
middle-ground approach?

 

- Patrick

 

Surprisingly, there IS a middle ground approach.  

 

Not marking-to-market means that the only people who really know the value
of a firm's assets are the insiders, since the lenders or investors will not
be able to value them from the outside.  So, we really MUST allow lenders
and investors access to this information.  Further, by resorting to pre-SOX
accounting, we would not make these firms any more stable.  After all, the
only thing that would change is the stated value, not the real value, of the
assets. 

 

So, what does reverting to cost-basis do for a firm?  It allows them to
maintain their "stated" equity.  So what?  Ah, here is where the government
can step in.  Stated capital has two key functions:  

 

Firms need to maintain a certain level of stated capital to comply with the
rules of FINRA or other regulatory bodies, and they must avoid appearing to
have liabilities exceeding assets.  This is key because there are two kinds
of bankruptcy:  (1) insolvency, which is the inability to pay bills when
due, and (2) negative equity.  These firms were not insolvent; for example,
AIG has over 350 billion of marketable assets, on top of its bad assets, but
its S & P bond rating fell below AAA (i.e. into "junk" grade), which
accelerated its bond obligations.  Rather, they ran afoul of the bankruptcy
rules for negative equity, or they fell below FINRA (or an insurance
commission, or any of a dozen bodies) rules for minimum capital.  By
contrast, Long Term Capital Management (remember them?) really did run out
of cash.

 

Congress, rather than eliminating mark-to-market, could do two relatively
simple things:

 

1.	Allow firms, in certain circumstances, to avoid being subject to
involuntary bankruptcy, even with negative equity, and
2.	Revise the rules for computing minimum capital, by adding back
mark-to-market losses.

 

This way, lenders and investors can see the true state of the firms, yet the
firms would not be forced to close.

 

David "I have to actually audit these entities, and have to (ugh) work with
SOX" Merfeld, CPA

 

 

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