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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