MONDAY, FEBRUARY 16, 2009
FEATURES MAIN
Scrap This, Bolster That:
Seeking Really Fair Value
By JACQUELINE DOHERTY

In the heated debate over mark-to-market rules, one question is being overlooked: Why do banks own so many investment securities?

THERE'S NOTHING GEEKIER THAN A DEBATE about accounting standards. But the debate over mark-to-market accounting rules has reached a level usually reserved for important issues like whether the Yankees or Red Sox are better, or whether Kansas, Duke, UCLA or Kentucky has a better basketball heritage.

Financial and economic bigwigs, including Goldman Sachs CEO Lloyd Blankfein and former Federal Reserve boss Paul Volcker -- now a key adviser to President Obama -- have chimed in on the subject, which will be highlighted in an upcoming hearing before the House Financial Services Committee.


One argument against fair-value accounting is that it increases the financial markets' cyclicality. When times are good, banks recognize the appreciation of their securities, which boosts earnings and equity. As a result, they can hold less capital, and have more money to lend. This feeds the economy's boom, and encourages lending at precisely the moment when it is most risky -- at the euphoric peak of an economic cycle, says William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985.

Then, when the economy moves into reverse, mark-to-market accounting forces banks to downgrade their securities' value. This, in turn, reduces their available capital reserves, just when they should be increasing to offset the economic downturn. That stifles lending, just when the economy needs it most.

"I would like to see them scrap the [mark-to-market] rule while they try to fix it," says Isaac. Credit Suisse's Zion counters that the cyclicality of banks' capital requirements is a problem that should be addressed by regulators -- not accountants.

Ronald Temple, co-director of research at Lazard Asset Management, offers this solution: Make banks bolster their reserves -- even in good times -- and don't base the requirements on market values.

In December, after re-examining the accounting rules governing securities valuation by financial institutions, the Securities and Exchange Commission defended them, for the most part. Rumors that new Treasury Secretary Timothy Geithner would recommend suspending the mark-to-market rules were credited with sparking the last stock-market rally two weeks ago. But early last week, shares again sold off, after Geithner's comments on the economic-stimulus package contained no reference to the subject.

IN THE DEBATE OVER FAIR-MARKET accounting, one important question isn't being asked: Why do banks own so many investment securities -- especially illiquid ones -- in the first place? JPMorgan Chase (ticker: JPM), perhaps the most responsible of the bunch, has $670 billion of trading assets and securities -- a sum not far below the $761 billion of loans in its portfolio.

The Bottom Line
Mark-to-market accounting has been blamed for much of the financial industry's woe. But, at least in the case of banks, the problem may largely stem from owning too many securities.


Some investments are more risky than others. But given that such a large percentage of their assets -- on average more than 20% -- are no longer in loans, knowing the current value of their investments is certainly meaningful for investors.

In reality, mark-to-market rules don't make bank earnings more volatile. Banks' decisions to hold a larger percentage of securities are making their earnings more volatile.

So perhaps the solution is to re-evaluate what banks should be allowed to hold, and how their reserve requirements are calculated. There's no need to pick on the accountants.

http://online.barrons.com/article/SB1234...