Increasing Toxicity: FAS 157 & Marking to Market
FAS 157, the accounting rule requiring financial institutions to mark their assets to market, has frequently been cited as a factor exacerbating the crisis. Steve Schwarzman is a vocal opponent of the mark to market rule in its current form, arguing that “the rule is accentuating and amplifying potential losses.” And while I’m sure an accounting rule is not the cause of the mess we’re in, I don’t always see the cause for marking assets to market – especially if they are fixed income products intended to be held to maturity which suffer primarily from a lack of liquidity in the market and only secondarily from fundamental impairment.
Today there’s talk of potential changes to FAS 157; at a minimum, it seems like we can expect to see some guidance on the application of the rule that might qualify or relax the mark to market requirement. I haven’t yet made up my mind if I should like this development – one half of me appreciates the potential relaxation based on the above reasoning (liquidity vs. fundamentals), but the other half fears that a decrease in transparency may cause prolonged or additional trouble down the road.
In addition to the impact FAS 157 has on asset markdowns, though, there’s another important side effect of the rule that tends to be forgotten: financial institutions know that they will have to mark their books to market, using whatever price comparable securities last traded at when they value the securities still on their books; as a consequence, when banks unload parts of their portfolios of toxic assets, they will make sure to sell those securities that are of good enough quality to find buyers at the price that the bank’s’ book was last marked at – otherwise the bank would not only take an additional loss on the assets it is selling, but it would also have to take further writedowns on the securities remaining on its balance sheet. In an environment like today – i.e. one of continuously deteriorating fundamentals – this means that sellers will have a strong incentive to sell higher quality assets first. The result: increasing toxicity of the assets left on the balance sheets of financial institutions. Where’s the silver lining?