Will This Thursday Change Banks' Fortunes?

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Not that anyone here preaches the virtues of short-term market timing, but this Thursday, March 12, could be a big day for bank stocks. Seriously. Big.

The U.S. House Financial Services Subcommittee is holding a hearing on what to do with mark-to-market accounting, acknowledging the absurdities of making banks like Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) value financial assets at current market values, even if markets are engulfed in hysteria and diverge from an asset's obvious intrinsic worth.  

Make no mistake about it: If even the slightest inkling comes out of that meeting that mark to market will be scrapped -- or just revamped -- much of the all-out panic gripping bank stocks could evaporate in a matter of seconds.  

Tired of writedowns? Get ready for the writeups.
Quite simply, absent mark-to-market accounting rules, banks could instantaneously repair their balance sheets … at least from an accounting standpoint. By not having to rely on market prices, the valuations of billions of dollars of assets could fall into the hands of an accountant who would "model" (read: guess) what the assets are worth. Since these accountants are internal members of banks themselves, their outcome is almost always that -- surprise! -- assets are worth waaaaaay more than the market thinks.

In case you're wondering, yes, these are the same accountants whose same models predicted that home prices would never fall, subprime was an infallible investment, and 30-to-1 leverage was an awesome idea. In a world where transparency and trust utterly failed investors, allowing banks to tell us what they think assets are worth might seem like a bad idea on steroids. And it is.

But in this specific case, the argument isn't quite that straightforward. Revamping mark to market could hugely benefit the stability of financial markets. AIG (NYSE: AIG  ) is a good example of how disastrous it can be to force a company to mark assets to market. Here's how Eric Dinallo, insurance superintendent of New York, described it last year:

AIG was forced to mark to market and post collateral against many … positions not because of actual defaults on subprime mortgages, but because of fears of defaults and the drying up of a market to trade these securities, thus resulting in very depressed market prices. By marking its securities to market, AIG was forced to announce losses, which kept growing.

In other words, market panic and accounting rules irrespective of actual losses is dumping fuel on AIG's fire. No one argues that the insurer made myriad mistakes and deserves to be where it is today, but the actual losses once the dust settles could easily be less than the mark-to-market deficits currently indicate. Again, I'm not defending AIG -- I'm defending sensible accounting practices that don't make the problem worse than it already is.

If mark to market is scrapped or relaxed in any way, the biggest winners could include banks like Morgan Stanley (NYSE: MS  ) , JPMorgan Chase (NYSE: JPM  ) , and Wells Fargo (NYSE: WFC  ) -- banks that, while hurt, are by and large expected to survive even with current rules in place. Financials like Citigroup and AIG would indeed benefit, but their fate is already written in stone, if only because investors already consider them dead or doomed to nationalization.

Bottom line
It's certainly possible, but I honestly don't expect something huge happening this week. Any momentous change to the rules would entail a heated debate between Congress, industry groups, the SEC, and the Financial Accounting Standards Board -- not the kind of thing that gets agreed on over an afternoon chitchat.

Even so, Washington's mere acknowledgment of this problem is a step in the right direction. Maybe, hopefully, it's a sign of things to come.  

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase is a former Motley Fool Income Investor recommendation. The Motley Fool is investors writing for investors.

Read/Post Comments (7) | Recommend This Article (31)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 10, 2009, at 1:04 PM, CDMED wrote:

    If the banks want to drop mark-to-market accounting to make my mtg look better on their books, is it fair to use m-t-m accounting to value my property?

  • Report this Comment On March 10, 2009, at 1:29 PM, BMFPitt wrote:

    So CitiBank can now write their investments in Nigerian princes back up to full value? Awesome!

  • Report this Comment On March 10, 2009, at 2:25 PM, wasmick wrote:

    It's interesting that when the models force valuations down well below actual market value or when there is no market from which to derive value we call them accounting models and when they derive higher valuations we call them guesses.

    Funny that.

  • Report this Comment On March 10, 2009, at 3:17 PM, wolfhounds wrote:

    Sure hope the modification of mtm comes through with a huge bank rally. I'll by long term puts on the xlf. The continuation of lower home prices forced by increasing foreclosures, notwithstanding the governments efforts to stem the tide, will result in real valuations. They won't be prettier or smell better than the banks books today.

  • Report this Comment On March 10, 2009, at 3:57 PM, EdgarJunkie wrote:

    Or here's a thought - divorce collateral requirements from GAAP accounting!

    Why does no one seem to recognize that the accounting change only affects collateral requirements because collateral requirements are based on the pre MTM rules? MTM is a drastic, fundamental change in accounting presentation. The fact that collateral requirement formulas weren't adjusted is a profound regulatory failure, not an accounting failure.

    Mark to market accounting provides valuable liquidity information. It is a key improvement in the transparency of corporate reporting. It is a non-cash item, and should be "backed out" for cash flow analysis anyway. Blaming accounting improvements is a smoke-and-mirrors tactic of poor executives.

    Furthermore, this would be an unprecedented government intervention in accounting rules. This would ultimately provide a forum for politicizing financial reporting, and undermine the legitimacy of GAAP. This is a terrible idea that ignores the real problem.

  • Report this Comment On March 10, 2009, at 4:04 PM, Deepfryer wrote:

    I agree that it's a terrible idea. If you let the banks live in some kind of fantasy world with made-up numbers, it's just going to result in another financial crisis somewhere down the road. Denial is never a good solution to ANY problem.

  • Report this Comment On March 10, 2009, at 7:27 PM, jerryguru69 wrote:

    Kinda like a poker game: you can't wait to see what the next round of cards will be, and the entire pot in the middle of the table is at stake. The value of Level 3 securities is mostly hokus-pokus anyway, that is why they are not Level 1 securities. I read somewhere that CDO, MBS, and other derivatives comes with a cash flow, which I was unaware of. There are rules (European?) that say you can carry these doodads on your books based on synthetic value you calculate based on tried-and-true Discounted Cash Flow equations, n'est pas?

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