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  • October 1, 2008 12:28 PM EDT by Elizabeth MacDonald

    A New Rule Change That Could Hurt Taxpayers

    A little understood but very important accounting rule being blamed for the $523 bn in losses and writedowns at financial companies around the globe is now being retooled by market and accounting regulators, in a last-ditch attempt to stop the steam pipes bursting and to get banks lending again.

    However, the move matters greatly to taxpayers, because analysts now say that banks who own severely damaged mortgage-backed bonds may be able to use the changed rule to get higher prices for these securities if they auction them off to the government as now planned in the $700 bn rescue bill.

    The rule change comes just at the end of the third quarter, which means companies may be spared the pain of big third-quarter losses and writedowns.

    And it comes as the Federal Bureau of Investigation is probing Wall Street firms to search for criminal securities fraud in the valuation of these bonds.

    How it Works

    Here's how it works.

    When borrowers get loans, the banks typically sell these loans to Wall Street firms, who then repackage them as bonds backed by the value of a house or property. Wall Street then sells these bonds to mutual funds, pension funds and all sorts of investors around the globe.

    As house prices drop in value, so, too, do the value of these bonds, which vary in type as mortgage-backed securities, collateralized debt obligations (CDOs), even CDOs of credit default swaps or exotic bonds called CDO-squareds.

    The accounting rule says that companies that own these bonds must value these bonds each quarter as if they were going to be sold immediately. That process is called "mark to market."

    But since these bonds have dropped in value, they are regarded as Kryptonite because no one wants them.

    Companies must then book these losses on these bonds even if they did not sell them. "Mark to market" has since been jokingly called "mark to mayhem" and "mark to madness."

    Relaxing the Rules

    The Securities and Exchange Commission and the Financial Accounting Standards Board have now "clarified" existing mark to market accounting rules saying companies have leeway in assessing value, and do not have to use the current market price, which is of course way down.

    The SEC and the FASB basically say that companies are not required to book fire sale prices when valuing these illiquid assets, including mortgage-backed bonds. Instead, management can use their own internal assumptions to measure fair value.

    Specifically, the accounting regulators said that companies were initially supposed to use fair values based on an "orderly transaction" between willing market participants. However, "distressed or forced liquidation sales are not orderly transactions," the SEC said in a statement. 

    Don't Blame the Rule

    It's important to remember here that no one really knows the value of these bonds and whether they are worth more or less than what the market says they are worth because the cash flow is or is not really there.

    It's important, too, to remember that it's not just an accounting rule that can be held to blame for record losses, but the fact that banks got themselves into trouble by recklessly giving too many loans to borrowers who either were irresponsible or could not afford them.

    It is no small irony that the government's plan essentially is an attempt to put a floor under these bad securities that were written down according to a governmental accounting body's rules.

    The question now is whether this accounting rule change will reflect the true value of these assets and whether doing so will force Congress to dole out the full $700 bn--or more--to rescue these assets.

    Record Losses

    The losses have caused banks to be in violation of their statutory capital requirements, forcing them to raise capital to plug balance sheet holes. The losses are also the reason why a growing number of financial companies have shut down, been forced into mergers, or been nationalized.

    And the losses are behind the reason why the Federal Reserve and central banks around the world have pumped record amounts of liquidity into markets, and have pushed the US central bank and the US Treasury to let banks dump their illiquid mortgage-backed bonds for more liquid Treasuries.

    The decision by the Securities and Exchange Commission and the Financial Accounting Standards comes as the London interbank offered rate, or LIBOR, hits record highs. Many adjustable rate mortgages--including dodgy no income verification loans and interest only loans--in the US are due to reset to higher interest rates because they are tied to LIBOR, which is the rate that banks in Europe charge each other for such loans.

    As more loans go belly up due to the higher rates, that means more losses for banks and financial companies.

    The financial-services industry has been lobbying the SEC and FASB for months now to alter the rules, a lobbying that picked up speed in the wake of the new $700 bn Congressional rescue bill that would set up a reverse auction mechanism to let banks unload these damaged bonds onto the government. Congress may include the change in its new version of the rescue plan.

    The American Bankers Association had complained to the SEC that auditors were forcing banks to value these bonds at unrealistically low "fire sale" prices, rather than at the higher values the banks believe these bonds should be worth in an orderly market.

    There is also some talk in Congress of a temporary or permanent repeal of the mark to market rules to allow for more long-term valuation of assets and loans.

    The Problem with the Rule

    The problem with this accounting has always been what critics say is its punitive effect.

    Companies have to record resulting losses from this mark-to-market exercise, which some say is the equivalent of sticking a finger in the wind, as if they actually lost cash even if they did not actually sell the bonds at all, and even if the cash flows are still coming in higher than what the market says the assets are worth (Fannie Mae and Freddie Mac have said that they are solvent on a cash-flow basis, notes economist Brian Wesbury).

    The writedowns taken by some firms have triggered a cascade of writedowns at other companies, as prices are seen to be set in the marketplace. For example, E*Trade last year priced some mortgage-backed bonds at 27 cents on the dollar, triggering writedowns at other firms. Merrill Lynch (MER) sold assets to the vulture fund Lone Star at 22 cents on the dollar (really 6 cents if you consider that Merrill financed 75% of this sale), also causing other writedowns.

    JPMorgan Chase (JPM) bought Washington Mutual (WM) at a garage sale price, triggering fresh new prices for assets on its books that triggered anew mark-downs on the assets at Wachovia, which was shephered by the Federal Deposit Insurance Corp. into the arms of Citigroup (C). 

    Risk to Taxpayers

    But the $700 bn rescue plan makes the change potentially more damaging to taxpayers because the relaxation of the accounting rule means banks may be able to keep higher prices on these bonds and then unload them at higher prices at auction to the Treasury. 

    "It is not in the interests of U.S. citizens and taxpayers to abandon mark-to-market accounting for a proposal in which taxpayer funds are being used," says Janet Tavakoli, founder and president of Tavakoli Structured Finance and one of the best market analysts on the dangers of credit derivatives.

    Tavakoli adds: "If we would have to sell the assets at a loss due to downward moves in market prices, we have a right to know that. If the assets have permanent losses so that even if we hold to maturity we would have losses, we have a right to know that too. At any given time, we have a right to know what our ‘investment' is worth."

    Tavakoli adds that the danger is that the government's new portfolio managers "can claim they are making money" while "the assets are declining in value due to defaults or permanent value destruction of collateral. This situation can continue for a long time to create the false appearance of profitability.

    Tavakoli notes that "in other words, U.S. taxpayers can be told they are making money on their $700 bn investment, when in reality they are losing money. I would rather know the market price, even if the news is bad news."

    Loophole Dangerous to Taxpayers in the Rescue Bill

    And check out this sentence I've highlighted in italics in section 101 of the new bill, entitled "purchases of troubled assets"--it could also mean even higher costs to taxpayers:   

    (e) PREVENTING UNJUST ENRICHMENT. In making purchases under the authority of this Act, the Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset. This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in Conservatorship or receivership, or that has initiated bankruptcy proceedings under title 11, United States Code.

    This section "probably indicates that JPMorgan Chase can sell the troubled assets of WaMu to the US government and make windfall profits," notes market analyst Richard Suttmeier. "Same for Citigroup with regard to Wachovia's troubled assets. Other future deals as well. That is a direct bailout of Wall Street on the back of taxpayers."

    A Better Way

    Check out what Tavakoli says is a better way than the $700 bn bailout plan:

    "Rather than adopt any form of the Paulson Plan, which uses billions of taxpayer dollars and forces risk and potential losses on taxpayers--instead of those who enjoyed the gains--I advocate an alternative."

    "Instead of the Paulson Plan, we can force creditors to accept a restructuring plan (this was done during the Great Depression). Creditors (debt holders) including credit default swap counterparties would be compelled to accept a restructuring plan. That requires partial forgiveness of debt in many cases and/or a debt for equity swap (in which the government takes equity stakes in these companies)."

    "If we are determined to violate personal property rights, I prefer it be done through a forced debt forgiveness and a forced capital restructuring (debt for equity swaps), rather than through a massive bailout (any of the various forms of the Paulson Plan)."

    "The Paulson Plan destroys capitalism (those who stood to gain--and already made off with large gains--should bear the risk) and violates the spirit of democracy established by the Founding Fathers of the United States."

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martin

The following ETF yield and value mitigate the premise that all mortgage backed securities have little value: The Lehman MBS Bond Fund (MBB) which paid (distributed monthly) $0.49 for the month of September . The following are links from the Ishares public website to the distribution history of the Lehman mortgage backed security bond ETF (exchange traded fund) and as well to the overview and the holdings page. If mortgage backed securitys are so toxic and worthless why are theese government agency instruments generating a steadily increasing distribution stream(cash flow)? Why is MBB trading at $102.11 a premium to its NAV of $101.83? Most of its holdings are fannie mae and ginnie mae and other govt agency debt valued at an average of par value. What is wrong with this picture? Neil Cavuto, Newt Gingrich, Ben Barnenke, Hank Paulson, you are all right. Calling debt that is generating over 5% per annum return "Toxic" is specious. It is an incomprehensible media and political travesty. It is driving a stake into the heart of our free market capitalist system. Do the arithmetic, please. Please Suspend permanently Mark to market fair value accounting. Make the uptick rule and the limiting of short sales to borrowed shares permanent again. How many failed banks do we think that Chase, Bank of America and Goldman Sachs can absorb. I still believe in free market "COMPETITIVE" capitalism.

October 1, 2008 at 3:36 pm

The J

Janet, too bad you cant use this rule change as long as the losses are unrealized you could just change the value of your 401K to whatever you want.

October 1, 2008 at 3:41 pm

Sara P

abolish corporate taxes = create jobs decrease apr on 'all' personal credit cards to maximum of 10%. Public could afford to pay back credit and therefore put money back in the world market and spur the economy. right now we are just stuck robbing peter to pay paul

October 1, 2008 at 3:41 pm

Dave Young

This is an unnecessary rule, and introduced too much beta/ volatility in the markey. What if housing values had gone higher? Would the holders of this junk debt have been given " extra brownie points" for buying smart? I say dump the rule, and get back to reality.

October 1, 2008 at 3:50 pm

Jed Clamped

Awe- no one liked the SS turnaround/restructuring opportunity on this I suggested.

October 1, 2008 at 3:59 pm

Jed Clamped

At this point, I'll settle for the opposite of GroundHog Day the movie.

October 1, 2008 at 3:59 pm

Jethro

Hey Liz MacDonald... Way I see it, anyone with over 100k would be fool to leave it in. So, should we not expect at this very hour ? silent runs on deposits ? everywhere ? How critical ? Who's to say. I see bending of the birch tree lately - to put some words together there. FDIC to 250k, even though it halves their resources, the confidence restore to prevent further run on deposits - remember - Indymac came down this way, and Washington Mutual iirc, had over 16 Billion taken out of deposits since Sept. Serious problem. Add in LIBOR and credit ? Deposits coming OUT ? Well - my comment here was does anyone here see any anticipated banks failing because of people simply - and without argument from anyone - withdrawing anything over 100k ? The days of Mr. Dryesdale are OVER. The Clamped's will NOT leave more than 90k in an account. Joint 200, Ira I think 250k. Oh well it's some trouble I figger is fixin to brew over soon when banks ARE forced to be accountable at quarter to say - uh, gee, uh, we just don't have it. Could you call citi for us ? Or wait, no, make that BAC... We want to fly with BAC for takeover ! ? Odd consolidation going to happen from effects of run on deposits happening this very moment. And if YOU have over 100k in a bank account ? FDIC insured ? think twice what you're doing reading this line right now.

October 1, 2008 at 4:04 pm

David

Don't forget the this wasn't just a function of banks being greedy, as you imply. Banks were coerced into making these loans by the CRA signed by Carter and by the teeth Clinton put into it to force banks to make loans to people who otherwise weren't getting them (sometimes for very good reasons). Furthermore, Fannie and Freddie were making a market for these loans because they purchased them and securitized them. If it had been left to the market (rather than these GSEs), I doubt so many crappy loans would have been made, since the banks would have been stuck with the risky paper they couldn't unload on Wall Street without an implicit government guarantee (made explicit by the takeover of those GSEs). Still, mark to market is currently artificially depressing the values of these securities, which in turn is killing the banks' balance sheets. I agree completely that the accounting change shouldn't facilitate higher prices for government purchase of these loans, but it might obviate the need to buy some or all of them at all. I'm all for that.

October 1, 2008 at 4:06 pm

Larry Parker

Mark to Market Accounting practices have been a notorious method used by CEOs for generations to inflate the values of companies. The real meaning of the bill boils down to this. Only four officials are being given the spending authority. Bernanke Appointed by Pres G.W.Bush, Dodd D-CT, Frank D-MA, and to a limited measure Shelby R-AL Shelby by the way has managed to siphon off $341,434,309.00 of your tax dollars to his state (Alabama) in the last 29 days (Month of Sept 2008). this setion even gives them the ability to hide their specious activities. SEC. 129. DISCLOSURES ON EXERCISE OF LOAN AUTHORITY. (a) IN GENERAL.— Not later than 7 days after the date on which the Board exercises its authority under the third paragraph of section 13 of the Federal Reserve Act (12 U.S.C. 343; relating to discounts for individuals, partnerships, and corporations) the Board shall provide to the Committee on Banking, Housing, and Urban Affairs of the Senate (CHAIRMAN Cristopher J.Dodd D-CT) and the Committee on Financial Services of the House of Representatives (CHAIRMAN Barney Frank D-MA) a report which includes— (1) the justification for exercising the authority; and (2) the specific terms of the actions of the Board, including the size and duration of the lending, available information concerning the value of any collateral held with respect to such a loan, the recipient of warrants or any other potential equity in exchange for the loan, and any expected cost to the taxpayers for such exercise. (b) PERIODIC UPDATES.— The Board shall provide updates to the Committees specified in subsection (a) not less frequently than once every 60 days while the subject loan is outstanding, including— (1) the status of the loan; (2) the value of the collateral held by the Federal reserve bank which initiated the loan; and (3) the projected cost to the taxpayers of the loan. (c) CONFIDENTIALITY.— The information submitted to the Congress under this section may be kept confidential, upon the written request of the Chairman of the Board(Ben Bernanke), in which case it shall made available only to the Chairpersons and Ranking Members (Richard C. Shelby R-AL)of the Committees described in subsection (a). (d) APPLICABILITY.— The provisions of this section shall be in force for all uses of the authority provided under section 13 of the Federal Reserve Act occurring during the period beginning on March 1, 2008 and ending on the after the date of enactment of this Act, and reports described in subsection (a) shall be required beginning not later than 30 days after that date of enactment, with respect to any such exercise of authority. 12 (e) SHARING OF INFORMATION.— Any reports required under this section shall also be submitted to the Congressional Oversight Panel established under section 125.

October 1, 2008 at 4:09 pm

Hilton Smith

I agree that the 'Mark to Market' accounting rule should be suspended immediately which should/could have the immediate effect of increasing the banks capitalization two or three fold, which should free up the credit crunch and NOT pass the bail out bill. The banks should deal with these toxic securities although the Fed might consider loaning some money against them to ease the credit crunch, but not guaranteeing them. To suspend the accounting rule AND pass the bail out bill is just GIVING the banks money for the toxic securities and sadeling the taxpayers with the risk/loss/cost of disposing of this stuff!

October 1, 2008 at 4:19 pm

Rhonda Mullins

I agree with Arlen>>>>>>>The banks are killing us in Denver....I am current and keeping my nose just barely above the water.....but my house has dropped in value so much because of this mess, I will die before I could think of breaking even. It has been the death of what used to be a very good place to buy a house...most people are just walking away its so ridiculous. When the ones who want to be bailed out who eroded the market to begin with wont even consider a short sale....what does that say about the nature of their greed. I can hear you thinking the same thing I do. Oh and by the way I am stll being taxed at the old higher value and I challenged it and the county of Arapahoe denied it. So I am paying the higher property taxes and stuck with that.......and then to top it off because I have a second which at the time I got it was assured the home was worth the value I had borrowed, was forced to take out more of that MIP to cover that second. Which if anything happened of course I would not be the benefactor. Can a person get any break in this country and make our Congress understand the debacle they are handing us and how much we do not want it...because it does not help us.....I will vote everyone out this year if this passes anybody but the people who vote for this and I will be taking names too.

October 1, 2008 at 4:50 pm

Susan Chamberlin

Thank you Liz. I need to understand what's going on and thanks to you, I think I've got a better handle on the problems and risks associated with these issues. You write concisely and plainly without talking down to those of us who have limited expertise in these areas.

October 1, 2008 at 5:00 pm

Thomas Worley

Liz McDonald does indeed understand the situation from the financial viewpoint of the victimized banks and others who bought these created mortgage backed instruments. Many of the Fox commentators have mentioned the leverage used on these instruments. The figure of 27 to 1, yes 27 to 1, has been stated many times. Doesn't this have the whiff, the smell, the odor of a Ponzi scheme? Is is possible to create these bonds, sell what you can and then use the remainder as collateral for loans to obtain even more funds? A hundred dollars worth of mortgage could be run up to $10,000 or more if the banker is too trusting and greedy, and the investment house is unashamedly evil. I believe we are faced with human history's most monumental financial crime, a pyramid of money such has never been seen before. These criminals will probably become next generation's economic advisors and Wall Street Lions, perhaps crime does pay and is the highest expression of American ingenuity and courage. Perhaps the Lone Ranger weeps in sorrow.

October 1, 2008 at 5:11 pm

Brenda

I never heard any mention of the horrid SOX Act. Talk about an onerous piece of legislative garbage. Sarbanes thought he was going to make the mess of ENRON never happen again, but instead he created another nightmare. If it were not for these do nothing political hacks in Washington (the thieves in the night that they are) being in the pockets of the likes of the Fannie and Freddie big-wigs, and the unreasonable lending practices in the name of affirmative action, we would NOT be in this position at all. There is nothing, absolutely nothing, wrong with capitalism. I am glad there are truly wealthy people in this country because they are the ones who keep the rest of us employed. But all this "bail-out" baloney is NOT going to be the panacea everone thinks, wants, or hopes the American public will believe. But then, we seem to be very cattle-like (or sheep take your pick) when it comes to those who want us to believe "the lights will all brighten and we will be in the promised land of "change we can believe in". BULL is what you are being fed by all these idiots!! NO BAILOUTS!!!

October 1, 2008 at 5:14 pm

Brenda

I have one more comment. Everyone needs to stop talking about SS going broke. That again is something the MORONS in Washington took from a TRUST FUND and stuck into the General Fund and have been spending it ever since. When is the government going to return the money they STOLE from that Trust Fund and return it to the SS Trust Fund? Never! We giveth and they taketh and squander it on their pork barrel projects. A pox on them and their house (and senate).

October 1, 2008 at 5:29 pm

Nick

Suspending FASB rule 157( the mark-to-market rule ) is a terrible idea! This rule forces honesty on the value of assets. If there is no market for your 'mortgage backed securities' and no one will pay you for them, then they are WORTHLESS! Will they be worth anything in the future? Maybe, but you can mark that on your pro forma balance sheets( and if anyone believes you, you might even get a buyer! ). Rule 157 was implemented to force companies to fairly value their assets. Using accounting tricks to inflate the value of assets has been done before with awesome results. Anyone remember Enron?

October 1, 2008 at 5:46 pm

Paul Cox

In a world where LIBOR and the TED Spread reflect record distrust between banks. Putting the transparency that Mark-to-Market provides will only have LIBOR escalate. The banks don't know what the toxic waste is worth. By removing Mark-to-Market will only make it more difficult to value these assets. The U.S. is creating sham accounting to deal with their problems. This will cause the world to flee as no one can trust what the American accounting system stands for.

October 1, 2008 at 7:42 pm

Larry Parker -TX

Do you wan to smack Wall Street and Capitol Hill upside the head? Follow these steps. 1. Make the absolute minimum payment on any outstanding loans. 2. Do not make your loan payments until the day they are due. - Don't be late of course 3. Withdraw all of your cash from your bank account. - Close your account 4. Do not use cash for any purchases - Use your Credit Cards instead. 5. Exercise your consumer rights to request a loan deferment on your mortgage. - Do not pay down your mortgage principal. If you can borrow more money from your bank then do it. Better still float (kite?) a big check. 6. Hold off making any significant retail purchases for as long as you can. 7. Do not pay any federal taxes until the very last due date. - Change your W9 form 8. Vote for Ron Paul - He's about as popular as a Moose at a tea party but he's been warning us about this crap for years. Sound familiar? That's how many financially stressed families get by every day. - Except for voting for Ron Paul of course. OR Just ask Ben Bernanke or Barney Frank D-MA or even Christopher J. Dodd D-CT to loan you a few million $$. They seem to think that printing up a few trillion greenbacks will solve everything. You will at least stay warm this winter by shoveling the mountain of money you'd have in your back yard into your furnace. Beware though as the IRS will take a dim view of your attempts to hide your assets in that manner so make sure you keep good records for how much you burn.

October 1, 2008 at 7:47 pm

Larry Parker -TX

Oh snd I really am pissed off. I have two primary mortgages on two homes, No seconds. one is with CitiMortgage and the other is Counrtywide. Conventional 30s and the kicker is that both corporations keep calling me to refinance at a higher rate. My personal income is far below the national average. I'm in debt to the tune of $260K I have unsecured credit of nearly $23K available and yet my credit score is 712. I pay my bills, I pay cash and I pay off my credit card charges within 23 days of incurring the debt. If I get the feeling that a creditor is trying to take advantage of me (Like trying to raise my APR or lowering my available limits) I close the account and apply elsewhere. No one has ever turned me down for a loan and I have never accepted any credit agreement that contained language designed to separate me from my money. Typically the very people who are at the highest risk of default in a financial transaction are offered the least favorable terms. So WTF are people who hold advanced degrees and who work in the finance industry not being held accountable. Those loan officers and bank managers that got paid very well to close on those loans should be required to pay for this stinking festering puss filled sore of mess. I'd go after every signatory and agent who had the lapse of reason to even consider offering a sub-prime loan to people who had no demonstrable way to make the payments required. I've worked in the credit challenged market selling phone services and had to sweat the end of month collections from dead beats. I gave that job up knowing that there was no honor in suckering people into contracts that all but guaranteed a defaulted loan. Guess what America, I blame Bankers (especially), Realtor, Builders, Politicians, Municipalities, Foreigners, Aliens -Domestic and Cosmic, lawyers, doctors, paediphiles, Martha Stewart, Al Bundy, the Cartoon Network,and most of all the guys who write for SNL. You know who you are. The few I hold harmless are most cops and those members of the armed forces that had the unfortunate luck of earning a Purple Heart, and children under 18 - Can't vote yet. My believing that the people running the American financial systems has morons in the family tree is an understatment.

October 1, 2008 at 8:48 pm

Tom

Warren Buffet said the government should sell a billion or so of these securities so that THE MARKET can set the value for the other $699 Bn. That is the ONLY way the government will have a chance at not overpaying for the assets it is buying. Changing the mark to market rule and letting that be the purchase price is just a way to let the taxpayers take 100% of the loss.

October 2, 2008 at 12:29 am

Jason

Yes i agree this is not the best situation and we can whine and complain about the government and Wall Street being irresponsible but lets face the facts people, what is the root cause of this problem? Its irresponsible consumers purchasing houses they cannot afford. Yes the tax payers bailing out finacial institutions is not a dream way to spend $700 Billion, but lets face it if not here then our government will surely find a way to blow $700 Billion in useless spending before you can blink, they just do it in smaller packages to where the taxpayer does not notice it all at once. Its time America wakes up to the fact that people spend more than they can afford on a daily basis and lets face it as long as this happens the financial status of our country will never be fully repaired. No i don't agree with the bailout but look at where it has already taken us, credit markets are frozen and we are all daily losing more and more on 401K plans etc. We all know that social security cant fund anyone's retirement so lets not pass the bailout and watch your future get flushed down the drain with Wallstreet. WAKE UP AMERICA!! This impacts each and every one of us directly!!

October 3, 2008 at 7:58 am

about this blog

  • Elizabeth MacDonald is the stocks editor for Fox Business Network. She is recognized as one of the top prize-winning business journalists in the country, and has received 14 awards, including the top prize in business journalism, the Gerald Loeb Award for Distinguished Business Journalism, and the Newswomen's Club of New York Front Page Award for Excellence in Investigative Journalism.

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