Back in May 2008 I posted “Why Mark to Market Sucks“. Today the FASB took steps to alter it but in doing so, may have made the issue even worse.
Here is what the FASB said:
FASB Mark To Market Changes
This does not truly address the issue and will lead to more investor confusion and doubt to the validty of finanial statements:
For instance, look at this section on marking debt instruments held to maturity:
The staff believes the Board’s intention was to require that credit losses be measured based on an entity’s estimate of the decrease in expected cash flows, similar to the model used to measure loan losses in Statement 114. The staff notes that the Statement 114 model was not prescribed in the FSP because comment letters received on proposed FSP FAS 107-a, Disclosures about Certain Financial Assets, expressed concerns about applying that model to available-for-sale and held-to-maturity debt securities. The staff believes these concerns primarily related to requiring the same model (the Statement 114 model) for all debt securities, including securities subject to Issue 99-20 and corporate bonds.
The staff recommends that the FSP clarify that credit losses should based on the reporting entity’s estimate of the decrease in expected cash flows or the entity’s best estimate of the amount of the other-than-temporary impairment that relates to credit deterioration. The staff recommends that the FSP continue to refer Statement 114 as a possible method that could be used to estimate credit losses and to require that investments accounted for in accordance with Issue 99-20 apply the guidance in that Issue. However, the staff does not recommend that the Board prescribe a specific method to be applied for securities that are not subject to Issue 99-20.
Also, for some instruments, such as those described in paragraph 14 of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, because an increase in prepayments would result in a decrease in expected cash flows, the staff recommends that the Board clarify that a decrease in expected cash flows that results from an increase in expected prepayments should be accounted for as a credit loss when an entity is determining the amount of an other-than temporary impairment related to credit losses that should be recognized in earnings.
Let’s do a real basic example:
I have debt instrument (MBS) “x”. I am supposed to value it based on “expected” losses in cash flows and prepayments. Why? Why just just value it on actual cash flows and adjust for prepayments? Simple example. I own MBS 101 that has 10, $100k mortgages in it all paying 10%. All are current so my MBS carries a value of 100. One loan gets pre-payed so my $1 million MBS now has $900k in mortgages but, all are still current and I receive d full payment on the pre-payed loan so it is still worth 100.
John and Mary default on one of the loans so I now have a $900K MBS but only 88% of the cash flows from it. That ought to be the current mark. What someone will pay for it if it is held to maturity means nothing. It ought to be market at what it is currently paying vs its potential.
Once you get into estimation of future defaults, doesn’t the whole idea of transparency become moot as it is now gone? Depending on the estimation, there lies the mark.
What the FASB has done is decrease the irrational market marks on banks book while at the same time creating increase investor skepticism of the new ones. It is not good for banks looking for investors or a market looking for clarity.
Disclosure (“none” means no position):