TOPICS: Disclosure Requirements, Fair Value Accounting, Mark-to-Market,
Mark-to-Market Accounting, Banking, Disclosure
SUMMARY: In a CNBC program on Monday, Warren Buffet called for suspension of
mark-to-market accounting for regulatory capital purposes. This article emphasize that
"market-to-market accounting is fine for disclosure purposes". It also notes that "CNBC,
sadly, has been playing a loop of Mr. Buffet that...leaves out his most important point.
Nobody cares about the merits of mark-to-market in the abstract, but how it impacts our
current banking crisis."
regulatory processes, and the purposes of financial reporting can be covered extremely
well using this opinion page editorial.
QUESTIONS:
1. (Introductory) What is mark-to-market accounting?
2. (Advanced) How can banks' capital ratios be insufficient and banks be reported as
insolvent under mark-to-market accounting, even if "their assets continue to perform"? In
your answer, define insolvency and compare the notions of impairment of an asset versus
the market value of an asset.
3. (Introductory) What is the difference between using financial reports for regulatory
purposes and using them for disclosure purposes? In your answer, comment on the
definition of "general purpose financial statements".
4. (Advanced) Why does regulatory reporting "require actions that might make no sense
in the circumstances"? In your answer, comment on how regulatory reporting results in
requirements to raise capital.
5. (Advanced) Refer again to your answer to question 3 above. Explain the implications
of raising capital for current shareholders.
6. (Advanced) Define the concept of moral hazard. According to these Opinion page
editors, how must regulators change their approach to handling our current banking crisis
to avoid the problem of moral hazard? How does that differ from using a system of
regulatory capital requirements for banks?
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Buffett's Unmentionable Bank Solution
http://online.wsj.com/article/SB123672700679188601.html?mod=djem_jie
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By HOLMAN W. JENKINS, JR.
Last week's post mortem on the Fannie and Freddie takeover was received better than we
might have expected. A few readers assumed Eddie Lampert and Bill Miller, fund
managers who lost money when Fan and Fred were seized, and whose letters to their own
investors we quoted, were engaged in special pleading.
AP
Warren Buffett.
In fact, the nationalization of Fannie and Freddie is water over the dam. The men's
perspective may be one of pain, but it is historical pain.
Now comes Warren Buffett, a big investor in Wells Fargo, M&T Bank and several other
banks, who, during his marathon appearance on CNBC Monday, clearly called for
suspension of mark-to-market accounting for regulatory capital purposes.
We add the italics for the benefit of a House hearing tomorrow on this very issue. Markto-market accounting is fine for disclosure purposes, because investors are not required to
take actions based on it. It's not so fine for regulatory purposes. It doesn't just inform but
can dictate actions that make no sense in the circumstances. Banks can be forced to raise
capital when capital is unavailable or unduly expensive; regulators can be forced to treat
banks as insolvent though their assets continue to perform.
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What happens next is exactly what we've seen: Their share prices collapse; government
feels obliged to inject taxpayer capital into banks simply to achieve an accounting effect,
so banks can meet capital adequacy rules set by, um, government.
(This sounds silly, but has been a big part of government's response so far.)
CNBC, sadly, has been playing a loop of Mr. Buffett's remarks that does a consummate
job of leaving out his most important point. Nobody cares about the merits of mark-tomarket in the abstract, but how it impacts our current banking crisis. And his exact words
were that it is "gasoline on the fire in terms of financial institutions."
Depressing bank stocks today, he said, is precisely the question of whether banks will be
"forced to sell stock at ridiculously low prices" to meet the capital adequacy rules.
"If they don't have to sell stock at distressed prices, I think a number of them will do
very, very well."
He also proposed a fix, which CNBC duly omitted from its loop, namely to "not have the
regulators say, 'We're going to force you to put a lot more capital in based on these markto-market figures.'"
Mr. Buffett obviously understands where we are today, though it seems to elude many of
those kibitzing about "nationalization," "letting banks fail" and other lagging notions.
Since last year, our banking system no longer rests on capital, but on government
guarantees. With those sweeping guarantees in place to protect their depositors and
bondholders, banks now are able to earn princely spreads above their cost of funds,
however questionable their balance sheets.
Banks will "build equity at a very rapid rate with the spreads that exist now," Mr. Buffett
said. With the possible exception of Citigroup, he added, "the banking system largely will
cure itself."
Notice he didn't call for subsidizing hedge funds to buy toxic assets. He didn't call for
more government capital injections -- which are not merely redundant when
comprehensive guarantees are in place, but positively destructive of the ultimate goal of
moving back toward a system based on private capital.
Mr. Buffett didn't utter the unstylish words "regulatory forbearance," but letting banks
earn their way out of trouble under an umbrella of government guarantees is precisely
that.
Hank Paulson started down just this road last July. Bank stocks soared. Then he turned on
a dime. Washington needed somebody to punish and felt it couldn't impose haircuts on
uninsured depositors and bondholders. That left only shareholders, who have been
allowed to face vast dilution and/or government takeover based on mark-to-market
regulatory capital standards.
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Yet the truth is, you get little or no moral hazard bang from punishing bank shareholders.
Equity investors, by definition, accept the risk of losing 100% of their stake in return for
unlimited upside. Go ahead and wipe out shareholders: Markets will turn around and
create the next 50-to-1 leveraged financial institution as long as the potential return
outweighs the risk.
The only real fix for moral hazard, in some future regulatory arrangement, would be truly
to dispel the belief of bondholders and uninsured creditors that they will be bailed out.
That's a subject for another day. The recent devastation of bank equity values wasn't
inevitable but was a choice (an addled and perhaps not entirely conscious one) by policy
makers trying to make sure bank shareholders didn't benefit from the massive safety net
rolled out for banks.
As strategies go, it was a terrible one. It greatly increased the toll the banking crisis
imposed on the economy, and the cost that fixing the banks will impose on taxpayers. But
there's still a chance to avoid a disastrous, taxpayer-financed government takeover of the
banking system. The alternative, just as Mr. Buffett spelled it out, begins with
forbearance on capital standards.
CLASSROOM APPLICATION: Understanding mark-to-market accounting, bank
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