Mark-to-Market Ruffles the Financial System

OLDWICK, N.J. September 14 (BestWire) — Usually, the accounting system doesn't get in the way of valuing company stocks and their outlooks. But in the market meltdown last fall and winter, the accounting framework may have been viewed for a time as more important than the economics of the businesses. "It's unfortunate," said Robert Stein, chairman of Global Financial Services at Ernst & Young. "Usually, the accounting supports decisions about valuations, but some would say that here, it got in the way."

Much has been debated about the role mark-to-market accounting rules played in driving down the values of financial services companies, including many large life insurers. Mark-to-market accounting was prohibited in 1938, but the Financial Accounting Standards Board reinstated and strengthened it through actions in 1993 and in 2007. Forbes magazine publisher Steve Forbes has been particularly outspoken about the 2007 action. "The bursting of the commodities and housing bubbles would not have threatened the very existence of our financial system had it not been for the perversity of mark-to-market accounting rules," wrote Forbes in his July 2009 Fact and Comment editorial. "This concept, enacted in 2007, turned the economic equivalent of a serious flood into a tsunami by relentlessly destroying the ostensible value of our banks' regulatory capital."

Coincidentally or not, the stock markets were near their all-time highs in November 2007. And in March 2009, when news surfaced that the board would relax mark-to-market-related accounting rules, stocks were at the bottom of the decline. "It was no coincidence that once Congress made it clear in early March that it wanted substantial and quick reform of mark-to-market accounting that stocks — especially those of banks and life insurance companies — vigorously rallied from their recession lows," Forbes wrote. "Mark-to-market accounting should be prohibited just as it was from 1938 to 2007."

Stein said it is incorrect to say that mark-to-market accounting returned in November 2007, when the board adopted FAS 157. He said it actually reappeared in 1993 when the board adopted FAS 115, a regulation about fair-value accounting that classified securities as either held-to-maturity, trading or available for sale. Most insurance company investments were being carried at fair value for the past 15 years, he said.

But FAS 157 did have an impact. "FAS 157 clarified the measurement of fair value and strongly reinforced the need to use market-observable information," said Stein. "That’s where this whole valuation process probably ran into trouble in the sense that it became difficult to tell what a real estimate of value was." The problematic assets that were the base cause of the market meltdown were the many varieties of residential mortgage-backed securities, and very few transactions or even quotes were being made on these. This inactivity caused a great deal of difficulty in determining what the values were, Stein said.

The issue really revolved around what accounting rules were intended to do. "Were they intended to follow irrational markets down and select prices based on sporadic and very, very shallow markets?" asked Stein. "Or were they intended to try to capture something along the lines of inherent market value or economic value?"

Annuities Under Pressure

Particularly sensitive to the market downturn last fall and winter were writers of variable annuities, due to their living benefit guarantee liabilities. GAAP accounting requirements caused these liabilities to rise very high and very fast. Earnings were crushed by these accounting provisions, and unrealized losses turned into realized losses. Equity portfolios in variable annuity writers went down 40% to 50%. Impairments mounted. Many of the major VA writers took substantial earnings hits. These included MetLife, Prudential, Hartford, Lincoln, Ameriprise, Manulife and Genworth. "The market got into a real frightened period, and that's when there was a lot of pressure on FASB about changing the rules," Stein said. "What FASB ended up doing was relaxing the impairment rules." Prior to 2009, the rule for impairment was that a company had to write the asset all the way down to fair value, to the levels of "all these speculative prices and depressed prices," Stein said. "So the board eliminated the effect of irrational credit spreads, liquidity issues and so on. In the event you anticipate that the cash flows from these instruments are being reduced, those are credit events, and you

need to take those as earnings hits." The rest, he said, could be held up as unrealized loss in equity.

The new rule was an elixir. It substantially reduced the number of impairments.

Looking ahead, however, Stein argues that insurers and other financial services companies would still be vulnerable to a new round of falling markets. That is because readers of financial statements can still see what impairments would have been under the old rules, and the statements show the portion that is being withheld from the earnings hit and is being retained in equity. "The market would not react any differently than it did in 2008," he said. "It would see the insurance liabilities rise and the assets fall through equity. It would be able to track the transition of these unrealized losses into recorded earnings impairments. All the same information would be available." Stein said it was the traders and speculators that drove down the stock prices and market capitalization of companies. The accounting process was ancillary to that, he said. Did they overshoot in the fall and winter? "I'd be inclined to say yes," said Stein. "If you look at how the economy has played out since then, and at these stocks today, virtually all have recovered very nicely off the extremely depressed lows. So yes, there was some overreaction, but it's one of those things you can only judge in

hindsight. When you're in free fall, are you going to say the economy is going to turn in six months? I don't think so."

Market values were as unrealistically negative as values at the top of the bubble were unrealistically positive two years earlier, he said. Critics such as Forbes have raised other accounting issues. One involves the uptick rule, which rule makers eliminated in 2007. That rule was like having speed bumps against short selling. Critics claim that eliminating that rule gave short-sellers free reign to drive down stock prices. Another involved enforcing laws against naked short-selling. So evidence exists that mark-to-market, which was intended to promote financial transparency, had unintended consequences. Usually, the accounting system supports market decisions about values and outlooks. But as Stein said, in this case, it may have gotten in the way. And Forbes said it threatened the very existence of our financial system.