If the delayed plan to overhaul the government's bailout of the financial system is not retooled to suspend or restructure fair value accounting rules, the stock market will likely award Timothy Geithner with a failing grade early into his role as Treasury secretary.
Geithner's plan, which was to be unveiled Monday before being pushed back a day in order to rally Senate support for the gigantic stimulus package, is reportedly set to include provisions that will allow the private sector to purchase bad assets on the balance sheets of troubled banks, considered to be the root problem of the financial crisis.
Additionally, Geithner's plan is expected to outline the next round of injections from the Troubled Asset Relief Program, or TARP, as well as details about spending money to combat escalating mortgage foreclosures. President Barack Obama's economic team members also reportedly continue to consider a "bad bank" to buy soured assets.
What isn't known is how Geithner and other officials in Obama's administration will handle rules currently in place for fair value, or mark-to-market, accounting rules. The current accounting standard says that banks must carry assets, including mortgage-backed securities, on their balance sheets at fair value.
Those who argue against the mark-to-market rules say that the financial crisis has depressed the value of the assets below their real valuation, making it impossible for banks to purge the toxic assets from their books.
The stock market has already weighed in with its opinion about possible changes to mark-to-market rules. After
reported Thursday that the
Securities and Exchange Commission
might be looking to suspend or restructure mark-to-market accounting rules, the
Dow Jones Industrial Average
surged more than 250 points from its intraday low to its session high.
"We had some rumors floating around last week and the market loved it," said Paul Mendelsohn, chief investment strategist with Windham Financial. "That tells you that the market understands the significance, even if the politicians may not, of temporarily doing away with mark-to-market on these securities and going mark-to-model. That has got to be part of the issue tomorrow."
To Mendelsohn, changing the fair value rules could be the most critical component of Geithner's plan. "Either you inflate it through the accounting rule or you buy those assets at their theoretical value and the banks will be fine," he said. "The bulk of the banks' problems are over if you do that. The market knows these things have more value. The question is how do you capture it."
The American Bankers Association has been reluctant to get out in front of Geithner's plan, instead saying it will offer comments on what has been proposed after details emerge. Still, the organization said that in the long term, mark-to-market rules should only be used where it is appropriate to the business model.
"That's not the case for banks," said Jonathan Snowling, spokesman with the American Bankers Association "It exaggerates the upswing as well as the downswings. If you're dealing with a financial instrument, such as a mortgage-backed security, just because you're not as likely to get as good of a turnaround on someone buying it up doesn't mean the assets will actually fail to perform or that the economic value has depreciated to that level."
Mendelsohn argues that a strong outside investor, like
, will be reluctant to make investments if they then have to mark them to market. "But if I can mark them to model to their theoretical value, when mortgage defaults slow down and housing prices pick up, I can make the assumption that I'm going to make a fortune," he added.
Not everyone is convinced that abandoning or modifying mark-to-market rules is the cure to what ails the financial system. John Hussman, president of Hussman Funds, argues that optimism in the stock market over these rumored changes is akin to someone taking huge losses in their portfolio, and believing that ignoring their brokerage statement will improve their financial situation.
"Look, if the underlying assets are likely to regain value over a reasonable amount of time, then it might be appropriate to modify the capital accounting rules so temporary fluctuations don't drive banks into failure," Hussman wrote in his weekly market commentary. "But if you've got securities that are marked down to 20 or 30 cents on the dollar, and the underlying borrowers are likely to default because you haven't changed their payment obligations, failing to mark the portfolio to market simply allows banks to go quietly insolvent without the knowledge of the public."
Hussman isn't alone in his assessment that a change to fair value rules won't fix the core of the problem. Even Geithner himself has endorsed continuation of mark-to-market accounting rules because they help protect investors and promote transparency. He wants a more comprehensive framework for regulating derivatives markets.
However, other members of Obama's economic team have pushed for a change in the rules. New SEC chairwoman Mary Schapiro said that the Financial Accounting Standards Board is "actively considering changes" to its mark-to-market rules, according to
. Mendelsohn says that a change needs to come sooner rather than later, or the market will be severely disappointed with the new Treasury secretary.
"If the temporary suspension of mark-to-market accounting is not in there tomorrow, the market is going to go down and I'd give Geithner an 'F,'" said Mendelsohn. "I'd even give him an 'F-.' If changes to mark-to-market are in there, I'd give him somewhere between a 'B+' and an 'A.'"
Paul Nolte, director of investments with Hinsdale Associates, says that even after details of Geithner's plan are released Tuesday, it is too early to grade the performance of the new Treasury secretary.
"In order for me to grade him, I need to see performance," said Nolte. "It's hard to grade
former Treasury Secretary Henry Paulson, even today, because we haven't seen the full implications of the things that he did or didn't do. All of this money used to turn around the system is not really going to have an impact on the financial side for maybe six months."