Mark-to-Market Changes Fail to Rally Stocks

Mark-to-market accounting rule changes should have sent stocks surging, but market observers say other government plans diffused a potential rally.
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Updates from 8:23 a.m. EST

A recent accounting rule change should have been a major boon for financial stocks, but an expected rally on its promise has been thwarted by government initiatives that could actually prevent a market recovery, Wall Street observers argue.

Market participants have long complained about the Financial Accounting Standards Board's statement 157, which was implemented in 2007 to change the definition of fair value -- the measure of the worth of an asset on a company's books -- the methods used to measure fair value, and the expanded disclosures about fair value measurements.

According to the current accounting standard, struggling banks must continue to carry assets, including mortgage-backed securities, on their balance sheets at fair value. Critics say such "mark-to-market" rules have led to assets being priced well below their real valuation, making it impossible for banks to purge the toxic assets from their books.

FASB Chairman Robert Herz said Wednesday the organization has added new projects intended to improve the application guidance used to determine fair values and disclosure of fair value estimates. FASB said it anticipates completing projects on application guidance by the end of the second quarter of 2009.

Prior to Wednesday's announcement, Paul Mendelsohn, chief investment strategist with Windham Financial, had argued that any change to FASB's 157 rule could prompt a rally on the Dow that could push the

Dow Jones Industrial Average

close to the 10,000 level because of its advantage to the financial sector. But Wednesday's announcement did not go far enough, Mendelsohn says.

Instead of a rally, the market has seen a sharp selloff in financial stocks.

Citigroup

(C) - Get Report

is down 23% today and

Bank of America

(BAC) - Get Report

is down 20%, while

JPMorgan Chase

(JPM) - Get Report

is down 5.5%,

Wells Fargo

(WFC) - Get Report

is down 18.9% and

U.S. Bancorp

(USB) - Get Report

is down 9.8%.

"They haven't said yet that they're going to suspend it, and there isn't anything concrete yet," he says. "If they had temporarily suspended the rules to allow banks to go back to the old way, I think that has a huge impact on the market. That's step number one that you must have. For now, it's still an open issue."

Herz said on Wednesday that the project to examine rule 157 is a response to investor concerns and recommendations made by the

Securities and Exchange Commission

, which recently completed its own study on mark-to-market accounting.

"The SEC expressed continued support of fair value accounting in its study, but recommended consideration of potential improvements in the guidance surrounding the application of fair value principles," Herz said in a statement. "We agree with the SEC and with our Valuation Resource Group that more application guidance to determine fair values is needed in current market conditions."

The American Bankers Association, which says it has consistently pushed for immediate repairs to mark-to-market accounting since March 2008, welcomed FASB's announcement.

"The current market has demonstrated how unreliable 'mark to market' accounting can be, and there are various views about how best to estimate market values, ABA President and CEO Edward Yingling said in a statement. "We are pleased that FASB has initiated a project to review and reconcile the process for estimating market values in illiquid markets."

However, Yingling said that the ABA is disappointed that "critical problems" regarding another accounting standard, other than temporary impairment, or OTTI, also need to be quickly addressed.

Obama Plan Compounds the Problem

But now there is a new, even bigger problem, Mendelsohn says. The negative aspects of President Barack

Obama's plan

to reduce the flood of home foreclosures, announced Wednesday, could further impair the value of an already toxic securities, he says.

The Homeowner Affordability and Stability Plan is intended to modify as many as 9 million existing mortgages that homeowners cannot afford, or whose value exceeds that of the home. Part of the plan is to force banks, in some cases, to reduce the principal of the original mortgage in order to help prevent foreclosures.

At first blush, the so-called "cram-down" provision of the plan could be devastating to banks. For instance, if a person has a $350,000 mortgage that is readjusted to $300,000 under Obama's proposal, that will force a bank to take a $50,000 writedown, affecting the value of a security.

Another problem arises in the hypothetical situation where the home is sold at some point in the future for $400,000. The question is who has the right to the profit -- the bank or the homeowner?

"What seems to have happened yesterday is the positive news on FASB 157 has been offset by the negative news in the way the 'cram-down' component is structured," Mendelsohn said. "A change in 157 is critical. Remember, the cram down affects the theoretical value of the securities. If you suspend 157 and you go back to hypothetical value of the securities, as long as the cram down doesn't negatively impact the securities, you can get a recovery."

However, the more damage done to the value of the security, the more the bank is in the hole. "If the bank has a stake in that difference when the house sells, that positively affects the value of the security," Mendelsohn said. "It doesn't make any sense to adjust the price and let the homeowner get the difference. You want to make sure the bank is made whole."

"If we suspend FASB 157 and we set up a structure where banks can reduce the principal but recapture it later on, that's when everything begins to work together," Mendelsohn said. One solution he offers is to develop a certificate program for banks that would allow them to recovery whatever value is lost in a mortgage cram down.

In the event that both work together, Mendelsohn argues the Dow could rally at least 1,500 points. "I think you could come up to the 9,950 level," he said. "The market is so oversold, it just needs to see something positive that there's a way out of this. All the market keeps seeing right now is that there's no way out. We only keep getting deeper into the hole."