This post appeared yesterday on RealMoney. Click here for a free trial, and enjoy incisive commentary all day, every day.How can a component of the Dow Jones Industrial Average teeter on the edge of bankruptcy? The AIG ( AIG - Get Report) story involves more than first meets the eye. There is a wide disparity between what is happening and the general public's understanding. Most media accounts emphasize the federal intervention, the potential cost of a bailout, the moral hazard arguments, and the fact that taxpayers may be on the hook for losses. These are all valid public-policy issues and worthy of discussion. Many of the accounts emphasize the rapidly rising total of capital requirements with little explanation of why these took place. (Ratings downgrades requiring more collateral for AIG.) Meanwhile, there is an increasing chorus of support for one key factor behind the problem: last year's implementation of FAS 157. This well-intentioned measure, introduced by accountants to avoid a Japan-like situation where institutions maintained assets on the books at unreasonable prices, instituted a procedure for mark-to-market evaluation. It is a good idea, implemented at the wrong time in the wrong way.
Why This Is ImportantFAS 157 rules have (at least) two negative effects:
- Requiring asset evaluations based upon the fire-sale prices of other firms. These forced sales into illiquid markets are unlikely to reflect the true value of the underlying assets.
- Requiring potential buyers to assume assets that are immediately marked down, placing additional stress on their capital.
New VoicesDavid Malpass puts the problem quite well in a paper on RealClearMarkets (revised today on Forbes.com):
The new mark-to-market rules are creating capital shortages by valuing assets as cautiously (meaning low) as possible, without a reasonableness test. The mark-to-market rules discourage takeovers (the bane of short-sellers) by forcing prices for post-merger assets to be lowered overnight (when reasonableness would argue that their value would increase due to the deeper pockets of the acquirer).The astute bank analyst Robert Albertson, featured on yesterday's Kudlow & Company, has a great summary:
The combination of rating agencies and mark-to-market accounting is proving to be a very dangerous cocktail that is pushing arguably solvent companies into insolvency. The problem is that they are financial companies that provide liquidity to the economy. So while we may be solving some issues in the short term for that, I think we are threatening ... the liquidity of the economy.Albertson again, replying to a Kudlow question about "fair value" and mark-to-market accounting:
It is a big issue, because everyone is trying to be precisely wrong.Indeed! What good is it to have a precise measurement of the wrong thing? Ned Riley, founder and CEO of Riley Asset Management, also weighed in on CNBC:
The 157 rule should be suspended. It was developed during a calm period. It was not developed during a period when fire sales were going on and assets were being marked down to an unrealistic price. We forget that some of this stuff is worth more than what they are going to pay for.These are only the latest analysts to recognize the FAS 157 rule as an important contributor to the problem.