Tunnel of Love

"I put a hand upon the lever said let it rock and let it roll
I had the one arm bandit fever there was an arrow through my heart and my soul." - Dire Straits - Tunnel of Love.


Treasury Secretary, Tim Geithner is certainly pulling the handle of the slot machine that is the Private Public Investment Program. Although the plan has potential and is along the lines of what the so-called Bank Vigilantes have been demanding (the removal of toxic assets from bank balance sheets), there are some road blocks. Not surprisingly, the road blocks could come from the world of accounting.

Within the myriad of discussions of toxic assets and how they should be valued, there continues to be the misconception that banks have already marked their toxic assets to market and need only to mark assets up to their "real" values (yeah right). It turns out that the majority of toxic assets on bank balance sheets are loans. It also turns out that loans are not subject to mark to market accounting. Because many banks have not marked down their loan value much, if at all, selling loans to asset managers via the PPIP is problematic for banks. It is problematic because in many instances the result could be realized losses for banks.

Another accounting road block could come from the FASB. The FASB is supposed to decide by April 1, 2009 whether or not to modify mark to market accounting. Although many equity-oriented investors and strategists are hopeful that MTM accounting is modified or eliminated, the bond market would take a dim view of such a decision. The bond market wants the garbage taken out. If the glow-in-the-dark assets remain on bank balance sheets, value at dubious levels set by the banks (kind of like a no-documentation situation in which we are relying on the honesty of the bank to value its health and capital ratios, yeah right) the bond market will at best continue to trade banks at somewhat distressed levels or at worst send credit spreads wider putting more stress on bank borrowing costs. The bond market takes a deeper view of corporate health. It is not always correct, but fixed income strategy goes beyond tracking trends and forecasting reversions to some arbitrary mean value.

I have been an outspoken critic of a suspension of MTM accounting. An editorial in today's Wall Street Journal authored by James S. Chanos (chairman of the Coalition of Private Investment Companies and founder and president of Kynikos Associates LP) echoes my concerns. Mr. Chanos states:

"Mark-to-market (MTM) accounting is under fierce attack by bank CEOs and others who are pressing Congress to suspend, if not repeal, the rules they blame for the current financial crisis. Yet their pleas to bubble-wrap financial statements run counter to increased calls for greater financial-market transparency and ongoing efforts to restore investor trust."





"We have a sorry history of the banking industry driving statutory and regulatory changes. Now banks want accounting fixes to mask their recklessness. Meanwhile, there has been no acknowledgment of culpability in what top management in these financial institutions did -- despite warnings -- to help bring about the crisis. Theirs is a record of lax risk management, flawed models, reckless lending, and excessively leveraged investment strategies. In the worst instances, they acted with moral indifference, knowing that what they were doing was flawed, but still willing to pocket the fees and accompanying bonuses."


"MTM accounting isn't perfect, but it does provide a compass for investors to figure out what an asset would be worth in today's market if it were sold in an orderly fashion to a willing buyer. Before MTM took effect, the Financial Accounting Standards Board (FASB) produced much evidence to show that valuing financial instruments and other difficult-to-price assets by "historical" costs, or "mark to management," was folly."



"The rules now under attack are neither as significant nor as inflexible as critics charge. MTM is generally limited to investments held for trading purposes, and to certain derivatives. For many financial institutions, these investments represent a minority of their total investment portfolio. A recent study by Bloomberg columnist David Reilly of the 12 largest banks in the KBW Bank Index shows that only 29% of the $8.46 trillion in assets are at MTM prices. In General Electric's case, the portion is just 2%."



"Why is that so? Most bank assets are in loans, which are held at their original cost using amortization rules, minus a reserve that banks must set aside as a safety cushion for potential future losses."

'MTM rules also give banks a choice. MTM accounting is not required for securities held to maturity, but you need to demonstrate a "positive intent and ability" that you will do so. Further, an SEC 2008 report found that "over 90% of investments marked-to-market are valued based on observable inputs.""



I didn't highlight Mr. Chanos' article to create a kind of mutual admiration society between he and I, but to highlight the fact that the chairman of the Coalition of Private Investment Companies (A.K.A. hedge funds, which can exert much more influence over the financial markets than myself) is voting "no" on eliminating MTM accounting in the banking world. Private investment companies can move markets by causing credit spreads to widen and push share prices lower by engaging in strategies which result in much share selling. Mr. Chanos may be the chief "vigilante"



"And the big wheel keep on turning neon burning up above
and I'm just high on the world
come on and take a low ride with me girl
on the tunnel of love" - Dire Straits