Save the Trillions!

With the stroke of a pen this past week, the Financial Accounting Standards Board (FASB) may well have helped save the banking system. In fact, with the changes in the rule concerning a bank's asset being subject to a "marked to market" (MTM) rule, the bank can more accurately value the asset subject to more relevant factors. For example, if a lender has mortgages that it intends to hold to maturity, and that mortgage is performing (the homeowner is making payments), it no longer has to be valued subject to distressed sales in the community. Foreclosures or defaulted mortgages heretofore, sometimes as few as one default in a community, could force the bank to mark down the value of their mortgages to that distressed price. This created a huge write-down of assets that otherwise were truly worth much more. That in turn created a dynamic downward pressure on the balance sheet, producing a crises in the bank's capital requirements.

Take the case of the Federal Home Loan Bank of Atlanta. In the third quarter of last year, according to a Bloomberg report, the bank had to write down its mortgage-backed securities by $87 million based on MTM rules, when in fact, their actual projected losses were only $44 thousand. In fact, by projecting the cash flow, says the Bloomberg report, along with an adequate discount, the true loss of assets intended to be held to maturity is insignificant. The same bank wrote down $98.7 million in the fourth quarter under the previous rules.

There are intelligent voices that would dismiss the significance of this due to accelerating losses in the mortgage market, but the immediate impact should be felt in such demonstrable ways as removing the attractiveness of bank stock "short sales" from the stock market, as well as freeing up more capital reserves on bank's balance sheets. Also in the Bloomberg report, William Isaac, former chairman of the FDIC, states that the MTM rules have removed $500 billion of capital from the financial system. He further states that due to capital leverage in lending being around 10 times, 'the rules "have destroyed over $5 trillion of lending capacity"'. Based on this, it can be safely assumed that liquidity of the credit markets was severely affected, if not frozen.

Even more compelling, the EU ministers are insisting that the International Accounting Standards Board (IASB), which administers these standards for Europe, adopt the FASB rules for the IASB. This standard would have immediate impact on European banks that are currently under water.

According to Reuter's, the true impact on the underlying securities may be small, from a trading perspective, but the fact is, it will have a huge impact on a bank's lending ability. Time will certainly tell, though it seems that this simple change could do more for the credit crisis than our pouring hundreds of billions of dollars into the system.