The stunning string of losses for banks could soon end because financial firms now will be allowed to ignore the market price for their "toxic" assets and assess them differently.
Thursday, the Financial Accounting Standards Board (FASB) tweaked a controversial rule requiring financial institutions to value assets at current market prices. The news, though expected, helped trigger a broad rally.
Known as mark-to-market accounting, the rule created havoc on banks' balance sheets the past year because the market for mortgage-backed securities collapsed as home values plunged, defaults spiked and foreclosures surged.
So, even though banks hadn't sold their assets, they had to write down their value on their balance sheets to the "market" price and record it as a loss. Just in the fourth quarter Citigroup wrote down the value of its assets by $7.7 billion, while Merrill Lynch took a $14.1 billion write-down.
As write-offs mounted, mark-to-market accounting became a lightning rod for criticism from both banks and Congress that the financial crisis had worsened because of the rule. Thursday, FASB responded by changing the rule to meet these demands amid applause from lawmakers.
"FASB ... recognizes the needs of investors for transparency but one that is also not blind to the exigencies of the ongoing financial crisis," said Rep. Paul Kanjorski, D-Pa.
Financial institutions now will have more latitude in determining the value of their assets, if they find that the market for those assets is inactive.
The banks can use their own judgment and models to assess the value of a security, as long as they support their findings with statements and explanations. Before, the last "distressed" market price had to be used to report the value of the assets.
"Rather than take the value of the last fire sale, they can value these assets using their risk assumptions," says Denise Valentine, senior analyst at Aite Group. Banks also don't have to take the entire impairment charge against earnings at one time.
The rule change will take effect in the second quarter, but companies are allowed to adopt them as early as the first quarter. How the change affects:
•The industry. Banks, especially the major ones that hold large portfolios of distressed assets related to mortgages, will benefit. Bankers believe the values for many securities in current frozen credit market conditions are considerably lower than what they are really worth. And if they decide to adopt these guidelines, it could boost incomes at banks as soon as the first quarter. "It will bolster future earnings at financial institutions and improve their capitalization levels," says Sean Egan, managing director of Egan-Jones Ratings.
•Investors. Wall Street was wowed Thursday by the change, focusing on the potential for it to boost earnings at banks. However, experts warn that the rule creates a more opaque market and doesn't solve banks' problems. And if the real estate market doesn't recover, they say the securities will likely end up being valued even lower.
"Investors will either believe the fictitious numbers and get burned when reality asserts itself or they won't believe (them) and continue to stay in the sidelines," says Barbara Roper, head of investor protection at the Consumer Federation of America.
•The government's plan for private investors to buy toxic assets from banks. If banks use these changes to increase the value of the assets, it could threaten the program's effectiveness. "Private buyers might lose confidence in the value of the securities and question the prices they are valued at and will not participate in the program," says John Foff, senior analyst at SNL Financial.