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FASB 157: Mark to Market

Written By Brian Hicks

Posted April 2, 2009

Everywhere in my garden, there are signs of spring this morning.

Popping up from the mulch, the green and purple sprouts are now everywhere.

And while it is still a bit chilly here in Baltimore, I know the hostas and daffodils out front can’t possibly be wrong. Spring is about to bust out all over.

Of course, those same shoots are beginning to show themselves in the markets these days, although they are certainly much less inevitable as the warmer weather. Even still, there have been some encouraging signs this week.

Despite the pall of bankruptcy for a few automakers, and the prospect of the worst jobs number in recent memory, the markets have somehow put the recent rally back on the table. And to hear the bulls tell it, the latest drop was a pullback and nothing more.

Given what is going on with the financial sector of late, they may just be right— for now anyway. What will happen later is another story for another day.

Yet, the rally in financial stocks has gathered some more steam this morning, as the Financial Accounting Standards Board (FASB) voted to relax its now infamous FASB 157 or mark-to-market rule.

In effect, political pressure has trumped transparency. Go figure.

FASB 157: Mark to Market

Adopted in the wake of corporate finance scandals earlier this decade, FASB 157 required commercial banks to value securities and loans held on their balance sheets according to prices being paid for similar instruments on the market.

Now, of course, that’s never any problem in a rising market since marking up an asset makes you look pretty smart. However, in a falling market like the one we are in now, marking to market is a bank’s worse nightmare.

That’s because when a bank has to write down an asset on its books, it not only has to take the loss, but also has to beef up its reserve of cash to cover its declining asset base. The net result is a black eye and less money to lend— even if the bank plans to hold the asset until maturity.

The rule took effect on November 15, 2007, which, coincidently, was very near the top of the market. Since then, however, the rule has created havoc on bank balance sheets as the value of those assets has spiraled down in a vicious cycle in which lower marks only beget even lower marks. It’s like falling without a parachute.

Some, like Chicago billionaire Sam Zell, agree. "Without mark-to-market fair value accounting," Zell said, "this crisis would never have reached this level." That statement came in September when the Dow Jones Industrial Average was still at the now-lofty level of 10,800, a pretty distant point from where we are trading today.

"Less Awful" Is Better Than "More Awful"

Since then, however, political and financial pressures have effectively ended the banking headaches embodied by FASB 157. Mark to market has been shelved, at least temporarily. A vote this morning by the FASB relaxed the rule. In its wake, the markets have jumped to upside.

The changes will now allow banks and other financial companies to use "significant" judgment when gauging the price of some investments on their books, including mortgage-backed securities. So, after being handcuffed by the rule, the banks are now free to sort of make it up as it suits them.

The result, the skeptic in me now says, will be write ups instead of write downs as the financials use that "significant judgment" to significantly juice their numbers.

That’s why the financials have bounced off the bottom with a vengeance, since these changes could boost their net income by 20 percent or more in the future. The new guidelines will apply to the second quarter that began this month.

And while these changes may only mask some of the garbage on their books, it will definitely change the news cycle in the financials to "less awful"— which in the big scheme of things beats "more awful" any day!  Real or not, it will have an effect.

So, from my perspective, the short-term bottom in financial stocks has been put in. From here, the entire sector could easily rise over 30%.

Of course, that is a net positive for the bulls as the green shoots are now springing up everywhere you look— especially in the chemical sector which I wrote about last week.

Believe or not, it’s time to go long.

This "less awful" rally has gotten some legs— for now, at least.

By the way, my mortgage broker buddies are busy these days making hay while the sun shines. To a man, they all say their phones are ringing off of the hook. Their only complaint these days is that they have jammed so many refi-loans into the pipeline that the banks are getting backed up big time.

That’s another positive sign for the financials and the broader markets.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory

P.S. As I mentioned earlier, the chemical sector is one that is in full-on rally mode. It’s banking huge gains these days courtesy of the rising market and the new stimulus bill. In fact, as I have discovered, a full 10% of the bill — or some $78 billion — will be funneled to the industry as a result. That has created a fantastic opportunity for investors in this industry, since these companies can now be bought at a serious discount. To learn more about this opportunity click here.