After the Financial Accounting Standards Board and the Securities and Exchange Commission reversed their stances on mark-to-market accounting last month and allowed banks to use discounted cash flows to value their securities, banks were hesitant to employ the new accounting rules for fear that investors would not trust the new valuations. Recently, Deutsche Bank revalued its assets, and investor approval was reflected in the 18 percent jump in share price. If other U.S. banks follow suit and revalue their assets according to discounted cash flow, it could substantially alleviate investor concerns about the solvency and stability of these financial institutions.

Arthur F. Burns Fellow Peter J. Wallison

Ever since the financial meltdown began over a year ago, U.S. banks and others have argued that their securitized assets, such as mortgage backed securities (MBS), should be valued according to their discounted cash flows and not their market prices. Now, a recent revaluation of its assets by Deutsche Bank--using new E.U. accounting rules--shows that investors will accept this change in valuation methods. This suggests that U.S. financial institutions--using new SEC and Financial Accounting Standards Board (FASB) rulings--could do the same in coming months and substantially alleviate current concerns about their solvency or stability.

On September 30, the SEC essentially reversed its position the use of mark-to-market accounting where there is no "active market." Shortly thereafter, the FASB did the same. This was a major change in accounting rules that has been lost in the news about the current financial crisis. Since the beginning of the financial meltdown in July 2007, accountants have required banks and other financial intermediaries to carry their portfolios of MBS at market prices--the price those assets would likely bring if sold on the measurement date. The affected companies complained about the mark to market rules, arguing that their MBS portfolios were producing cash flows consistent with much higher valuations, and the market was not producing valid market prices because buyers had withdrawn from the market. Nevertheless, accountants were following the directions of the FASB in FAS 157, which they said required the use of market prices whenever those prices were available.

In truth, there was great deal of implicit flexibility in FAS 157. Its language noted that market prices were an appropriate measure of value "unless those prices are the result of a forced liquidation or distress sale." Since there were few buyers, and the sales that were going on were forced on banks by the withdrawal of financing sources, it seemed a fairly strong case could be made that market prices are being distorted in just the way contemplated by FAS 157. But in a March letter to the CFOs of public companies, the SEC stated: "Only when actual market prices ...are not available is it appropriate for you to use" other asset valuation methods. On the strength of that reading of FAS 157, accountants continued to insist on mark to market valuations even where the prices were the result of distressed markets and liquidation of assets by forced sellers.

The TARP legislation, as it finally passed Congress, contained authority for the SEC to suspend FAS 157. The SEC already had this authority, but it apparently took the congressional action as sufficient "political cover" to change its view--something it should have done long before. In its statement on September 30, the SEC said that where there is no "active market" it is acceptable to use another method of valuing MBS or other securities, specifically mentioning discounted cash flow. This is exactly what the banks had been saying all along--that their securitized assets should be valued according to their cash flows, and not the prices they would bring in a distressed market.

There was one remaining issue, and that was whether investors would accept this change in valuation technique as valid. Before the change occurred, investor groups, accountants, and some analysts had argued that the change from marking MBS to market would have no credibility--that it would be seen by investors as simply a political decision, and authority for financial institutions to arbitrarily revalue their assets. However, now there is strong evidence that investors don't look at it that way.

Shortly after the SEC acted, the International Accounting Standards Board--the E.U. equivalent of the US FASB--ruled that European banks and others could reclassify their MBS and other securitized assets as "held to maturity," which exempts them from mark to market valuation and allows them to be valued on a basis closer to their discounted cash flows. Deutsche Bank was the first major E.U. financial institution to use the new rule and revalued those of its securitized assets that it intends to hold to maturity. This resulted in a profit instead of a projected loss for Deutsche Bank in its most recent accounting period. Most important, investors endorsed the change, increasing Deutsche Bank's share price by 18 percent when the new results and accounting change were announced.

This is strong evidence that many U.S. institutions and their shareholders could have avoided enormous losses in the past year if the SEC and the FASB had acted more quickly to recognize a simple fact: that mark to market accounting should not be used when there is no active market. More important for dealing with the current financial crisis, if in coming months U.S. banks and others can revalue their securities assets according to their discounted cash flows, it could substantially alleviate current investor concerns about the solvency and stability of these financial institutions.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.