Another post deserving a brief update: Nonidentical Twins: Solvency and Liquidity.  The accounting rules have changed on mark-to-market accounting, but it won’t help financials at all, because now the accounting will be distrusted.  Even Goldman Sachs, who covertly runs our government, believes that is so.  Cash flows talk, and estimates of future free cash flows drive stock prices.  Accounting rules do not affect free cash flows, and the best accounting systems try to make earnings approximate free cash flows.

Here’s one more difficulty with changing the accounting standards: companies have the choice when they buy an asset of labeling it held to maturity, available for sale, or a trading asset.  The accounting varies depending on the choice, but held to maturity means that there is no mark-to-market.  So why didn’t financial firms tag assets to be held to maturity?  Because if you sell too many assets so tagged, your auditors get annoyed, and would try to compel you to tag all of them as available for sale, at which point mark-to-market applies.

So, let’s take a trip to Bizarro-world, where companies never have to do asset impairment, ever.  You can hold a security at par even after it has declared bankruptcy.  Only when the bankruptcy settlement payment is made in cash or new securities, would the value change on the balance sheet.  How would investors in bank stocks operate in Bizarro-world?

For one, during times of credit market stress, they would significantly reduce the price-to-book multiples that they would be willing to pay for banks.  Book values aren’t trustworthy without impairment done on a good faith basis.

There is no free lunch with accounting rules.  Make them more liberal, and investors become more conservative.

Many bank managers might say, “It’s a money good asset; if I hold it long enough, I will get par.  Why should I be penalized today?”  They should be penalized for two reasons:

• The probability of getting par back has declined.
• The ability of the bank to hold the asset to maturity has declined.

The first reason is simple enough.  The second reason is not well-understood.  Those that argue against mark-to-market accounting implicitly assume that all financial institutions have the capability of holding until the asset matures (pays off in full).  But that is not always true.  Many seemingly strong financial institutions (rated AAA or AA!) — recently found they could not hold their assets to maturity.  If a bank has to raise liquidity prematurely, those mark-to-market prices (if done fairly, which I think is rare) reflect the true value of the assets.

This is why I believe that most liquidity problems are really solvency problems, but the banks are clinging to old prices, and don’t want to admit that things have changed.  As we joked at AIG domestic life companies back in the early 90s: “Oh, almighty actuary! Utter the weasel-words that allow this rusty tub to stay afloat so that we can continue to draw on our salaries!”  (Yeh, it was that bad in that unit then.  The rest of the company was better, supposedly.)

Substitute  the word accountant for actuary, and that is what the present fair value rules are creating.  What it means is that a company must break due to a lack of cash flows before it goes insolvent.  That puts our accounting on the level of Madoff and other Ponzi schemes.  No one is broke until there isn’t a dollar left in the till.

It’s a lousy way to do business, but investors will adjust, and lower valuations.