Mark-to-market and its effects on community banking during the financial crisis. An examination of perceived risks

Author:Hilde Patron, William J. Smith
Position::Department of Economics, University of West Georgia, Carollton, Georgia, USA; Department of Economics, University of West Georgia, Carollton, Georgia, USA
Pages:55-72
SUMMARY

Purpose - The purpose of this paper is to study the impact of the relaxation of mark-to-market (MTM) standards on community banks’ share prices. Mark-to-market valuation of securities became increasingly common in the late 1990s and 2000s, as regulators sought to create more transparent and more current depictions of bank financial positions. However, MTM accounting may be sub-optimal in the... (see full summary)

 
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Mark-to-market and its effects
on community banking during
the nancial crisis
An examination of perceived risks
Hilde Patron and William J. Smith
Department of Economics, University of West Georgia,
Carollton, Georgia, USA
Abstract
Purpose – The purpose of this paper is to study the impact of the relaxation of mark-to-market (MTM)
standards on community banks’ share prices. Mark-to-market valuation of securities became
increasingly common in the late 1990s and 2000s, as regulators sought to create more transparent and
more current depictions of bank nancial positions. However, MTM accounting may be sub-optimal in
the presence of severe market frictions, such as those experienced during the nancial crisis of the late
2000s. To comply with capital requirements associated with MTM accounting, banks of the late 2000s
dramatically liquidated portfolios with potentially solvent assets in illiquid markets, taking huge losses.
During the nancial crisis, mortgage-backed securities held by banks began to plummet in value. Banks
were forced to either liquidate these assets even though there were no buyers or dramatically reduce the
values of their portfolios based on re-sale prices. On a cash-ow basis, these securities had value, as
many mortgages bundled in these securities continued to be paid on time; however, with markets frozen,
market prices did not reect this value.
Design/methodology/approach – This study shows that, for a sample of 134 community banks,
share prices increased after the MTM relaxation, even after accounting for a variety of other economic
factors.
Findings This paper shows that, perhaps counterintuitively, the steps taken by the Financial
Accounting Standards Board to relax MTM accounting standards may have acted as a stabilizing
factor on the market price of community bank shares by allowing banks to selectively liquidate assets,
boosting asset prices until uncertainty was resolved.
Originality/value – This paper examines the impact of recent changes in accounting standards on the
perceived risks associated with the banking sector. It specically focuses attention on the impacts these
changes had on community-based banks within the USA.
Keywords Financial crisis, Community banks, Mark-to-market, Stock prices
Paper type Research paper
Introduction
Mark-to-market (MTM) accounting is not a new concept in the nancial world; however,
during the early acts of what would eventually become the nancial meltdown, the
Financial Accounting Standards Board (FASB) (2006) adjusted the accounting rules to
specify that valuations should take into account the current state of the market for
assets. On the surface, these adjustments might not seem to have changed much; but,
some have blamed this change in accounting standards with intensifying the severity
and lengthening the duration of the recession by inadvertently damaging banks, the
The current issue and full text archive of this journal is available on Emerald Insight at:
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Mark-to-market
55
Journalof Financial Regulation
andCompliance
Vol.23 No. 1, 2015
pp.55-72
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-02-2014-0014
value of their assets, their ability to meet federal banking regulations and their ability to
extend credit when it was most needed. This paper examines the impact of recent
changes in accounting standards (and other selected signicant nancial events
occurring during the Great Recession) on the perceived risks associated with the
banking sector. We specically focus our attention on the impacts these changes had on
community-based banks within the USA.
Statements of Financial Accounting Standards Number 157 (also known as FAS157)
dene fair value as “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date”
(Financial Accounting Standards Board, 2006). FAS157 became effective for scal years that
began after November 15, 2007. This rule change forced many companies, including banks,
to place current market prices on assets that were considered to be among the hardest to
value, those known as Level-3 assets[1]. Federal law requires banks to maintain a certain
level of equity on their balance sheets, and banks typically viewed as sound would have had
at least $4 in equity for every $100 in assets (mostly outstanding loans). Note that many
conservative banks had leverage ratios greater than this level. As one might imagine, a rule
change regarding how banks value their assets may, in turbulent times, impact their ability
to comply with federal laws regarding equity and increase the likelihood of a federal
takeover. Over the period from October 2007 to October 2008, approximately $8 trillion in
wealth evaporated from the US Stock Market (Brunnermeier, 2009). The exposures to the
housing collapse and severe market uncertainty froze credit markets. Late in December
2008, the value of real home equity had fallen by 41 per cent. Existing median home prices fell
27 per cent. By the third quarter of 2009, about 3.2 million homes had gone into foreclosure[2].
The loss of bank equity through negative re-valuation of assets during the housing crisis and
the subsequent nancial meltdown has been named as an exacerbating factor that helped
extend and deepen the 2007-2009 Recession. When the prices of assets related to the real
estate markets began to fall, banks were forced to take big write-downs on assets
(specically their mortgage portfolios). To counter these large losses in asset values, in many
cases, banks have been pressured to increase their level of capital reserves through a
combination of reduced lending, increased borrowing, and stakeholder/founder capital
infusions.
The concern for many banks is not that asset prices have fallen, but that FAS157 has
articially forced valuations too far down. Some bankers have voiced concerns that
asset values on the books were (and are) far lower than they will eventually be worth
when markets fully emerge from the economic recession. But, in the meantime, many
banks have been forced into receivership when, on a cash-ow basis, they might have
remained viable enterprises. According to Steve Forbes:
In effect, MTM accounting rules forced nancial institutions to value securities for capital
purposes as though they were day-trading accounts. Traditionally, an asset was held at book
value for regulatory capital purposes unless it was disposed of or became impaired. In 2007
that standard was overturned by the Financial Accounting Standards Board (FASB). When
panic set in regulators and auditors forced banks and insurers to write down the values of
assets to absurdly low levels that weren’t even remotely justied by their cash ows (Forbes
Magazine, 2010).
As a result, banks have lobbied for more (not less) exibility in valuing their assets. It
may be pointed out that banks themselves are not buying these assets at the prices near
what they claim they are worth; however, given the potential for these assets negatively
JFRC
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