For Banks, New Debt Rules May Be 'Double-Edged Sword'

Banks are expected to get some relief Thursday on how they price billions of dollars in toxic debt that's strangling their balance sheets. But market pros say the long-sought accounting changes could just add more confusion—and won't make banks more attractive to investors.

Financial stocks rallied on Wednesday in anticipation of the change in mark-to-market accounting rules by the Financial Accounting Standards Board. But while Wall Street has clamored for the changes since the credit crisis began, traders and other market experts wonder how big of an impact the move really will have.

"To a degree it is going to create a better climate," says David Lutz, managing director at investment banking firm Stifel Nicolaus. "But it is a double-edged sword. We're getting less transparency."

It's unclear exactly what changes the FASB plans to make on Thursday, but none is expected to be radical enough to have an immediate impact on stocks. Still, most investment experts say bank stocks should be avoided until the full impact can be weighed.

Advocates of mark-to-market rules say they provide a clearer picture of troubled assets' value because they are priced according to their present worth in the marketplace. The alternative, known as mark-to-model, allows banks to price the assets at a model determined by the institution and at times not easily in view of the investing public.

With the rise of derivatives used to package now-distressed mortgages, mark-to-market opponents say the rules need to be changed because there is no fair market value for the bad assets. The current bid offer in the marketplace is at a level that would wipe out some banks if they had to sell at those prices, some analysts say.

"No one can borrow money to buy any of these assets anymore," says Michael Cohn, chief investment strategist at Atlantis Asset Management in New York. "Mark-to-market doesn't work for very illiquid assets."

The bad assets should be priced according to cash flow and other generally accepted accounting practices, says Cohn, whose view is similar to many who believe mark-to-market needs to be relaxed.

Differentiating between assets that are credit-impaired as compared to those that are liquidity-impaired, such as the mortgage-backed securities bedeviling banks, would be a sensible middle ground, says Sue Allon, CEO at Allonhill, a Denver-based mortgage due diligence firm that prices assets for hedge funds and investment banks.

"Unburdening bondholders from the looming risk of downward price pressure in a highly irrational market would have a stabilizing effect and would be one of many strategies to help bring back confidence and stability to Wall Street and Main Street," Allon wrote in comments that appeared in the Journal of Structured Finance trade publication.

Yet even as Cohn advocates for dumping mark-to-market, he acknowledges that big banks that are experiencing severe capital issues won't become any more attractive simply because they can shore up their balance sheets through accounting procedures.

"Would I be buying them based on this? No," he says. "I'm still under the impression that the large banks are dead money, not because of this but because they're going to be broken up and you don't know how this is going to happen. ... How do they go from being too big to fail to not too big to fail?"

Fitch Ratings also has advocated for changes to mark-to-market, but warned that unless the FASB institutes measures to provide transparency investors could remain confused over the value of the distressed assets.

"Absent increased disclosures, investors and analysts may assume the issuer has taken the least conservative approach to valuation and impairment," Dina Maher, senior director at Fitch, said in a statement.

Indeed, several pressing questions remain among those who believe the rules should be altered.

The American Bankers Association has been pressing for a provision that would allow banks to recoup losses retroactively for assets that have already been written down.

Some also are concerned over whether increasing valuation for the toxic assets will discourage financial institutions from selling them, a trend that would thwart the Treasury Department's goal of using funds from the Term Asset-Backed Securities Loan Facility (TALF) to help create a market for the assets.

But whether banks do decide to hold the assets in hopes that they'll be worth more at maturity probably will depend on the strength of the institution holding them.

"With the better capitalized banks, yes (they might hold the assets). But the worst-capitalized banks? No, they need the money," Lutz says. "At the end of the day the banks that need to raise capital are going to raise capital if the Treasury program allows them to. If they can hit a bid they're doing to do it any way they can."

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And it won't be until that point—when the assets are actually sold and there is disclosure about the resulting financial impact—that investors will get a clear view on whether changing mark-to-market has helped.

"I don't think it's a game-changer," says Dave Rovelli, managing director of US equity trading at Canaccord Adams. "You might get a rally, but this is a few months down the road when you see where these things get priced."

Even then, the big money-center banks are going to be risky investments because their problems run deeper than capital ratios, Lutz adds.

"As a trader I would be buying these things into their earnings and selling them after their report when they spike up," he says. "I don't think they're out of the woods."

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