Paulson’s Economic Patriot Act is about marking to market

The interesting thing about the Paulson proposal is that it gives the U.S. Treasury carte blanche to buy any of these toxic assets at any price it chooses. This is relevant because of mark to market rules in FAS 157. I have posted a few times on the mark to market rules of FAS 157 that have caused a ton of writedowns at major money center banks.

Why this is relevant is that if the Treasury buys these toxic assets at relatively high prices, not only does the holder of the asset get the asset off its books, all other companies holding these assets can mark the assets higher to the new price paid by treasury. Paulson wants to revalue the entire banking sector’s balance sheet. This is the most important feature of Paulson’s Patriot Act.

FAS 157 was enacted by the FASB (Financial Accounting Standards Board), the U.S. accounting group that delivers edicts that U.S. listed companies. FASB describes the edict on their website like so:

Summary of Statement No. 157

Fair Value Measurements

Summary

This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.

Reason for Issuing This Statement

Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.

–FASB website

The crux of the edict is that companies must mark to market. However, marking to market is considered to be very pro-cyclical, meaning it overstates assets on the balance sheet when the economy is in an upswing and it understates asset value during downturns like the present one. Given the market panic, it is probable that many assets have been marked down far below their ultimate fair value.

On Wall Street, there has been a lot of buzz about the fact that some distressed assets, while toxic, are trading below fair value. Paulson, being a former denizen of Wall Street, has probably heard this chatter and agrees with the overall thrust of it.

In my opinion, this may explain the hidden agenda behind his plan: Paulson wants to revalue assets on all banks’ balance sheets in order to stem the tide of writedowns.

Under Paulson’s Economic Patriot Act, taxpayers will be on the hook only if these assets the Treasury plans to buy are overvalued. They might even see a gain if they are undervalued. Paulson is clearly betting that the assets are undervalued.

But even if they are overvalued and more writedowns are likely, Paulson certainly believes he can prop up asset prices, at least temporarily. This buys banks time. Time is an valuable asset here because:

1. it may give banks enough time to consolidate the industry
2. it may allow banks to earn their way out of trouble due to the steepness of the yield curve
3. it may give Congress enough time to come up with a new, better plan once the new President comes into office in 2009.

Again, I don’t like his plan and I don’t like the tactics the Bush Administration is using to promote it smack of fear mongering – hence, my designation of this as the Economic Patriot Act.

Nevertheless, the fact that Paulson believes he can revalue the whole asset class en masse makes his plan’s calculus that much more interesting. With everyone else focused on the deficit, we should realize asset revaluation is the real story behind this plan.

Related posts on FAS 157
Regionals options suffer due to accounting rules
What is a credit writedown?
The regionals versus money center banks
De-leveraging redux