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Some Blame Obscure Accounting Rule for Financial Crisis

Fate of Freddie Mac, Fannie Mae in doubt today

These days when you look at the dismal condition of our financial markets, you can point in any direction and say theres the culprit -- from lack of government intervention, to the problems at mortgage giants Freddie Mac and Fannie Mae, to an overall crisis in confidence, even to an accounting rule that some are saying may not have caused the credit crisis, but is certainly making things a lot worse.

It may have all started with defaults in subprime mortgages, and then moved on to mortgage insurers and other asset backed derivative securities, but now theres a new debate raging over what's driving the current credit crisis.

Some experts are pointing to a little known accounting rule cooked up by the Financial Accounting Standards Board (FASB) and titled FAS 157. This rule states that companies have to mark-to-market, or put a market price on any financial instruments they hold and trade.

This is relatively easy if that instrument is a stock, but what if it's a "Credit Default Swap?" What are those you ask? A credit default swap is a derivative, in this case a complicated insurance-like contract that promises to cover losses on a security in the event of a default.

To further muddy the waters, the market in which they trade is unregulated, which means they can move from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. They can even be bought and sold from both ends the insured and the insurer, and all of that makes putting a mark to market value on them almost impossible.

The situation becomes all the more daunting when you consider that the top 25 commercial banks -- including Citibank, Bank of America, JP Morgan Chase and Wachovia -- held more than $13 trillion (yes thats trillion with a t) in credit default swaps at the end of the third quarter of 2007, according to the Comptroller of the Currency.

Regulators like the Securities and Exchange Commission argue that mark-to-market is important in todays Sarbanes-Oxley environment of transparency. But critics of the rule claim most of the write-downs are causing capital shortages in financial institutions that are not related to any actual losses, or even expected losses.

They say if those written down assets were held to maturity, they could be redeemed at par. Some go even further and say that just eliminating unnecessary mark-to-market rule would help resolve the current crisis.

On the other side of the argument, JPMorgan Chase CEO Jamie Dimon, in an interview on the Charlie Rose Show, maintained the crisis isnt being caused by an accounting issue and that most of the losses will be realized.

His view is supported by a research report put out by Credit Suisse of 380 companies in the S&P 500 that have adopted the fair value mark to market rule. The report stated that marking assets and liabilities to market value clarifies economic reality for all stakeholders.

On its face, the mark-to-market rule appears to make sense, in that you have to put a price on an asset that you could get if you sold it on an open market.

The problem is that with credit default swaps or something called collateralized debt obligations, which are filled with those ugly sub-prime mortgages, there is no market because nobody will buy them. Steve Forbes recently joined the debate by asking, "How can you mark to market something when there's no longer any market?"

Fannie Mae and Freddie Mac

Adding to the market's woes, there was a meltdown today at Fannie Mae and Freddie Mac that caused the Dow Jones Industrials to dip below 11,000 for the first time in two years. It now appears as if the government will be forced to take them over amid fears the mortgage finance companies are at risk of default.

Bush administration officials are reportedly considering a plan to have the government take over one or both of the companies and place them in a conservatorship if their problems get any worse.

How much worse does it have to get?

Meanwhile, investment bank Lehman Brothers teetered on the brink Friday after losing a third of its value during the week. Its stock was driven down by a perceived risk that it could default on its loans as measured by the market for -- guess what? -- credit default swaps.

Warren Buffet called it years ago when he first described derivatives as financial weapons of mass destruction. Just look at the destruction theyve caused so far.

So where does the truth lie in this black hole that seems to be sucking the life out of our financial markets? The best and the brightest cant seem to agree. So that answer must be somewhere within that murky combination of factors of greed, over-extended leverage, poor risk management, and yes, even in misunderstood pricing of marketing to market securities that have no markets.

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