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April 10, 2009

Better Late Than Never

ATT00261Last week, the Financial Accounting Standards Board eased one of the most onerous burdens on the U.S. banking system, the “Mark-to-Market Rule”.  This week, the SEC is seeking comments on five possible rules to limit short selling.

The “Mark-to-Market” Rule or FAS 157 was imposed on banks in 2007.  This rule changed how banks were able to calculate their assets on their balance sheet.  It forced banks to take long-term assets and mark them down as if they were short-term assets based on current market conditions.

In the same year (2007), the Securities and Exchange Commission dropped a significant restriction on short selling called the “Uptick Rule”.  A short sale is when someone borrows stock from his or her broker, and then sells it.  That person is required to buy back the stock and make their broke whole at a later date.  The hope for the short seller is that the stock falls so they can buy it back at a low price and pocket the difference.  The
Uptick Rule required a short seller to wait until the stocks went up before they could short sell it.

It might be coincidental that both of the changes were made in 2007 before the banking crisis and the bear market.  Banks, under the “Mark-to-Market” Rule were required to value their loans’ securities at the current market price.  When the market all but disappeared, banks were forced to write off large amounts of capital from their balance sheets and rein in lending, helping to create the credit freeze.  At the same time, short sellers were able to piggy back on each other, driving stock prices to fall more

This has all happened before.  In the 1930’s, short sellers were running amuck, and banking Mark-to-Market Rules were contributing to bank failures. As a result, the rules of both were changed.  The new accounting rules and the Uptick Rule served the Americans well until they were changed in 2007.

Congressional pressure on the Financial Accounting Standards Board brought the “Mark-to-Market” Rule into effect in 2007, and has now helped cause its removal, unfortunately, after much damage has been done.  This experience should give lawmakers pause before they take any new well meaning action. We would be better served if they enforced the existing laws, like the one against naked short selling.