Blackwall Partners Research Note: Mark-to-Market Accounting August 25, 2011

Bill Isaac was the FDIC Chairman and a key figure in helping restore the U.S. financial system following the

Savings & Loan Crisis. Isaac testified before Congress on March 12, 2009 regarding mark to market accounting

(“M2M”). We had identified this as a matter of critical importance and we applaud our friend and former Dallas

Federal Reserve Bank President Bob McTeer for championing the need for reforms alongside Bill Isaac. The

dramatic and destructive effects M2M contributed to the magnitude of the 2008-2009 financial crisis now easily

can be measured – it over predicted mortgages losses by nearly twenty (20) fold.

Isaac produced the first chart (See: next page) before Congress to illustrate as of that day the gravity of the over

statement of losses via M2M. McTeer also testified on the same day before Congress as to the inaccuracies of

this accounting measure. We wrote incessantly about the inherent flaws in M2M and are on record as the first

researchers to formally warn the Securities & Exchange Commission several months before TARP was then

needed to “fill” the inaccurate, but vast “non cash” capital whole M2M “blew” through bank balance sheets.

The following is an excerpt from Bill Isaac’s post back in June of this year regarding these events… For those

that have followed our bank research for some time, this is closing-the-loop on an issue almost nobody believed

was at the core of the financial crisis at the time. The on-going malaise in our economy is still greatly

influenced by the highly inaccurate accounting mechanism.

Mark to Market Revisited

(A Picture is Worth a Thousand Words)

Posted: Jun 8, 2011 I have long opposed mark to market accounting, which requires that financial institutions mark their financial assets to market prices even when market prices bear no relationship to the true economic value of those assets based on cash flows. Mark to market accounting was put into place by the Securities and Exchange Commission and the Financial Standards Accounting Board beginning in the early 1990s over strenuous objections from the Treasury, the Federal Reserve and the FDIC.

I argued during the crisis of 2008-2009 that mark to market accounting senselessly destroyed over $500 billion of capital in U.S. financial institutions. Because banks are able to loan about $8 for every dollar of capital they hold, the $500 billion market to market write-offs destroyed $4 trillion of bank lending capacity, wreaking havoc on the financial system and the economy and contributing to millions of people losing their jobs and homes and starving small businesses of credit. We have yet to recover.

A subcommittee of the House Financial Services Committee invited me to testify (alongside the SEC and FASB) at a hearing on mark to market accounting on March 12, 2009. The hearing resulted in the SEC and FASB agreeing to modify (regrettably, not repeal) mark to market accounting to alleviate its more pernicious effects. Many credit that event with calming the financial crisis and turning around the markets.

My testimony that day included a slide showing the impact of mark to market accounting on just one $3.65 billion portfolio of mortgage backed securities held by one of our nation’s largest banks. The chart showed that the bank expected a maximum of $100 million of losses on the portfolio but had enough extra collateral to cover those losses so no net losses were expected. Yet, mark to market accounting required the bank to write off over $900 million of the portfolio.

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The bank recently updated the chart showing the performance of this same portfolio as of March 31, 2011 (updated chart below). The portfolio declined to $2.1 billion due to prepayments and normal amortizations. The bank now expects total net losses of $28 million. The mark to market charge on the portfolio has been reduced from over $900 million at the end of 2008 to just $44 million, even though nothing has really changed except market perceptions of value!

These two charts tell you everything you need to know about mark to market accounting. It was an accounting practice also present during the Great Depression, prolonging it inexorably.

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Our warnings to the SEC back in the summer of 2008 (link below) went without response, but began the running log of

commentary the agency received on the matter and the SEC eventually made the commentaries a matter of public record.

http://www.sec.gov/comments/4-573/4-573.shtml

Comments on:

Study on Mark-to-Market Accounting

[File No. 4-573]

Sep. 25, 2008 Michael P. Durante, Managing Partner,

Sep. 25, 2008 Paul Simeanuer, Analyst, Council of Institutional Investors

Sep. 23, 2008 Edward L. Yingling, President and CEO, American Bankers Association

Aug. 7, 2008 Steve Grossman

Jul. 25, 2008 Michael P. Durante, Managing Partner,

Isaac wrote a book on the financial crisis, which in large part, centers on M2M titled – “Senseless Panic.” We believe it is

the most accurate depiction of the cause and effects of the crisis. “Too Big To Fail” is but a salacious soap opera

sideshow… perfect for “movie of the week”. Bill’s book is the real deal.

Regards,

Michael P. Durante

Managing Partner

Blackwall Partners LLC