Friday, December 11, 2009

Accounting Rules in the Spotlight – Again

Earlier this year, a lot of attention was paid to “mark to market” accounting (officially, FASB rule 157). The debate was heated, as critics of the rule blamed it for dramatically worsening the financial crisis, while proponents argued that it improved transparency. The rule was ultimately relaxed in March largely due to pressure from Congress (even though the Financial Accounting Standards Board is supposedly an independent organization). That change helped stem the losses flowing out of the financial sector and helped spark the huge turnaround in financial markets.

Now, a new set of rules from the FASB is ruffling some feathers again. FASB rules 166 & 167 require financial companies to bring many of the assets held in off-balance sheet entities back onto their balance sheets by early next year, which could impede the healing in that sector by requiring additional capital to be raised by those firms.

It remains to be seen exactly what the impact of the rules will be, but the market may already be anticipating a negative outcome. After rocketing off the March low and leading the market higher for several months, financial stocks have recently been underperforming. Whether that’s directly related to the new rules or is just a temporary pause isn’t entirely clear yet. We currently have only a very modest weighting in Financials due to the many ongoing challenges in the sector, and will be paying close attention to how they act as the rules take effect.

Chart: Financial Sector ETF (red line, top panel) vs. S&P 500 ETF (blue line, top panel) with relative strength (green line, lower panel) – Financials have been underperforming since 10/14