While the Financial Accounting Standards Board (FASB) couldn’t possibly compete with the G20 summit in terms of headline-grabbing power, the organization did join with the world’s top leaders in breaking some good news that fueled the stock market’s fire.

Nothing as groundbreaking as the G20, but more a clarification of its position and verbalization of some important changes to mark-to-market accounting (MMA).

Let’s see why this news is so significant and how it contributed to the stock market’s rally – as we predicted here a couple of months ago…

Mark-To-Market Accounting: What It Means

In case you’re unfamiliar with the “mark-to-market” term, here’s what it means:

Mark-to-market is an accounting concept that says you should mark the assets on your books according to what the market price is for them today.

It doesn’t sound like a very revolutionary idea until you dig into it a little deeper. Because in order to determine a fair price for something, there has to be a market for it. When a market does not exist due to lack of demand, supply, or fear, prices do not reflect the long-term reality, but rather a short-term occurrence that may or may not last.

For banks, this is a big deal because their massive mortgage-backed asset portfolios are mark-to-market, based on the last sale, rather than what the mortgages will ultimately pay. For example, if the last sale at 22 cents on the dollar, then that’s where they have to mark their assets. At such low levels, the banks must then post more collateral to meet margin requirements (they call it the leverage ratio), resulting in a weaker balance sheet and write-offs against income.

So what if there is no market? Does that mean your asset is worthless?

The Rule Change That Could Save Billions

Theoretically, the answer to the question above is “yes.” But practically speaking, it’s a no. The middle ground, which was announced today, is a “mark-to-model” system, whereby fair value is determined by the quality of the paper and the expected income by the time the paper matures.

And it could save the U.S. Government and taxpayers a few hundred billion dollars.

Because financial companies like banks can reduce the capital allocated to margin and improve their capital ratios, bank stocks like Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC), JP Morgan (NYSE: JPM) and Citigroup (NYSE: C) took off. All four made double-digit percentage moves at the open.

Exciting news, right? But hold on to your enthusiasm for a minute…

The Panic Party

It’s not that MMA didn’t offer some leeway to the financials that were affected by this rule. But interpreted in its strictest form, it became some type of Wahabi interpretation of the Koran: Way out there.

Let me explain further…

Back in the fall, when there was no market for many of the mortgage assets held by banks, investors, analysts and short sellers questioned the value of these assets. The banks could have (and should have) just ignored it and marked the assets to what they believed they were worth, based on their grade and discounted cash flow.

But they took a different route – by far the worst of the two. They overreacted and bowed to the pressure of marking their assets, most of which are paying (and will continue to pay) until maturity at levels reflecting fire-sale prices.

I guess they figured that since everyone else was panicking, why not join the party?

But here’s why they shouldn’t have jumped off the with all the other lemmings…

The High Leverage-High Loss, Lose-Lose Situation

When banks mark assets to the market, they also have to mark their capital requirements to meet minimum standards for leverage. So if the asset is worth 100% of its face value, and the leverage at the time was 30-to-1, things would be fine.

But if that asset was marked down by 80%, all of a sudden that leverage would balloon, leaving the bank with one of two options…

Either increase capital to reduce the leverage, or go out of business by selling those assets at fire-sale prices.

Across the financial spectrum, both happened. Some banks went under (WAMU and IndyMac) because the weight of the increased leverage was too much to bear, while others had to raise capital or take it from the government.

However, some simply pocketed the money and decided not to lend it to stimulate borrowing. Instead, they used it to bolster capital requirements, which contributed to this “credit crunch.”

Irresponsible Merrill + Sluggish Accountants = Widespread Panic

What should have happened is this: Banks mark to a model that showed a higher value – something that the FASB allowed.

Basically, they would have had to mark their assets held to maturity on their books, using reasonable assumptions. They probably would have, except for one problem…

Last fall, Merrill Lynch sold a huge portfolio of its mortgage-backed securities at 22 cents on the dollar – a decision that caused widespread panic because that’s what established the market. While the banks did not mark to that price, investors made the assumption that the price was set and banks should adhere to it.

We all know what happened next. Stocks got punished, banks panicked, and the vicious circle of capital raising, dilution, government intervention, and market sell-offs began in earnest.

Had the FASB come out that day and said what it did today – that it supports taking the mark-to-model route, despite what the market was saying – we could have avoided a lot of bloodshed.

Course, that would require accountants making quick decisions – something they’re not exactly renowned for.

Maybe we’d still have seen some abuses of the rule. And perhaps it will be abused now, as I’m sure a lot of assets will be marked up. But overall, banks will now have the luxury of determining fair market value in the absence of an orderly market.

And more importantly, they can reduce the capital required to back these loans, taking pressure off their balance sheets.

So what should we do about it?

The Investment Strategy You Should Use On Bank Stocks Now

Just as it was a good time to sell put options on these shares over the past few weeks, it might be just as good now to sell call options.

And I see this as an opportunity to sell out-of-the-money (OTM) call options against your financial stocks.

Today’s mark-to-market news, along with volatility, means you’ll get more premium for your options. Take advantage of that.

I’m not saying that if you own Wells Fargo at $15.50 today that you should sell the $17.50 calls. Rather, you could sell $30 or $35 calls – because even those calls are paying a pretty fat premium.

And take the January 2010 $40 call options… which imply that the price will fully double in eight months – and will pay you $1.40 per contract today. That’s the equivalent of collecting a fat 10% dividend!

To which I have to say, “Ain’t volatility sweet?”

Source: How To Play Today’s Mark-To-Market Accounting News