Accounting magic: Suspend one rule and watch banking woes disappear
The dire financial condition of the biggest U.S. banks has inspired a lot of talk about nationalization in recent weeks. It has also stoked a long-running argument over an accounting rule that governs how banks value their investments, including all the toxic mortgage-related bonds and derivatives eating holes in their balance sheets.
Some observers say it is making banks' problems appear much worse than they really are; other say the rules are essential to keeping shareholders informed about financial institutions' true health.
Both sides agree changing the rule would make banks' problems vanish. But they differ over whether that would be a good thing.
The debate surrounds an accounting rule called FAS 157, which requires financial firms to carry certain assets held for investment purposes on their books at their "fair value," or the price a buyer would be willing to pay in the open market. For that reason, the rule is also known as the "mark-to-market" rule.
This has become a huge problem for banks with big stakes in mortgage-backed securities and derivatives, because no one is buying them right now. With home prices falling, foreclosures rising and no end to the recession in sight, investors clearly feel there's just too much risk.
When that happens, the rule requires banks to reduce the value of their investments for accounting purposes. That can lead to big losses -- hundreds of billions of dollars since 2007, in fact.
The debate over FAS 157 has been raging since the Financial Accounting Standards Board, the private, non-profit group that oversees such issues, implemented it in late 2007. (Previously, companies had been able to use their own models to determine values of investments like the ones now causing trouble for banks.) Now, as talk of bank nationalization swirls, some people feel the rule should be suspended.
"Our slavish adherence to this rule, and our refusal to even discuss its suspension, has literally destroyed hundred of billions of dollars worth of wealth and value around the world, led to the huge and accelerated fall in contingent asset prices, raised the specter of deflation and exaggerated the cyclical downturn of the global economy," wrote CNBC economics editor Martin Baccardax in a column on the network's web site yesterday.
Brian S. Wesbury and Robert Stein, economists for First Trust, an investment firm, made a similar point in a column yesterday on Forbes.com.
"Suspending mark-to-market accounting could fix major problems at no cost," they wrote, later adding, "In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting."
Here's the argument against FAS 157: Banks aren't going to sell their mortgage-related investments now. Instead, they'll wait until the housing market improves and investors regain confidence. Then they'll be able to get a much better price than they can today.
So why punish banks with losses they may never realize? Eliminate fair value accounting and the problem disappears, returning banks to health and making nationalization unnecessary.
FAS 157's supporters also believe suspending the rule would make banks' problem with toxic assets disappear -- not by solving it, but by simply hiding it from view.
"Let's not hide what the market value of these assets from the marketplace or from investors," said Cynthia Fornelli, executive director of the Center for Audit Quality, in an interview. "It's a real fallacy to think that the economic crisis is somehow attributable to fair-value accounting."
Fornelli and other FAS 157 supporters argue that the suspending the rule wouldn't change the value of banks' toxic investments. Instead, doing so would just hide that information from investors and the public. Since the rule only applies to assets the banks themselves have declared they would unload if the price were right, aren't shareholders entitled to how much would be lost if they were sold today?
To the rule's backers, Economics 101 reigns supreme. A thing is only worth what someone will pay you for it. Just because you don't want to -- or in many banks' cases, can't afford to -- sell it for what buyers are willing to pay doesn't affect its price.
For now, the question seems settled. The same law that set aside $700 billion for the Treasury Department to invest in banks also required the Securities and Exchange Commission to study whether suspending fair value accounting rules would be a good idea. In a report released Dec. 30, it decided to keep them in place, finding they "did not appear to play a meaningful role in the bank failures that occurred in 2008." Instead, it will "improve" them, though some fear -- and others hope -- that will make them weaker.
Which side you fall on depends on whether you believe an accounting rule can make a problem disappear -- or just make it invisible.