So the Financial Accounting Standards Board (FASB), pressured both by the banks and their supporters on Capitol Hill, caved in on mark to market accounting. Appropriately enough they did so yesterday, on April Fool’s Day. It’s bad enough that the old version of FAS 157 allowed the notorious mark to model, or “mark to fantasy,” standard for infrequently traded financial instruments, where there are no reliable price quotes. That standard caused plenty of confusion about the real value of assets held by banks, such as collateralized debt obligations (CDOs). In the case of CDOs and other derivative securities, the true asset values had to be falling along with the value of the residential real estate that served as the underlying collateral, but the banks got to choose their assumptions about what the assets were worth. Objective analysts relied on their own work, or on indices published by firms such as markit.com. That way a few alert observers estimated reasonable values and forecast the trouble in the banking sector accurately enough. Banks did their best to fudge and keep marks on bad assets as high as possible until they were forced to take write-offs, usually when they filed their annual 10-K reports.
But the old form of FAS 157 was defensible in one respect. If you don’t have a price quote, you do need something else to value an asset. It’s just a matter of whether you are sincerely trying to estimate the most accurate value — or if you’d rather defend a value that you wanted to put on your books before your did your analysis in the first place.
Now, if we understand the first reports on the new FAS 157, banks are actually getting latitude to disregard current market prices of assets if they deem that such assets are trading in a temporarily distressed, “fire sale,” market. Gee, I wish my broker would let me do that, and take cash out of my account on that basis too.
Without having actually seen the new guidelines, it would seem that unless the security actually stops paying interest, a bank can value it at 100 cents on the dollar even if that same security or substantially similar ones are trading at significant discounts in the markets. If you think we had a transparency problem before, we’ll now have to read bank 10-K’s as if they were written by the old Soviet press agency TASS. Will banks even have to write footnotes telling us which assets would sell at a discount in the current market, and for how much? And how detailed would those disclosures have to be? Inquiring minds would really like to know. At least under the old system banks and their auditors felt they had to ‘fess up at year-end about a fair portion of the bad stuff, and give us some hints about where other problems might lie.
Now it appears that nearly all banks get to claim that their problems are a near term, liquidity issue (their assets are good but can’t be sold into a panic) rather than a solvency issue (many assets permanently impaired). We think the latter is true for at least some of the major banks, and as stated in previous columns, we’d expect the bad assets to drop in value as a weakening economy forces additional borrowers to default.
The banks of course are arguing that they can all earn their way out of their problems, we illustrated in our column on the Bank of America — all we have to do is let them tell lies for awhile. We’d better hope so. The truth is, we don’t know if the borderline institutions can earn their way out, we won’t know for several years, and during that time anyone trying to understand the balance sheets of many banks might be even more clueless than they were under the previous rules.
We also have to think back to the money market panics of 2007 and 2008, where credit froze up because people didn’t know which banks were safe to lend to. If bank balance sheets become even less believable than they are now, the only thing making it safe to lend to a US bank, is the implicit guarantee from the Treasury and the Fed. The Government will continue to have to support weak institutions that no one understands, for an indeterminate time, rather than liquidating the weak institutions. We have taken a giant step toward semi permanent bank nationalization (in fact but not in name) and seem poised to repeat the mistakes of the Japanese.
We also agree with independent accounting analyst Robert Willens, who says that the new accounting standard will conflict with the Treasury’s PPIP program, whose objective is to get the banks to sell their bad assets. While PPIP is a taxpayer rip-off, at least before the April Fool’s Rule PPIP would have induced banks to sell off weak assets (by offering banks more than the weak assets are worth), even if the price paid might be less than 100 cents on the dollar. But under the new rule, why sell anything if you can avoid taking a writedown at all… unless of course… in several years the borrowers default and the asset goes to pennies on the dollar….
But the market loves it. Banks lead the DJIA to a gain of 245 as we write, an hour and 45 minutes into the April 2 session. So for now April Fools remain that way. At least on New Year’s Day you know if you’ve drunk too much the night before.