Thursday, April 2, 2009

FASB and the Mark-to-Market Rules

The Financial Accounting Standards Board (FASB) should have released their easier guidelines on ‘mark-to-market’ accounting on April Fool’s day because that date would have been much more appropriate for what they have done.

Once again the accounting profession has shown that accounting is an “art” rather than a professional practice and art, as we well know, like pornography, is in the eye of the beholder.

FASB has “revised the rules to allow companies to use their judgment to a greater extent in determining the ‘fair value’ of their assets. In other words, there are no rules!

Arguing for the change is, of course, the banks. The banks “have contended that during the current financial crisis, when many markets are frozen or not functioning smoothly, the rules have unfairly pushed those valuations lower and forced them to take big losses on the basis of market fluctuations that are temporary.”

There are three points I would like to emphasize here. First, an appropriate accounting for the financial condition of a firm is a prerequisite for understanding the state that the company is in. Without this knowledge, the customers of the banks, lenders as well as depositors, are at a loss about the financial condition of the bank, investors are at a loss about the condition of the bank, and regulators are at a loss about the condition of the bank.

Second, if the revised rules “allow companies to use their judgment” then there are no unbiased standards or relatively objective criteria by which to judge the condition of the bank. What good are financial statements if people can put whatever they want on their balance sheet?

Third, the explanation for the change includes the assumption that the problems being faced by the affected financial institutions are ones of liquidity and not ones of solvency. We are told that “when markets are frozen or not functioning smoothly” it will be hard to price the assets. We are being told that this is what the banks face today, the problem that for some bank assets, the markets in which they trade are illiquid.

What if the problem is, as some of us believe, that a few (or more) of these banks are insolvent and it is not just a problem of the liquidity, or illiquidity, of their assets?

The administration and the congress keep giving us solutions to the financial chaos around us that are intended to relieve the problem of liquidity. They seem to keep their head in the sand when it is suggested that maybe the problem is one of solvency.

And, what is the real underlying situation here? Banks and other financial institutions, in an effort to squeeze out a few extra basis points in terms of their return on equity, not only added assets to their balance sheets that exhibited a greater amount of credit risk, they also increased their leverage ratios to extraordinary lengths, and, in addition, added further interest rate risk to their balance sheets by increasing the mis-match of the maturities of their assets and liabilities.

They knew what they were doing! And, they knew what the consequences would be if things went against them!

Now, these same people are crying false tears because events did not go their way and they got caught!

Congress and others got mad at the executives of AIG for attempting to live up to the contracts that were given to employees in terms of the bonuses they were to receive. In the current situation, Congress and others are up-in-arms because they want to change the rules under which the banks and other financial institutions were to be held accountable for.

And Rick Wagoner can be forced out of GM, but the same bank leaders that got the banks where they are remain in their executive lofts.

Go figur’.

The financial performance of the banks will now improve. There are a dozen or so articles in the financial press contending that the new P-PIP will suffer because of the change in the accounting rules. Just what we need—another government program, like TARP, in which the nature of the program changes once the program has been presented to the public.

In truth, the condition of banks and other financial institutions has not changed! Those that are insolvent are still insolvent. Those that are not insolvent are still not insolvent. But, the public, the lenders, the depositors, the investment community, and the regulators are worse off.

The change in the accounting rules is another bailout for the bankers!

Happy April Fool’s day!

1 comment:

Brian said...

I may misunderstand this rule and it's application to the banks but if I don't misunderstand it this seems like a positive change. My understanding is that in a case where a bank makes a $500,000 loan against a $600,000 house and the borrower ceases to make payments against the loan the bank is forced to record the value of the loan as zero on their balance sheet since the payments are not being made and it is not likely that they can sell the note on a secondary market. Where the rule falls short is that it ignores the value of the collateral in the case of a loan secured by real property. While the value of the asset (right to foreclose) held by the bank will not be the full future value of the $500,000 loan payments it is certainly not zero and the change in the rule to allow the bank to assign a value other than zero is clearly logical. Do I understand this rule correctly?