Mark-to-Market is NOT the Problem…

. . . and resorting to ‘accounting tricks‘ to solve the problem of systemic risk and the failures of the financial crisis is not the answer. Why..??

I read about an interesting anecdote at a House Financial Services Committee hearing last month, so I looked it up (see the video below). Robert Herz of the Financial Accounting Standards Board (FASB) said that financial services companies about to go bankrupt sometimes call him demanding a change in accounting rules just before they’re about to go under.  It seems when a bank being forced by regulators, acting in the public interest, to admit that its broke (i.e., insolvent) is not a pleasant experience, but it is necessary because no private lender will lend to a bank whose financial situation is non-transparent – that is, obscured or hidden. (See video clip AIG acctg math).  So it was no surprise that as the big banks issue their falsely rosey 1Q earnings report — bank stocks fell this week – taking the rest of the Market with them – because the “invisible hand” of the Market knows that resorting to “Accounting tricks” such as temporarily suspending “mark-to-Market” or so-called “Level 3 gains” as a crutch for profitability is a shell game.  And here’s the thing: they’re doing so with complicity from the Federal Reserve, the Treasury Department and the Obama Administration.

Unfortunately, FASB recently eased accounting rules to allow financial institutions to value securities on their books using their own subjective judgment, instead of using fair value, standard accounting practices to mark them at current Market prices. This means that instead of valuing, say, subprime residential mortgage as what they are worth today, banks can now pretend that these loans are going to come back to full value at some speculated future date regardless of the underlying credit quality. The net effect is that banks can choose to report profits simply by reclassifying how they value assets rather than admitting losses or capital impairments. This is not just a rules change, this a fundamental cheating of the system at the expense of the investing public.  Banks, by being allowed to do this are hoisting the losses from the speculative risks that they took on taxpayers; while being allowed to reap all the upside of the bets.  This is a statement to our banking system that banks can and should obscure losses and emphasize gains. This is what is referred to in the industry as “assymetric information” and one of the leading indicators of inefficient markets.  In effect, they are saying, “heads we win, tails you lose.” 

Since this accounting change, we’ve seen three major institutions prettying up their financial statements. Wells Fargo recorded record profits, and its stock jumped more than 20% in one day on the news. Goldman Sachs also reported tremendous earnings, surprising in these difficult times, and sold $5 billion of stock in the secondary market immediately afterwards; and earlier this week, Bank of America’s CEO, Ken Lewis, painted an incredibly rosey picture this morning on CNBC — already known for lacking journalistic integrity when it comes to its ‘soft’ interviews of executives of publicly-traded companies, nor as the most reliable source of financial news.  What we need is for truly objective organizations, not vested in the appearance of profitablity, to do some forensic accounting sans tricks, to examine what the true balance sheets of these companies reveal.  These banks are  now using odd accounting tricks designed to obscure the truth of their status to investors. Earnings season just started, so we’ll soon see if this is a trend, but so far, I’m not encouraged since the Obama Administration appears willing to let this happen.

In a recent interview, Jonathan Weil, a journalist who helped uncover the Enron scandal, pointed out that much of the increase in Wells Fargo’s earnings came from a new accounting term called ‘Level 3’ gains and its application to Wells Fargo’s mortgage servicing portfolio. “So what are Level 3 gains?” asks Weil. “Pretty much whatever companies want them to be.”

And Floyd Norris of the New York Times noted that Goldman Sachs used a more prosaic trick having nothing to do with mark to market accounting – the company moved its fiscal year up a month and simply left out its losses from December, which is now known as an ‘orphan month’.  So the rule that says ‘one year has twelve months’ can now also be made open to subjective quantification by the bank’s CFO and his chief accountant.  This is precisely why I protested the mark-to-Market changes last month because I feared that these kinds of tricks would become commonplace — and to the detriment of investors.

In my opinion – and in that of many of the most considered economists in the world –  FASB made a conveniently expedient balance sheet ‘solution’  by allowing banks to use subjective judgment to avoid admitting losses or book fake profits. That may create a positive short-term appearance of profitability  for investors and shareholders, but it won’t increase credit, nor improve bank balance sheets, any more than changing the definition of “marriage” will legitimize objectionable behavior for some people who just know better.  No one believes the banks are truly profitable, and the proof of that is the only entity willing to lend them money, is the government.