Banks and Congress: One More Mistake Can't Hurt?

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In successfully lobbying the Financial Accounting Standards Board (FASB) to relax rules regarding mark-to-market accounting, the banking industry and Congress have moved us one step further away from resolving the credit crisis. It's disconcerting to witness another misguided action, part of a pattern increasingly reminiscent of Japanese policymakers' "head-in-the-sand" approach to Japan's banking crisis in the 1990s. Lost decade(s), anyone?

What today's decision means
Today's FASB vote will allow banks to exercise "significant" judgment in valuing assets (including mortgage-backed securities (MBSs)) on their balance sheets instead of focusing on market prices. Banks and lawmakers have argued that current prices don't reflect an orderly market and that the security values are greater than distressed transactions indicate. Banks will be able to apply the new rule to their first-quarter financial reports.

As a value investor, I can agree that market prices may not always be the best indicator of fair value, and that may be the case in the MBS market at this time. Nevertheless, the rule change is a mistake. One of the problems with giving the bankers greater freedom to value these assets is that it reduces the consistency that comes from using market prices, impeding investors from comparing banks to determine which ones are fundamentally sound.

How to undermine investor confidence
Relaxing the current rule undermines investor confidence, at a time when banks should be doing everything in their power to attract private capital to the sector. Furthermore, if we assume that market prices are lower than fair value, using market prices sets a hard floor on balance sheet values (and bank earnings). That's very useful in an environment in which investors are spooked by the uncertainty regarding the banks' financial condition – a lot more useful than bankers' woolly estimates of security values. (Remember, the same bankers piled these toxic securities onto their balance sheets in the first place.)

This doesn't prove that the market agrees with my assessment, but as I write this, the KBW Bank Index is virtually flat, against a 3% gain for the S&P 500:

Stock	Intraday Gain (April 2, 2009)*
SPDR KBW Bank ETF (NYSE: KBE)	(0.1%)
JPMorgan Chase (NYSE: JPM)	(1.7%)
Bank of America (NYSE: BAC)	+1.5%
Citigroup (NYSE: C)	+2.2%
US Bancorp (NYSE: USB)	+1.1%
Wells Fargo (NYSE: WFC)	+3.6%

*At approximately 2 p.m.

The U.S. banking system has a fundamental solvency problem. Trying to sweep it under the rug with cosmetic measures will only delay a recovery of the sector and the economy.

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