On April 2, the Financial Accounting Standards Board (FASB) voted to relax fair-value accounting (also called mark-to-market) rules. The changes allow companies greater leeway in estimating the prices of some assets, such as mortgage-backed securities. As you might expect, many bankers were pleased, since it's now easier for them to take writedowns that might otherwise have hurt their financial results.
But wait just a second…
Here's the problem as I see it: We're allowing companies to use significant judgment in estimating asset values … the kind of judgment those companies lacked in acquiring those same assets. Why should we trust them now?
It's interesting to note that the House Financial Services Committee pressed FASB Chairman Robert Herz in a March 12 hearing to relax the mark-to-market rules. Major banking giants such as Citigroup (NYSE: C ) and Wells Fargo (NYSE: WFC ) were vocal about the need for the changes, given the illiquid market conditions for many securities.
But I also must mention that Arthur Levitt and William Donaldson -- both former SEC chairmen -- opposed the FASB changes; they fear the new rules will reduce transparency for investors. While I can see arguments on both sides, I ultimately think the rule change supports a shell game that could potentially cause great harm to unwary investors.
Yes, change the rules!
One can argue that you shouldn't have to write off assets whose markets have almost entirely disappeared. Some collateralized debt obligation (CDO) tranches now get bids worth cents on the dollar, yet those who wait the storm out could easily get more cash flow from their securities than the present market price. In other words, with no reasonable bids in the market, you might well get paid to wait, rather than to sell.
Yet if that's the case, why aren't there plenty of smart, opportunistic folks out there placing better bids? Certainly, the efficient market hypothesis would suggest that those people should be stepping forward right now. (In case you slept through that part of economics class, the efficient market hypothesis states that all available information is priced into the market, and, therefore, the market reflects all known facts.)
The way I see it, the market reflects the opinions of the majority of investors -- but that doesn't mean those investors are right. Like the people who bought Nasdaq stocks in early 2000, or overpaid for homes during the housing bubble, the majority can certainly be wrong, and that majority often pays a heavy price for its mistakes. That explains how current bids could be lower than what may seem reasonable.
No, leave the rules alone!
Yet contrary to what industry lobbyists seem to believe, the FASB rule change doesn't really help the banks in a meaningful way. As a recent Goldman Sachs report noted, the change may improve banks' regulatory capital, but any impact it might have on tangible common equity is less clear. And in any event, smart investors will look past any accounting changes and draw their own conclusions.
Unfortunately, the situation is beginning to look more and more like Japan did in the 1990s, when the government and banks ended up burying problems in the banking system, rather than acknowledging trouble and working toward solutions. That kept the economy operating in subpar mode for 20 years; as a result, the Nikkei remains down more than 75%, two decades after hitting its all-time high. I certainly hope that the authorities learn from the Japanese example, but with this FASB move, they seem to be repeating it.
Of course, the leverage and financial innovation that brought on the current banking crisis took years to develop, so it's hard to see how the crisis could get fixed in a short period of time. Accounting changes may put off the day of reckoning for some institutions, but the idea that unchecked growth of risky securities could actually lower the risk in the overall system has proved fatally flawed.
So don't get tricked by the rallies in bad banks' stocks. Even though banks are among the top performers in this rally -- Bank of America (NYSE: BAC ) more than doubled from the end of March to last Friday -- my advice remains the same: Stick to well-run banks, and avoid the zombie ones as if they were, well, actual zombies.
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