Why the FASB Change Hurts Investors

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.

More on FASB and banks:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy promises not to eat your succulent, delicious brains.


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  • Report this Comment On May 12, 2009, at 4:47 PM, WmFBuckley wrote:

    Ivan-

    You obviously don't have a single clue regarding the topic of this article. Mark to market, or FAS 157, implemented by the equally clueless Chairman Cox of the SEC in November 2007 was the impetus behind the credit crisis because it distorted bank earnings and capital through paper write-downs, locked up their balance sheets, caused all banks tremendous meaningless losses, made bank lending and securities markets seize up and removed all transparency for bank shareholders. I have been an accountant for 40 years, and this is the most "Brain-dead" ruling that FASB ever came up with. If you really want to be informed on this subject and not pander to the short selling community, you should read what Brian Wesbury, Steve Forbes, Warren Buffet, Mark Mobius, and other knowledgeable people have to say about the ridiculousness of Mark to Market. It was tried in the Depression, you know, and prolonged that event by 5 years. Read Brian Wesbury's article below:

    Money

    Why Mark-To-Market Accounting Rules Must Die

    Brian S. Wesbury and Robert Stein, 02.24.09, 12:01 AM EST

    They eliminate the time and growth needed to fix the economy.

    We have been accused of beating a dead horse when it comes to our support for either suspension of, or targeted relief from, market-to-market accounting.

    And we suppose after writing thousands of words, producing videos and giving speeches about the issue, some might be tempted to let it go. But we can't do that, especially when the government continues to spend trillions of dollars and is coming very close to bank nationalization.

    This is a real shame. Suspending mark-to-market accounting could fix major problems at no cost. Unfortunately, many people dismiss this issue without really understanding its impact on the economy.

    We are economists, not accountants or bank analysts. We really don't think a debate about how big the housing bubble was, or whether a certain bank is viable or not, is worthwhile when it comes to accounting rules. That misses the point. Mark-to-market accounting rules affect the economy and amplify financial market problems.

    The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.

    Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.

    Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.

    Comment On This Story

    Because these accounting rules force banks to write off losses before they even happen, we lose time. This happens because markets are forward looking. For example, the price of many securitized mortgage pools is well below their value, based on cash flows. In other words, the market is pricing in more losses than have actually, or may ever, occur. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.

    And this affects growth. By wiping out capital, so-called "fair value" accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed, and the government proposed bailouts. This drove prices down even further, which hurt the economy. And now as growth suffers, bad loans multiply. It's a vicious downward spiral.

    In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting. This gave banks time to work through the problems. At the same time, the U.S. cut marginal tax rates and raised interest rates, which helped lift economic growth. Time and growth allowed those major banking problems to be absorbed, even though roughly 3,000 banks failed, without creating an economic catastrophe.

  • Report this Comment On May 12, 2009, at 5:39 PM, ilovesum wrote:

    They should keep the mark to marketing rule. When the market is over-inflated the companies will look better than they should , when market is low as it is now then they will be under-valued. It will average out.

    Mark to market will force these companies to protect for the downside.

    Should we let the companies put some imaginary value on their assets ? At least this way everyone is playing by the same rule.

    Unregulation caused a lot more problems than this ever will.

  • Report this Comment On May 12, 2009, at 6:59 PM, almostafoolster wrote:

    What is happening is the improper rating of mortgages security pools both when they were created and then when mark to market occurs. A pool of mortgages from subprime lenders should never have been rated AAA to start with.

    A pool of AAA bonds that are composed of mortgages with 80% loan-to-value in 2005, a 7% interest rate, and 90+ percent performing loans should never be valued by mark to market rules at 60 cents on the dollar.

    The mortgage pools were rated too high when they were created. They are now not adequately valued. Both distort the financial positions of the banks. Mortgage pools need to be valued at the projected loss rates. To do anything else distorts the financial position of the banks holding them.

  • Report this Comment On May 13, 2009, at 9:12 AM, rd80 wrote:

    The best demonstration of the lunacy of forcing mark-to-market in illiquid markets is from several of the banks earnings statements last quarter. Part of C and BAC's 'good' results were from marking liabilities to market.

    Yep, because the market perceived their credit to be weaker, the market value of their debt and CDS obligations decreased. They then marked those liabilities down to market effectively increasing earnings.

    Turns out mark-to-market applies to both sides of the balance sheet.

    Still think mark-to-market in illiquid markets is good for investors?

  • Report this Comment On May 13, 2009, at 11:40 AM, ivanmartchev wrote:

    As to me having a clue, I discussed the issue with a CPA with 10 years under his belt in both corporate and public practice. Some of the more particular points come from his expertise. I can assure you, the man has all the clues in the world...

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