Today the Financial Accounting Standards Board (FASB) changed the accounting rules by which companies are valued in a very significant way. Under heavy pressure from Congress and the banking industry, the theoretically independent FASB eased the Mark to Market Accounting Rules for how assets that a company holds on its books are valued.
Reuters reports that: “The five-member Financial Accounting Standards Board voted unanimously to let banks exercise more judgment in using mark-to-market accounting…. But the board split 3-2 on backing guidance that would let lenders take smaller losses on impaired assets such as mortgage backed securities, a move critics said would let banks hide reality from investors.”
There are at least two ways to look at this development.
On the one hand, many financial institutions complain that being forced to value assets for what they would actually bring in a down market, with few buyers for anything, severely impacts their reported equity position. They complain that the mark to market rules require unwarranted writedowns and reported losses. The reduced equity positions resulting from lowering the mark to market value of assets, reduces banks capital reserve ratios and their ability to lend. Many financial industry executives suggest that mark to market accounting rules have been a significant cause of the severity of the current recession.
It should be recalled however that few of those bankers were complaining when those same rules allowed them to report rapidly increasing equity values and soaring profits in the good times.
The obvious flip side to the argument against mark to market is that if you don’t value assets at market value, what should the basis of asset valuation be?
According to the Wall Street Journal, Patrick Finnegan, director of financial reporting policy for the CFA Institute (Certified Financial Analyst), suggested that the new rules give companies “too much room to fudge the truth”. He was quoted as saying “Financial statements are not there to reflect management’s assumptions.”
William Poole, former Federal Reserve Bank of St. Louis president, told Reuters: “I think it’s a mistake. If it’s too cold in the room, you don’t fix the problem by holding a candle under the thermometer…….It may increase reported bank earnings by 20 percent, but it has nothing to do with the reality of bank earnings. It’s very important to maintain that distinction.”
While this move is obviously welcome by firms that will report otherwise impossible profits by assigning new higher values to assets nobody is willing to buy, it does raise some serious questions about the value of financial reporting itself. And it seems ironically contrary to President Obama’s promise to deliver increased accountability and transparency along with improved regulation on banks and financial institutions. Real accountability and transparency are somewhat hard to achieve if companies are allowed to put prices on assets based on something other than real market value.
At the end of the day, nothing fundamental has changed. There aren’t new buyers for the problem assets the banks are carrying on their books, no matter what they claim those assets are worth. And there is no more real capital in the banks to back their lending.
The new rules are one more gift to the large Wall Street banks that played such a large part in creating the economic mess we are now in. And like the rest of the gifts those institutions have been getting lately, I suspect it will be Main Street and the tax payers who will end up paying for it.
The one change to mark to market accounting rules that would make sense was suggested by Josh Hendrickson, the Everyday Economist in Rosser’s Path Forward. He recommends “a change that has been reported to have been adopted in Germany. Banks that declare a willingness to hold onto an asset to maturity, may value it at its original face value. Thus, promises to hold certain assets to maturity takes them out of being subject to the mark to market rule and stabilizes their capitalization, and hopefully, the financial markets more broadly.”
As I have suggested here before – stable, rational and fair rule of law is essential for society to prosper. Changing such fundamental rules of business as how accounting standards should value assets, seems a whole lot like changing the rules of a baseball game in the middle of the fifth inning. If considered, it should be done with great care.
There are several rules of the great game of business that need to be improved for our society to become more economically and environmentally sustainable. But it is not coincidental and I suspect it is not great news that this new accounting change seems so very clearly intended to benefit the most powerful and politically connected in our society.
I would like to hope something good may come of this. But it is hard to imagine how pricing assets on anything other than fair market value is likely to lead to transparency, accountability or a sustainable future.