Today, the Financial Accounting Standards Board endorsed misleading accounting practices by relaxing mark-to-market or fair-value accounting rules. Rather than requiring companies to value assets based on what their market value is, the new changes allow companies to use significant judgment in valuing assets at what they could arguably be sold for in an “orderly” market (whatever that is). Since the markets have been anything but orderly for almost two years now, the rules change effectively endorses fictitious valuations. These changes were reportedly the result of intense pressure on the Financial Accounting Standards Board from large banks and companies. Recently, mark-to-market accounting rules have been under fierce attack by bank CEOs and others who are trying to blame it (instead of their own reckless risk management) for the current financial crisis.
The softening of the mark-to market rules runs counter to increased calls for greater financial-market transparency and ongoing efforts to restore investor trust. CNBC quoted Nassim Taleb, author of “The Black Swan” as saying: “Altering mark-to-market accounting rules would bring more opacity to the financial system” and “is like putting your head in the sand.”
The change may also undermine the Treasury Department’s plan to remove toxic assets from banks’ balance sheets, reported Heidi N. Moore of the Wall Street Journal in her April 1, 2009 article entitled “Move to Ease ‘Mark’ Rule May Subvert Treasury Plan.” Treasury plans to spend up to $1 trillion to clean up the banks’ balance sheets by removing “impaired” assets. Proponents say the rule change is meant to eliminate forced revaluation of illiquid assets at deeply discounted, firesale values. But now that the change has taken effect, banks will have a new incentive to keep the assets on their books, rather than cooperate with the Treasury Department’s plan to remove the assets, since banks could then use their own judgment to set values as long as there are no willing bidders to set a market price. Of course, the values that would be assigned to such assets would have no reasonable relationship to what they actually be sold for, and thus contribute to market opacity rather than transparency.
Were the former mark-to-market rules really as significant and as inflexible as critics charge? Absolutely not, says James Chanos in his March 23, 2009 opinion piece in the Wall Street Journal entitled “We Need Honest Accounting.” That is because mark-to market principles were generally limited to investments held as “available for sale” (i.e., held for trading purposes), and not required for securities held to maturity. As Mr. Chanos points out, a most assets held by financial institutions were not subject to mark-to market rules. He cites a recent study by Bloomberg columnist David Reilly, which showed that only 29% of the $8.46 trillion in assets held by the 12 of the largest banks were reported at mark-to market prices. Most bank assets are loans held at their original cost using amortization rules, minus a reserve that banks must set aside as a safety cushion for potential future losses, according to Mr. Chanos.
Furthermore, while companies have recorded market declines in these assets as “unrealized losses” on their balance sheets, they do not affect earnings or regulatory capital requirements unless the losses are determined to be “other than temporary,” according to Michael Rapoport in his April 1, 2009 Heard on the Street Column entitled “Accounting Rules Should Avoid Impairment.” The rule change relaxes the standards under which companies must take “impairment charges” on their “available-for-sale” investments that have sustained “other than temporary” unrealized losses.
Under the rule change, however, banks can avoid taking “impairment charges” by simply saying they do not intend to sell “available-for-sale” investments that have incurred mark-to-market losses and probably will not be forced to sell them. In other words, they could simply put their heads in the sand and bring opacity to the financial system, as the Black Swan author said.
This dodge could be very important where toxic securities with serious mark-to market losses comprise a large part of the capital structure. While it might be good for the banks, it would not be good for investors who need clearly reported, accurate valuations on which to base investment decisions.
Banks need to be regulated. The public is entitled to full and honest disclosure. The new rule runs counter to both of those concepts. Unfortunately, the public will have to wait a bit longer before it can trust Wall Street banks.
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