Today the Financial Accounting Standards Board voted - by one vote - to relax accounting standards for certain types of securities, giving banks greater discretion in determining what price to carry them at on their balance sheets. The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets.
This makes no sense, for three reasons.
1. Investors and regulators are not idiots. They know what the accounting rules are. If banks claim they were forced to mark their assets down to Âfire-sale prices, investors can look at the facts themselves and apply any upward corrections they want. Now that banks will be able to mark their assets up to prices based solely on their own models, investors will the downward corrections they want. ItÂs a little like what happened when companies were forced to account for stock option compensation as expenses; nothing happened to stock prices, because anyone who wanted to could already read the footnotes and do the calculations himself.
[...]
2. Between the two options, this is the unsafe choice. Accounting in general is supposed to embody a principle of conservatism. Given plausible optimistic and pessimistic rules, you are supposed to choose the pessimistic one.
[...]
3. Mark-to-market is a red herring to begin with. Accounting rules are much more complex than Âall assets must be marked to market and Âall assets can be marked to model. There are different types of assets (Level 1, 2, and 3); different types of impairments to asset values (temporary and other-than-temporary); different accounting impacts (some writedowns on the balance sheet affect income statement profitability, some donÂt); and, most importantly, different ways of holding assets. How a bank accounts for an asset depends in part on whether it says that asset is held for trading purposes, is available for sale, or will be held to maturity. Wharton has a high-level discussion of some of these issues, but if you really want to understand them you should read Sections 1.B-D of the SECÂs study of mark-to-market accounting, which I helpfully summarized for you in an earlier post.
The SECÂs conclusions were, in short:
* Most bank assets are not marked to market to begin with, and half of the ones that are marked to market are the type that donÂt affect the income statement.
* Marking assets to market had only a very small impact on bank capital through September 2008.
* The bank failures of 2008, including Washington Mutual, were not caused by marking assets to market (increasing loan loss provisions were a bigger culprit). In each case, stock prices started falling before the banks took writedowns, implying that investors already knew something was fishy before the accountants did anything.
[...]
I suspect he's closer to being right than the bankers and congressmen who were pushing this change.
Cheers,
Scott.