In less good news, banks get to value more of their assets by wishful thinking
A once-obscure accounting rule that infuriated banks, who blamed it for worsening the financial crisis, was changed Thursday to give banks more discretion in reporting the value of mortgage securities.Via digby. Why is this bad? Digby quotes James Kwak:
The change seems likely to allow banks to report higher profits by assuming that the securities are worth more than anyone is now willing to pay for them. But critics objected that the change could further damage the credibility of financial institutions by enabling them to avoid recognizing losses from bad loans they have made.
Critics also said that since the rules were changed under heavy political pressure, the move compromised the independence of the organization that did it, the Financial Accounting Standards Board.During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.
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 “fire-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 make the downward corrections they want. It’s 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.Maybe FASB could let me use "mark-to-my desires" accounting when stating my income on my mortgage application. After all, in this unusually bad economy, the market is not valuing my work properly.
However, the situation is not symmetrical, and the change is bad for two reasons. First, fair market value (”mark to market”) has the benefit of being a clear rule that everyone has to conform to. So from the investor’s perspective, you have one fact to go on. The new rule makes asset prices dependent on banks’ internal judgment, and each bank may apply different criteria. So from the investor’s perspective, now you have zero facts to go on. It’s as if auto companies were allowed to replace EPA fuel efficiency estimates with their own estimates using their own tests. We all know the EPA estimates are not realistic, but we can find out exactly how they were obtained and make whatever adjustments we want. If each auto company can use its own criteria, then we have no information at all.
Second, this takes away the bank’s incentive to disclose information. Under the old rule, if a bank had to show market prices but thought they were unfairly low, it would have to show some evidence in order to convince investors of its position. Under the new rule, a bank can simply report the results of its internal models and has no incentive to provide any more information.
So what we get is less information and more uncertainty.
Update: Here’s a thought. What if the function of these rule changes is to make it easier for banks to ignore the results of the PPIP auctions? For example, Bank A puts up a pool of loans for auction, but doesn’t like the winning bid and rejects it; Bank A doesn’t want to be forced to write down its loans to the amount of the winning bid. Or, alternatively, Bank B sells a security to a buyer, and Bank A holds the same security; Bank A doesn’t want to be forced to write down the security to the price of Bank B’s transaction.
The change to fair value accounting (Rule 157) may make it easier to claim that the sale by Bank B was a “distressed sale,” meaning it can ignore it for valuation purposes. Even if it can’t ignore the sale, the change to other-than-temporary impairment may make it easier for Bank A to classify any impairment as temporary and therefore avoid an income statement hit. You’d have to be a specialist to know the answers for sure, but in any case these rule changes don’t make it any harder.