We believe political influences that dictate one particular outcome for an accounting standard without the benefit of a public due process that considers the views of investors and other stakeholders would have adverse impacts on investor confidence and the quality of financial reporting, which are of critical importance to the successful operation of the U.S. capital markets.

Other critics argue that rules governing banks have actually been softened by the changes in mark-to-market accounting. Banks are now free to “write-up” the values of assets that had few, if any, buyers.

Mr. Issac also notes that the bill does not deal with the Basel capital accords and the procyclical accounting for loan-loss reserves. Nor does the bill institute an independent watchdog to oversee the system.

What’s the rush? Let’s do it right. The economy seems to be getting better. Let’s find a solution that works, rather than one that is easy to pass through Congress now…remember the old saying, “Decide in haste, repent at leisure.”

It’s just one in a series of changes made to accounting rules that allow banks to shift or ignore losses or pretend that liabilities aren’t liabilities. The struggle for control of the financial recovery — where the money goes, how it’s counted and who survives — is nothing short of war. Truth has been the first casualty.

The latest rule change allows banks to split losses into ones that they recognize immediately and others that are pushed down the road and may pop up on the books later. It passed in April with barely any notice from the press. The accounting tricks allow banks, which may otherwise be deemed insolvent, to continue to operate. It’s a hell of a time to be an accountant.

“It’s more fascinating than it’s ever been before,” says Rick Martin, head of technical accounting at Pluris Valuation Advisors LLC, who specializes in derivatives and securitized assets, the type of products that brought down the economy. “Accounting used to be kind of dry. The last year or two it’s just been unbelievably exciting, as I’ve seen auditors and companies and accounting standards setters go head to head.”

Even the FASB, a quasi-public board with authority to establishes financial accounting standards, has consistently split three to two — three board members with corporate backgrounds standing with banks and an academic and a former investor objecting to loosening the rules.

Making banks’ books less transparent is a Bizarro-World response to a global financial collapse that began when markets froze in reaction to concerns about the solvency of banks and the true value of their assets.

Rep. Alan Grayson (D-Fla.) says the push to change accounting rules is a logical result of allowing insolvent banks to stay open. The short-term motivation is to stay in business as long as they can, but it’ll backfire in the not-too-long run.

“When we talked about the credit system freezing up, what we were really talking about is the fact that banks stopped believing in each others’ credit worthiness. Playing games with accounting rules is certainly not going to make people feel any differently about that,” he says. “It’s happening because insolvent banks are pressuring people in Washington to give them relief.”

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It’s the kind of financial gimmick that works until it doesn’t. Subprime loans bundled and sold as AAA securities rose in value as long as people believed they were worth something. Then reality intervened.

“These companies are trying to kill the messenger…What they don’t seem to realize is that changing accounting rules does not make them solvent,” says Grayson. “Frankly, it doesn’t make any difference whether FASB blesses those games or not. People who invest sums in the hundreds of millions or billions of dollars are sophisticated enough to be able to understand when the rules are being bent.”

The games with accounting rules began last fall when the first serious signs emerged that the economy was about to crater. When the government decided to bail out the financial sector, it had a Catch-22 on its hands: It didn’t want to just give the money away, so the government needed collateral from the banks.

The collateral took the form of warrants, which represent a future claim on earnings. The problem was that normal accounting rules require warrants to be listed on balance sheets as liabilities. Doing so would have further weighed down the already-struggling banking sector.

So the Bush administration’s Treasury Department asked the SEC and FASB — pronounced FAZ-bee in the number-crunching world — if banks could just go ahead and ignore that rule.

“When you issue warrants it’s a liability to you because the guy that’s holding the warrants is going to exercise it at some point. But in this case, with the government warrants, the FASB and the SEC didn’t even put in a new rule, all they did was issue a letter to the government,” says Martin. “The paraphrase of the letter is, we’ll turn the other way.”

The exact wording of the October 24th letter says, “…we would not object if the Warrants, as defined in the documents provided, were to be classified as permanent equity.”
The accountants suggested that the banks should get shareholder approval before fudging the balance sheet, but added that if they couldn’t, it was still okay.

“If an issuer does not have required shareholder approval, including shareholder approval for sufficient authorized but unissued shares of the class of stock that may be required for settlement, we would also not object to classification of such Warrants as permanent equity provided that the issuer takes the necessary action to secure sufficient approvals prior to the end of the fiscal quarter in which such Warrants are issued,” wrote Russell Golden, technical director for FASB; and James Kroeker, deputy chief accountant at SEC.

The Treasury Department proudly displayed the letter on its website in November, inviting banks to kick their liabilities off their balance sheets.

The simple issuance of the letter doesn’t allow skeptical board members to dissent,which two of the five have been doing with a regularity unusual to the consensus-driven atmosphere accounting usually lives in.

When the accounting board decided earlier this year to reform mark-to-market accounting rules, two board members dissented. Robert Herz, the board chairman, joined with two other industry representatives and cas the deciding vote in favor of the change. The holdouts were Thomas Linsmeier and Marc Siegel. They tried to stop the board again in April when it pushed through the rule allowing banks to split losses off and push them into the future. Board meeting minutes indicate an intense debate, with Linsmeier and Siegel repeatedly casting two no votes and being overridden by the other three.

“Messrs. Linsmeier and Siegel believe that accounting standards should be focused on serving the needs of investors, who did not request this urgent change,” read the minutes of the meeting. The two also objected that the rule was passed “on an expedited basis with limited due process.”

The caving came after an intense round of lobbying from Wall Street banks and Washington. In March, a House financial services subcommittee held a public browbeating of FASB chair Robert Herz and other regulators, giving the board three weeks to change accounting rules or have Congress do it instead.

Treasury Secretary Timothy Geithner publicly called for reform of the mark-to-market rule, placing himself on the side of banks.

Three weeks after the hearing, just as Congress had demanded, the mark-to-market rule was changed; Herz told reporters not to question the board’s motivation, always a good reason to start questioning motivations. (Especially considering Herz’ own remarks at the hearing.)

Congressional Republicans have long called for accounting rule changes, but the behind-the-scenes support has been bipartisan. Bank lobbyists meet with members of Congress and those members pressure FASB and other regulators to go easy.
“The pressure from these insolvent institutions is entirely bipartisan. Both Democrats and Republicans get the same sort of entreaties from people whining about their own enormous mistakes and the consequences thereof,” says Grayson.

Martin sees the latest rule, allowing losses to be pushed into the future, as doing particular violence to accounting transparency.

“A loss is a loss is a loss is a loss,” he says. “In accounting theory you match your losses with the period in which they occur. And what we’re doing here is saying, you know what, some of these losses, they might turn around, they might not really be losses, we’re just going to hang them up on the balance sheet until the dust settles from this economic storm. If good things happen later on down the road, we’ll report those good things happening on our books at that time.”

What, after all, is the point of reporting quarterly profits if the losses in that quarter aren’t counted?

There’s a practical problem, too. By allowing banks to classify some losses as present losses and others as some future something-or-other, the rule becomes difficult to police.

“It’s going to be impossible. It’s not going to be practicable to audit. It’s going to be a nightmare to put this into practice consistently,” says Martin.

The mark-to-market and the latest rule change generated nearly a thousand letters, many from investors and community banks arguing that the change would make balance sheets less believable, according to meeting minutes. Investors form a powerful political bloc against the banks. Most pensions fund the retirement of union workers and government employees, teachers, cops and firefighters. They want honest accounting.

Martin says that the Big Four accounting firms are allied with investors and have backed up Linsmeier and Siegel’s efforts to stand firm. Calls to the Big Four yielded no comment.

Linsmeier and Siegel, through FASB’s communication’s shop, declined to comment, saying they’d let their dissents in the meeting minutes stand for themselves.

Allowing struggling banks to kick losses to the future requires investors to believe that those banks will exist in the future. And the new FASB rules don’t give investors confidence, especially with banks collapsing all around, the rules dissenters said.

“[T]he rapid disappearance of certain financial institutions that appeared able to hold such instruments to recovery has reduced investors’ confidence in whether impairments are not being recognized in earnings based on questionable assertions that the entity can withstand market conditions for a sufficient time period to recover the estimated cash flows,” they warned.

The Federal Deposit Insurance Corporation’s list of “problem” institutions is up to 305, the most since 1994. In the first quarter of the year, it took over 21 banks and another 15 in the second quarter.

Banks that attack auditors and accountants are only hurting themselves in the long run. “The system that we have is meant to inform people on an objective basis who is solvent who is not so they can, among other things, raise capital,” says Grayson. “And so fiddling with accounting rules and pressuring people in Washington who administer those rules, what they’re really doing in the end is impairing their own ability to raise capital. Nobody — and I mean nobody — is going to be willing to invest in banks that play games with their books.”

Further obstacles may await home-loan banks with regards to their main business, which is making loans, or advances, to the commercial banks, credit unions, insurers, and thrifts that make up the home-loan banks’ membership. Banks’ demand for advances has gone down after receiving direct financial aid from the government, and this demand may decrease still further if the FDIC enacts a planned rule change that would require institutions with high dependence on advances to pay higher fees. Considering these complications, it seems further challenges are in store for home-loan banks.

Read this article that was in the WSJ yesterday:  Mortagage Securities Drag FHLB to a Loss.

MARK-TO-MARKET ACCOUNTING:  Practices and Implications

1. Determining whether a market is inactive and whether transactions are distressed for the purpose of determining the fair value, and
2. Readdress the impairment model for credit losses with 5 or so options

A quick look suggests the recommend proposal (Option B) by the staff is positive (but the Board could reject).

Won’t be effective until March 31st so people in the middle of the audit for 12/31 may not get the benefit.

There has been discussion going on about the rating process and its effect on supply and demand (I missed the beginning) and Triple C bonds, so it suggests they heard our point from last week.

More to follow.

Link to meeting going on:     http://fasb.trz.cc/live.php

Handout:    http://www.fasb.org/board_handouts/03-16-09.pdf

Step #1:  Restore confidence in housing market.

Solution:  Offer price protection for 5 years to any new purchase of a home for owner occupied purchasers.

Rationale:  People who are interested in purchasing a home are still aware that the market has not bottomed, and they may become upside down.  If the U.S. Government offers “price insurance” of 95% of the purchase price for 5 years in exchange for a monthly insurance premium added to the mortgage, that risk has been eliminated for the homebuyer.  The government is currently insuring virtually every mortgage loan written today to the lender; why not to the borrower?  Hyundai has established a similar program for new car sales, and it has been extremely successful.  This would be revenue positive for the U.S. Government.

Step # 2:  Increase spendable cash flow for every homeowner by almost $3,000 per year

Solution:  The US Government should offer a 4.50% fixed rate 30 year refinance to every mortgage borrower regardless of loan size and appraised value.

Rationale:  Assuming an outstanding mortgage amount of $250,000 at a 6.5% interest rate, the annual savings by refinancing that loan into a 4.5% rate would be $3,768 per year.  That extra cash would certainly work its way into the economy!  The only criteria is that you have to be current on your payments for the past 12 months in your previous mortgage.  This would be revenue neutral to positive for the US Government because they can currently borrow for 30 years below 4%.  Freddie and Fannie Mae can sell these refinanced loans as government guaranteed mortgaged back securities.  Freddie and Fannie Mae already have most of this exposure;  let’s use their mandate to help current homeowners.

Step #3:  Eliminate 50% of the “toxic” assets, increase the valuation of the remaining ones and recapitalize the banking system

Solution:  See #1 & 2

Rationale:  Since the majority of the “toxic” assets are mortgage related, and because the majority of mortgages have been securitized, solutions like the TARP and mortgage remediation have fallen short.  What you may not know is that a minority of “bad loans” inside a security can cause the entire security to be viewed as “toxic”.  Refinancing the good loans will significantly reduce the amount of outstanding “toxic” securities, and also allow banks to “write up” many of their previous “write downs”.  Hundreds of billions of capital and market value would be restored to the financial system without direct government intervention.

Step #4:  Heal the banks and restore lending in America

Solution:  Pass a 3 year reduction in capital requirements in banks, reduce rather than increase the regulatory scrutiny, and redefine “Fair Value” for OTTI to the “expected loss incurred.”

Rationale:  Banks are not lending because they are preoccupied with self-preservation.  Banks must keep a minimum level of capital or they will be deemed insolvent and closed.  Write downs of “anticipated” losses in advance of the realized losses can be very tricky, especially in this market.  Many of today’s write downs will not ultimately result in anywhere as severe as realized loss.  Regulation and accounting both contribute to this downward spiral of capital (as well as falling asset values, which #1 will certainly positively impact).  Regulators are under intense pressure to “regulate” better, which has an adverse reaction, banks refuse to lend out of regulatory and accounting fears.  If we enact numbers 1, 2, and 3, banks will actually become much healthier over a reasonably short time frame period because many of their “write downs” will be certainly not be realized.

Step #5:  Stop draining capital from the system that requires more bailouts

Solution:  Enact a “mark to market” holiday for 3 years.

Rationale:  Did AIG really lose $60 billion dollars?  For reported earnings and capital levels the answer is yes, although much of that write down and others’ write downs reflect very long term commitments that may actually turn out to produce vastly different cash flow results.  Unfortunately, in a regulated business such as banking and insurance, once your reported capital levels are below minimum, you are effectively out of business unless “bailed out.”  MTM caused wildly inflated asset prices on the way up during the boom. Can we at least agree that the current MTM accounting rules are causing wildly negative unintended consequences, and if not halted may ultimately put every financial institution and insurance company out of business?  There is a better solution and let’s take 3 years to study what it should be before we cause additional damage.

Interestingly, the implementation of this 5 step program would likely not cost the US taxpayer a dime, but we believe the impact to the US and world markets and economy would be profound.

Copyright 2009. Richard S. Berg. All rights reserved.