Key change in accounting may boost banks' balance sheets

For months, America’s financial system has been buffeted by uncertainty over the value of banks’ assets, which are generally written down to whatever the markets say they are worth – even if they are barely traded since no one wants to own them.

On Thursday, the group that makes the nation’s accounting rules announced it is modifying this key provision, termed mark-to-market. It will now allow banks to consider the value of assets as if they are being sold in an orderly fashion, not in a distress sale.

This modification by the Financial Accounting Standards Board (FASB) is likely to have wide ramifications. With one accounting rule change, the banks’ balance sheets may look stronger. Possibly, the huge injection of taxpayer money for the banks may seem less risky. However, some investor groups warned that the rule change may make it harder for banks to attract capital in the future, if the value of the banks’ portfolios is viewed as subjective. And some are saying that the change must not be viewed negatively by the public.

“It’s important the American people believe this is just not an artificial change in policy that will cover up some asset that should be shown in some other way,” says Donald Powell, a former chairman of the Federal Deposit Insurance Corp., which insures bank deposits. “I want the American people to believe in the banking industry.”

The FASB action is in response to a congressional demand issued at a hearing last month to modify the mark-to-market rules – or risk Congress becoming involved. This has prompted some concern that FASB is setting accounting rules in response to political pressure.

The timing of the change is important. The US Treasury recently announced it will try to put together a public-private partnership to take up to $1 trillion in bad assets off the banks’ books. “This could make the auctions more successful” for the banks, says Bob Brusca, an economist at Fact & Opinion Economics in New York. “Now, the banks have a chance to get these assets off their books at a better price.”

Also, the Federal Reserve is completing stress tests of the banks to determine if they will need additional capital if the economy goes into a deeper slide.

The financial services industry says it’s not entirely happy with the FASB change. Last month, the industry thought that FASB would give it more flexibility to set up proper valuation, says Irving Daniels, a vice president for banking and securities at the Financial Services Roundtable, a lobbying group that represents the industry in Washington. “It looks like FASB has regressed on how to properly value assets now, and that’s hugely critical. It’s hard to determine now what is what.”

But some Wall Street analysts thought the change would benefit the financial firms. “Companies can therefore exercise significant judgement around asset values for many securities in current market conditions, which could significantly boost reported results for banks,” wrote Julia Coronado, an analyst at Barclays Capital in New York. “The new rules are in effect for [the second quarter of 2009] but may be applied retroactively to [the first quarter of 2009], results for which will begin to be released in two weeks.”

How to price depressed loans and securities has been a hot topic during recent congressional hearings. At a March 12 hearing before the Senate Budget Committee, Treasury Secretary Timothy Geithner expressed reservations about some of the proposed changes. “My personal view is we have to be very careful not to do things that would erode confidence in the people’s ability to assess the risks in exposure to a bank,” he stated. “There are some versions of those proposals that would have that risk.”

Federal Reserve Chairman Ben Bernanke, in a Feb. 25 hearing before the House Financial Services Committee, called the mark-to-market issue “a very difficult question.” In principle, he said, it is good for firms to be valued as accurately as possible. “You know it’s good for investor confidence that they think they’re seeing the true value of the underlying ... firm,” he said.

But, he added, “it is absolutely the case that under certain circumstances, when you have markets where the asset is not traded or is very thinly traded, it's very difficult to use market information to judge what the appropriate value is. And that makes the mark-to-market approach very difficult to execute in a sensible way.”

On Thursday, the stock market, which had been anticipating the change, reacted in a very positive fashion. As of about 2:30 p.m. Thursday, the Dow Jones Industrial Average was up almost 290 points. The FASB decision was one factor in the market rally, says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla. “But the FASB news had been rumored for a while,” he notes.

Although the stock market reacted well to the announcement, some investors expressed some skepticism.

“My thought is that rigging the scale does not mean you have lost weight,” says Doug Roberts, director of research at Channel Capital Research in Shrewsbury, N.J. “This is kind of a temporary fix, but you still have to know what these things [the illiquid assets] are worth.”

Even though one of the results of the move may be to bolster the balance sheets of the banks, the change could make the banks look less attractive as investments, some analysts argue.

“If we water down financial America’s accounting rules so we no longer have balance sheets we can believe in, if we water down the accounting rules to let companies declare the values they want, what does that do to investor confidence?” asks Espen Robak, president of Pluris Valuation Advisors, a New York company that values illiquid assets. “You will want to know what it is they are not telling you, and that will make you much more cautious about buying stocks.”

The Chartered Financial Analyst Institute (CFA), in a letter to FASB, was even more blunt. The move, it said, means “the capital markets will remain closed to major banks and other financial intermediaries for an extended period of time and a higher cost of capital imposed.” It continued, “Investors will not be willing to commit capital to firms that hide the economic value of their assets and liabilities. Reduced capital access will restrict the ability of the banks to diversify their funding sources and slow the recovery process.”

At its press conference, FASB said it valued the input from the CFA. But Robert Herz, FASB chairman, said it reached out to many groups, including mutual funds, hedge funds, and the rating agencies, “and the majority supported what we were doing.”