Hair of the Hound?

FASB announced today a “relaxation” of accounting rules for banks. “Relaxation” is a lovely euphemism. Everybody is in favor of relaxation. Who could be against it? What it actually means is a reduction in risk management. We could all be really, really relaxed if there were no laws at all, by that way of thinking.

FASB is the Financial Accounting Standards Board (often pronounced “Faz-bee”), a non-profit, non-governmental accounting industry organization (www.fasb.org). Member organizations include the American Institute of Certified Public Accountants, the American Accounting Association, and 28 others.

FASB attempts to maintain generally accepted accounting principles (GAAP) in the US, which is what makes it possible to understand the financial statement of just about any audited company. If you’re a company and you do not conform to GAAP, your auditors will not sign your financial statements.

The Securities and Exchange Commission (SEC) is responsible for setting and maintaining the accounting standards that publicly traded companies in the US must follow, but the SEC handed off that job to FASB in 1973. I don’t know how a government agency can privatize its legal responsibilities like that, but it happened, and it has been working okay ever since.

To the point, today FASB changed the acceptable accounting rules for banks that are holding piles of those “toxic assets” we have heard so much about. Banks are supposed to show those assets on their financial statements according to what they are worth. But what ARE they worth? In reality, they are worth almost nothing because if they put them up for sale today, they would find few, if any buyers.

Let’s say they are worth only 20 cents of their face value. Why not sell them at 20 cents each then and be done with it? The main reason is that you don’t really know if they are worth 20 cents. You might not get any buyers at 20 cents, or even at 10 cents because there just isn’t a market out there. Nobody’s buying anything. So in effect, if you put the toxic assets on the non-market right now, you could find they are worth zero dollars.

The banks have so many of these assets, they are not willing to put them up for sale and find out they are worth nothing. That would mean a large part of the bank was worth nothing, and that would mean the bank was insolvent. So to put the assets up for sale would be suicide. So they won’t do it. But they have to do it if they want to get the assets off their books because that is the “mark to market” GAAP rule.

But here is the wrinkle: Bankers claim that some of these assets are actually quite valuable. They are probably worth 60 or even 80 cents of face value, they say, because they are debt instruments from solid borrowers with good credentials who are making their payments and there is no problem with these assets other than the fact that everybody is afraid of them. In a normal market, these would be good assets. It just happens that there is no market right now.

FASB has bought that argument and said, okay, you can assign whatever price you think is reasonable to these assets and show that on your books. You don’t have to really mark them to market because there is no market. FASB will allow banks and their auditors to use "significant judgment" to value their “impaired assets” (no longer toxic, just impaired, and who hasn’t been impaired from time to time? ).

Conveniently, the first quarter just ended two days ago and banks are now feverishly preparing 1Q reports. What a godsend to be able to show that the bank is actually healthy, not rotten to the core! How do you think they will value the troubled assets? Zero? Not likely. Twenty percent of face? Well, why not use some “significant judgment” and value them at 80% of face, because then, hallelujah, the report will show that the bank is healthy!

You might think the bankers would be showering FASB with tearful thanks for letting them off the hook and for nullifying the consequences of their greed and irresponsibility. But no. The response of the American Bankers’ Association was to ask FASB, “Could you make that retroactive? This is great for 1Q09, but you know, we took a major hit in 4Q08, so if you would make the rule retroactive, we could revise the ’08 statement and we would really come out smelling like a rose!”

This request would make us laugh with despair, except that House Financial Services Committee Chairman Barney Frank (D-MA), said he will consider it! I hope he meant, “I will give it all the consideration it deserves.” Which is NONE! Frank is a smart guy, and so far he has done the right thing. We must wait to see if he is who he appears to be.

One interesting consequence of the FASB “relaxation” is that Paul Krugman is thwarted. He has been saying for weeks that the banks are rotten and the only cure is to cut out the cancer by nationalizing them. But this FASB move finesses him. Now the toxic assets will have a fantasy value based on their owners’ opinions, but if that fools enough people, investors might show up at Geithner’s yard sale and buy some. Then a market will in fact exist, and the price will be a real-market price, and the financial reports will suddenly be true, and the banks will be recovered. It’s like the Emperor’s New Clothes. If nobody calls “naked!” the scheme might work.

If that is the outcome, I will be the first to praise its brilliance. Markets are 99% psychology anyway, so it could work, and that would be wonderful.

There are loose ends though. One is the moral issue of letting all those greedy banks off the hook so easily. We are supposed to hold our noses and let that go for the sake of the recovery, but that is not easy to do.

Another is that this sleight of hand by the green eyeshade crowd is exactly the kind of non-transparent shenanigans that brought the whole system down in the first place. It is a hair of the hound that bit us. Does that theory work?