Issue of the week: Uproar over an accounting change

It’s hard to believe that “a once-obscure accounting rule” could spark such controversy, said Floyd Norris in The New York Times. But many banks blame the “mark-to-market” rule “for worsening the financial crisis,” and last week, they persuaded the Financial Accounting Standards Board to loosen it. “The change seems likely to allow banks to report higher profits,” since it gives them the leeway to avoid recognizing losses from their bad loans. The accounting rule requires banks to report—or mark—changes in the value of their investments every quarter, as measured by those investments’ current market prices. So if a bank bought a Treasury bond for 97 cents on the dollar in February and, as of March 31, the bond is trading for 98 cents, the bank records the gain as a profit. But if the bond’s traded value sinks, the bank records a loss. The rule is easy to apply to actively traded securities such as Treasury bonds. But the banks argued that the rule should not be used to value mortgage securities, since that market is virtually frozen. The accounting board agreed and will now let banks use their own discretion in valuing hard-to-trade securities.

In other words, said Stuart Whatley in Huffingtonpost.com, banks can now substitute their self-serving opinions for the judgment of the marketplace. The banks, as well as the Obama administration, love this idea—for obvious reasons. “If all of a sudden these banks are forced to eat huge losses, their balance sheets will resemble Swiss cheese,” and Treasury Secretary Timothy Geithner will have to beg Congress for more funds to replenish the banks’ capital. But now, banks can delay a true reckoning of their losses. “It is as if we’re leaving it up to a drug addict to arrange his own intervention.”

Such “howls of outrage” are misplaced, said John Berry in Bloomberg.com. Under the old rule, banks valued their mortgage bonds based on the most recent trade of a similar bond, even

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if the transaction was a distress sale. And they had to use the latest price even if they planned to hold the bonds to maturity. That forced “many financial institutions to overstate losses on trillions of dollars worth of assets.” One Atlanta bank, for example, had to mark down its mortgage securities by $87.4 million in the third quarter last year, even though if the bonds were held to maturity, the bank’s projected loss would be only $44,000. This accounting change really does fix a problem that needed to be fixed.

But it also allows banks to muddy their true financial picture, said Holman Jenkins Jr. in The Wall Street Journal. Investor Warren Buffett recently suggested a smart compromise. The accounting standards board should still require the banks to mark down their assets to current prices. That would give investors useful information. But the banks should not have to deduct their paper losses from their capital. With that simple tweak, banks would not be “forced to raise capital when capital is unavailable or unduly expensive,” and regulators would not be “forced to treat banks as insolvent though their assets continue to perform.”