When an organization exists to make rules, don’t be surprised when it makes a lot of them. So it is with the Financial Accounting Standards Board. But one should at least be able to expect that the rules FASB makes are well-developed, do no harm, and support the general proposition that financial statements provide clarity and transparency. 

On this score, though, FASB hasn’t done so well in recent years. For example, through FAS 140 and FIN 46(R), FASB allowed off-balance sheet “qualifying special purpose entities” (structured investments vehicles, variable interest entities, and the like) that make leverage non-transparent and reward risk-taking through gain-on-sale accounting.  Through exposure drafts proposing the elimination of QSPEs, FASB has admitted its rulemaking missed the mark.  Similarly, it’s time to admit that its FAS 157 rules for valuing illiquid and hard-to-value financial instruments are half-baked and have contributed more than their share to the current financial crisis. 

Defenders argue that fair value accounting provides clarity and has only helped indentify market problems. There may be some truth to their argument, but in the present economy, mark-to-market accounting offers a better reflection of sellers’ desperation than it does the value of securities sold or investments held on the balance sheet.

I’ve noted here before that FAS157-driven accounting results depend greatly on whether a particular asset is treated as a loan or an investment. Look again at the example of The Bank of New York Mellon, which in the fourth quarter wrote down the value of its $5 billion Alt-A MBS portfolio by $1.24 billion, roughly a 25% mark to market.  In its disclosures, the company noted that if that same asset were given loan accounting treatment (and what is a MBS but a collection of mortgage loans, after all?), its expected loss, based on estimated cash flows, would have been only $208 million, a mark of just 4.1%. The difference between the two accounting results: more than $1 billion.

Capital One’s just-released 2008 10-K provides another apt example of how FAS 157 yields disparate and unrealistic valuations, even as it creates substantial market confidence, capital adequacy, and solvency problems for banks, insurers, and others.  Note in the accompanying table that, at the end of 2008, the carrying amount of loans held for investment was $101 billion, compared to an estimated fair value of $86.4 billion.  Net of a $4.5 billion allowance for loan losses, net loans held for investment were $96.5 billion, $10.1 billion or 11.7% more than the fair value estimate.  One should note that at the end of 2007, the estimated fair value of loans held for investment exceeded the carrying amount by more than $3 billion.

Consistent with GAAP, Capital One reported a year-end tangible book value per share of $28.24, a substantial tangible common equity to tangible assets ratio of 5.57%, and a Tier 1 risk-based capital ratio of 13.6%, much more than well-capitalized for regulatory purposes. But subtract intangibles and the $12 billion in mark-to-market adjustments to assets and liabilities, and the company is insolvent. Obviously, no company can be well-capitalized and insolvent simultaneously, but is it any wonder that the market is so confused, that regulatory capital ratios are no longer credible, and that Capital One’s stock trades at $12.05, 43% of reported tangible book? 

This is transparency?  This is clarity?  Fair value accounting may not have caused the banking crisis, but FASB certainly made a direct contribution through FAS 157.  Fair value accounting may not be the cause, but it has surely made the present crisis much worse.  The damage grows each passing day, with real costs to companies, investors, and taxpayers and with real impact on guided and misguided policy choices coming from Congress and the new administration. 

The SEC should immediately suspend mark-to-market accounting for most banks until it can be appropriately revised. 

Mary Schapiro?  Convince us that the SEC protects investors and the markets.  Tim Geithner?  Are you listening?

What do you think?  Let me know! 

Related:

The "Aggregator" Bank: A Good Idea, Depending On . . . . 

Mark-to-Market Insanity

Mark-to-Market: Stop the Madness