How the FASB aids and abets obfuscation by wonky zombie banks

The Financial Accounting Standards Board (FASB), at its meeting on April 2,  has once again relaxed mark-to-market accounting rules. This occurred after the House Financial Services Committee, a wholly owned subsidiary of the American Bankers Association, had, at hearings on March 12, 2009, effectively ordered the FASB to revise its guidance on fair value in inactive markets.  The HFSC used the threat that, if the FASB were not sufficiently accommodating, Congress would legislate on the matter off its own bat to give the zombie banks what they wanted.

The FASB blinked and wimped under, as it had before. It made proposals less than a week after the House Financial Services Committee hearings.  With some minor revisions, these proposals have now  hardened into final guidance, despite protests from investor advocates and accounting-industry representatives, who argue that rigorously enforced mark-to-market rules force firms to reveal their least inaccurate picture of their true financial health.

At the April 2 meeting,  the FASB also voted to allow more flexibility in valuing so-called impaired securities, although this new flexibility is restricted only to debt securities.

Under FAS 157, the FASB’s standard on fair-value measurements, holders of financial assets recorded at fair-value must state what these values are based on. Three levels of information or assumptions are distinguished, corresponding to  how “publicly observable” the information is. In level 1, the value of an asset or liability stems from a quoted price in an active market. In level 2, it is based on “observable market data” other than a quoted market price. In level 3, which often applies to asset valuations in illiquid markets or in “distressed” sales (or “fire sales”), fair value can be determined only by inputs that cannot be observed or verified objectively.  Typically this means prices based on internal models or management guesses.

Basically, the new guidance allows banks to shift a whole load of toxic and impaired securities from level 2 to level 3.  Up till now, a frequent source of level 2 information were prices achieved by competitors’ asset sales to help determine the fair-market value of similar securities they hold on their own books. Banks are now allowed to ignore prices achieved in competitors’  asset sales when these transactions aren’t “orderly”.  This includes transactions in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements.  This is vague and broad enough to drive a coach and horses through fair-value accounting for most imperfectly liquid assets.

Leaving the valuation of illiquid securities to managerial discretion will lead to systematic and systemic overvaluation.  Banks with significant amounts of toxic assets and plain bad assets on their balance sheet have lied, lie and continue to lie about what they have on their balance sheets.  This has now been made easier.  No wonder bank stocks rose and bank credit default swap rates declined.  Reported asset values will be boosted.

Analysts estimate that, now that banks can mark toxic assets using their own models (which are private information) rather than what they would fetch on the open market, quarterly profits at some banks could be boosted by up to 20 per cent.

There was a similar response of banks’ stock valuations and CDS rates last year when the FASB last allowed banks more scope to increase the opaqueness and lack of transparency of their accounts.  This was when it allowed banks to reclassify securities held on its balance sheet between the three categories “held to maturity”, “available for sale” and “trading”.  Basically, “held to maturity” securities can be valued in any way the management sees fit.  Securities “available for sale” and “held for trading” are, generally, marked-to-market.  Unrealised gains and losses are, however, only passed into the income (P&L) accounts in the case of securities held for trading.

The IASB (International Accounting Standards Board) promptly followed the lead of the FASB when the FASB permitted the re-classification of securities between the three categories.  Banks throughout the US and Europe immediately shifted securities out of the “held for trading” category and into the “available for sale” and “held to maturity” categories.  It was a major exercise in shareholder deception and deception of the wider public.  I expect the IASB to stand to attention and salute once more now that the FASB has run up the further-emasculation-of-fair-value-accounting-flag.

Why o Why?

The official excuse for this egregious pandering to the interests of zombie bank managers and unsecured creditors is that mark-to-market (or fair value) accounting is to blame for exacerbating banks’ capital problems and causes exacerbation of pro-cyclical and potentially systemically destabilising  detrimental feedback loops between lack of market liquidity, distress asset sales, mark-to-market, margin calls, falling asset prices and lack of funding liquidity.

That argument makes no sense.  It is clearly desirable that regulators and supervisors exercise regulator/supervisory forbearance as regards the implications of mark-to-market for regulatory capital requirements and for any other regulatory requirements when asset markets are distressed and illiquid.  They should do the same when asset markets are perfectly liquid but subject to speculative bubbles.

But given micro-prudential regulatory forbearance as regards mark-to-maket capital losses incurred on illiquid securities, and given sensible macro-prudential responses by regulators, monetary and fiscal authorities when securities markets are illiquid, there is no earthly reason for deliberately lowering the informational content and quality of published corporate accounts.  This impairment of the informational content of the corporate accounts will be the inevitable consequence of replacing valuation using market prices (even illiquid market prices) with the judgment of the deeply conflicted managers of these corporations. Investors will be worse off.  Corporate governance will suffer.  Accountability of corporate executives and boards will diminish.  And, because mark-to-myth is likely to prevent necessary corrective measures from being taken, or at least to delay them, the FASB’s encouragement of marking-to-myth is likely to increase future financial instability.


It really is wonderful how the US political and regulatory establishment is riding out in support of its wonky banks.  First, the Treasury Secretary Timothy Geithner proposes a toxic and bad assets purchase scheme (the PPIP or Public-Private Investment Program) which subsidizes the private parties in the public-private partnerships  bidding for the toxic assets by leveraging the private and public equity involved in the bids through non-recourse loans or guarantees.  This permits – indeed encourages – private bidders for toxic assets to make bids far in excess of their estimates of the fair value of these assets.  Their rents can then be split between the private bidders for the assets and the banks selling them.

Second, in case even this isn’t good enough, banks that would rather not sell these toxic or bad assets, even at these inflated prices, can avoid pressure (from the regulators or from shareholders) to sell by marking-to-model (that is, marking-to myth) the assets rather than marking to market.  This gives the management of the bank more time to ‘gamble for resurrection’ at the expense of the shareholders and other stakeholders, including the tax payers.  Most importantly, banks with large amounts of undeclared crud on their balance sheets will act like zombie banks, engaging in little new lending or new investment in the real economy.  While their managers sit, wait and pray for a miracle, intermediation between households and non-financial enterprises continues to suffer.

The G20 have made many pious statements about the need to recognise the losses that have been incurred, on and off the balance sheets of banks and shadow banks, and to ensure that the dead hand of the overhang of past losses does not act as a tax on and deterrent to new lending and borrowing by banks.  Yet the primus inter pares in the G20, the USA, decides to give its banks another large fig leaf behind which to hide their losses and gamble for resurrection.  This continues and prolongs the zombification of most Wall Street banks.

The FASB, like the rest of the American regulatory and standards-setting establishment, appears to have been captured lock stock and barrel by the vested interests of the large Wall Street zombie banks (management, shareholders and unsecured creditors).  This may well have been another example of cognitive regulatory capture, like that which has afflicted the SEC and the Fed.

No doubt the IASB will wimp under also, and promulgate a new ukase permitting European banks also to substitute managerial judgment/wishful thinking for market valuation. Our accounting standard setters are making terrible and very costly choices.  Paraphrasing Churchill: mark-to-market accounting is the worst accounting principle in the world, except for the others.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website