Look for another rosy round of profits when banks turn in their numbers for the second quarter ending in June when it will be legal for them to improve their balance sheets by shifting losses into the future, thanks to new accounting rules passed by a one-vote margin by the Financial Accounting Standards Board (FASB).
It's just one in a series of changes made to accounting rules that allow banks to shift or ignore losses or pretend that liabilities aren't liabilities. The struggle for control of the financial recovery -- where the money goes, how it's counted and who survives -- is nothing short of war. Truth has been the first casualty.
The latest rule change allows banks to split losses into ones that they recognize immediately and others that are pushed down the road and may pop up on the books later. It passed in April with barely any notice from the press. The accounting tricks allow banks, which may otherwise be deemed insolvent, to continue to operate. It's a hell of a time to be an accountant.
"It's more fascinating than it's ever been before," says Rick Martin, head of technical accounting at Pluris Valuation Advisors LLC, who specializes in derivatives and securitized assets, the type of products that brought down the economy. "Accounting used to be kind of dry. The last year or two it's just been unbelievably exciting, as I've seen auditors and companies and accounting standards setters go head to head."
Even the FASB, a quasi-public board with authority to establishes financial accounting standards, has consistently split three to two -- three board members with corporate backgrounds standing with banks and an academic and a former investor objecting to loosening the rules.
Making banks' books less transparent is a Bizarro-World response to a global financial collapse that began when markets froze in reaction to concerns about the solvency of banks and the true value of their assets.
Rep. Alan Grayson (D-Fla.) says the push to change accounting rules is a logical result of allowing insolvent banks to stay open. The short-term motivation is to stay in business as long as they can, but it'll backfire in the not-too-long run.
"When we talked about the credit system freezing up, what we were really talking about is the fact that banks stopped believing in each others' credit worthiness. Playing games with accounting rules is certainly not going to make people feel any differently about that," he says. "It's happening because insolvent banks are pressuring people in Washington to give them relief."
It's the kind of financial gimmick that works until it doesn't. Subprime loans bundled and sold as AAA securities rose in value as long as people believed they were worth something. Then reality intervened.
"These companies are trying to kill the messenger...What they don't seem to realize is that changing accounting rules does not make them solvent," says Grayson. "Frankly, it doesn't make any difference whether FASB blesses those games or not. People who invest sums in the hundreds of millions or billions of dollars are sophisticated enough to be able to understand when the rules are being bent."
The games with accounting rules began last fall when the first serious signs emerged that the economy was about to crater. When the government decided to bail out the financial sector, it had a Catch-22 on its hands: It didn't want to just give the money away, so the government needed collateral from the banks.
The collateral took the form of warrants, which represent a future claim on earnings. The problem was that normal accounting rules require warrants to be listed on balance sheets as liabilities. Doing so would have further weighed down the already-struggling banking sector.
So the Bush administration's Treasury Department asked the SEC and FASB -- pronounced FAZ-bee in the number-crunching world -- if banks could just go ahead and ignore that rule.
"When you issue warrants it's a liability to you because the guy that's holding the warrants is going to exercise it at some point. But in this case, with the government warrants, the FASB and the SEC didn't even put in a new rule, all they did was issue a letter to the government," says Martin. "The paraphrase of the letter is, we'll turn the other way."
The exact wording of the October 24th letter says, "...we would not object if the Warrants, as defined in the documents provided, were to be classified as permanent equity."
The accountants suggested that the banks should get shareholder approval before fudging the balance sheet, but added that if they couldn't, it was still okay.
"If an issuer does not have required shareholder approval, including shareholder approval for sufficient authorized but unissued shares of the class of stock that may be required for settlement, we would also not object to classification of such Warrants as permanent equity provided that the issuer takes the necessary action to secure sufficient approvals prior to the end of the fiscal quarter in which such Warrants are issued," wrote Russell Golden, technical director for FASB; and James Kroeker, deputy chief accountant at SEC.
The Treasury Department proudly displayed the letter on its website in November, inviting banks to kick their liabilities off their balance sheets.
The simple issuance of the letter doesn't allow skeptical board members to dissent,which two of the five have been doing with a regularity unusual to the consensus-driven atmosphere accounting usually lives in.
When the accounting board decided earlier this year to reform mark-to-market accounting rules, two board members dissented. Robert Herz, the board chairman, joined with two other industry representatives and cas the deciding vote in favor of the change. The holdouts were Thomas Linsmeier and Marc Siegel. They tried to stop the board again in April when it pushed through the rule allowing banks to split losses off and push them into the future. Board meeting minutes indicate an intense debate, with Linsmeier and Siegel repeatedly casting two no votes and being overridden by the other three.
"Messrs. Linsmeier and Siegel believe that accounting standards should be focused on serving the needs of investors, who did not request this urgent change," read the minutes of the meeting. The two also objected that the rule was passed "on an expedited basis with limited due process."
The caving came after an intense round of lobbying from Wall Street banks and Washington. In March, a House financial services subcommittee held a public browbeating of FASB chair Robert Herz and other regulators, giving the board three weeks to change accounting rules or have Congress do it instead.
Treasury Secretary Timothy Geithner publicly called for reform of the mark-to-market rule, placing himself on the side of banks.
Three weeks after the hearing, just as Congress had demanded, the mark-to-market rule was changed; Herz told reporters not to question the board's motivation, always a good reason to start questioning motivations. (Especially considering Herz' own remarks at the hearing.)
Congressional Republicans have long called for accounting rule changes, but the behind-the-scenes support has been bipartisan. Bank lobbyists meet with members of Congress and those members pressure FASB and other regulators to go easy.
"The pressure from these insolvent institutions is entirely bipartisan. Both Democrats and Republicans get the same sort of entreaties from people whining about their own enormous mistakes and the consequences thereof," says Grayson.
Martin sees the latest rule, allowing losses to be pushed into the future, as doing particular violence to accounting transparency.
"A loss is a loss is a loss is a loss," he says. "In accounting theory you match your losses with the period in which they occur. And what we're doing here is saying, you know what, some of these losses, they might turn around, they might not really be losses, we're just going to hang them up on the balance sheet until the dust settles from this economic storm. If good things happen later on down the road, we'll report those good things happening on our books at that time."
What, after all, is the point of reporting quarterly profits if the losses in that quarter aren't counted?
There's a practical problem, too. By allowing banks to classify some losses as present losses and others as some future something-or-other, the rule becomes difficult to police.
"It's going to be impossible. It's not going to be practicable to audit. It's going to be a nightmare to put this into practice consistently," says Martin.
The mark-to-market and the latest rule change generated nearly a thousand letters, many from investors and community banks arguing that the change would make balance sheets less believable, according to meeting minutes. Investors form a powerful political bloc against the banks. Most pensions fund the retirement of union workers and government employees, teachers, cops and firefighters. They want honest accounting.
Martin says that the Big Four accounting firms are allied with investors and have backed up Linsmeier and Siegel's efforts to stand firm. Calls to the Big Four yielded no comment.
Linsmeier and Siegel, through FASB's communication's shop, declined to comment, saying they'd let their dissents in the meeting minutes stand for themselves.
Allowing struggling banks to kick losses to the future requires investors to believe that those banks will exist in the future. And the new FASB rules don't give investors confidence, especially with banks collapsing all around, the rules dissenters said.
"[T]he rapid disappearance of certain financial institutions that appeared able to hold such instruments to recovery has reduced investors' confidence in whether impairments are not being recognized in earnings based on questionable assertions that the entity can withstand market conditions for a sufficient time period to recover the estimated cash flows," they warned.
The Federal Deposit Insurance Corporation's list of "problem" institutions is up to 305, the most since 1994. In the first quarter of the year, it took over 21 banks and another 15 in the second quarter.
Banks that attack auditors and accountants are only hurting themselves in the long run. "The system that we have is meant to inform people on an objective basis who is solvent who is not so they can, among other things, raise capital," says Grayson. "And so fiddling with accounting rules and pressuring people in Washington who administer those rules, what they're really doing in the end is impairing their own ability to raise capital. Nobody -- and I mean nobody -- is going to be willing to invest in banks that play games with their books."
If you're an accountant with expertise in this area, write me at email@example.com.
Ryan Grim is the author of the forthcoming book This Is Your Country On Drugs: The Secret History of Getting High in America