I heard an interesting anecdote at a Financial Services Committee hearing last month (see the video below). Robert Herz of the Financial Accounting Standards Board (FASB) said that financial services companies about to go bankrupt sometimes demanded a change in accounting rules about two weeks before they went under. A bank being forced to admit it is broke is not pleasant, but it is necessary, because no private actor will lend to a bank whose financial situation is obscured or hidden.
Unfortunately, FASB recently changed accounting rules to allow financial institutions to value securities on their books using their own subjective judgment, instead of being forced to mark them to market prices. This means that instead of valuing, say, subprime residential mortgage as what they are worth, banks can now pretend that these loans are going to come back to full value. The net effect is that banks can choose to report profits simply by reclassifying how they value assets rather than admitting losses or capital impairments. This is not just a rules change, it's a statement to our banking system that banks can and should obscure losses and emphasize gains.
Since this accounting change, we've seen two major institutions prettying up their financial statements. Wells Fargo recorded record profits, and its stock jumped more than 20% in one day on the news. Goldman Sachs also reported tremendous earnings, surprising in these difficult times, and sold $5 billion of stock in the secondary market immediately afterwards
Both banks have used odd accounting tricks designed to obscure the truth of their status to investors. Earnings season just started, so we'll soon see if this is a trend, but so far, I'm not encouraged. Journalist Jonathan Weil, who helped uncover the Enron scandal, pointed out that much of the increase in Wells Fargo's earnings came from a new accounting term called 'Level 3' gains and its application to Wells Fargo's mortgage servicing portfolio. "So what are Level 3 gains?" asks Weil. "Pretty much whatever companies want them to be."
Floyd Norris of the New York Times noted that Goldman Sachs used a more prosaic trick having nothing to do with mark to market accounting - the company moved its fiscal year up a month and simply left out its losses from December, which is now known as an 'orphan month'. Is the rule that says a year has twelve months also open to subjective judgment?
I protested the mark to market changes last month because I feared that these kinds of tricks would become commonplace. After all, who will lend to a bank that pretends a year has thirteen months in it? If banks make this kind of accounting routine, even the free calendars they give out will become useless.
FASB made a mistake by allowing banks to use subjective judgment to avoid admitting losses or book fake profits. That may create a positive short-term impression for stockholders, but it won't increase credit any more than changing the definition of inches will make airplane seats more comfortable for tall people. No one will believe these banks anymore, and the only entity that will lend them money is the government.