Numbers Banks Are Reporting Are A Literal "Fraud": Investors At Risk

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Beware Bankers Spinning Story of Smooth Results: David Reilly
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Commentary by David Reilly

Sept. 11 (Bloomberg) -- The financial results that companies give investors are supposed to paint a picture of how things are. Banks and their regulators want to turn that notion on its head so they can spin a smooth tale of how they would like things to be.

Sadly, some accounting rule makers may be ready to appease banks and the politicians who back them. If that happens, financial results will change from a vital tool for investors to a vehicle catering to managers, regulators and employees.

This would undermine the idea that the needs of investors drive markets, replacing it with a more corporatist outlook favored by companies and politicians in continental Europe and Japan. In other words, the goal of providing unbiased, impartial information about a company’s worth would be trumped by a company’s business model and the broader needs of the financial system.

This battle over financial reporting is playing out in the debate over proposed accounting rules for how banks value things such as loans and bonds.

The International Accounting Standards Board is hoping to have new rules in place by year-end. The Financial Accounting Standards Board in the U.S. is moving at a slower pace, though the boards hope to eventually agree to similar rules.

Both groups have come under fire from banks and regulators in the past month, although the IASB has drawn the most heat. That’s happened even though the IASB has already bent too far to please the industry.

Listen to Government

In late August, French Finance Minister Christine Lagarde wrote to the European Commission decrying some of the proposed rules while saying the independent IASB must be made “more responsive” to government wishes.

Banks and their regulators meanwhile have claimed that proposals from both boards rely too much on mark-to-market accounting. The American Bankers Association yesterday wrote to Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke asking that they bring up the issue at the meeting later this month of the G-20 industrialized nations.

The attacks go deeper, though, seeking to change the underpinnings of financial reporting and who it should serve.

The accounting-rule changes should gauge the worth of a company’s holdings based on its business model, according to a letter from the ABA last month. This would allow banks to overlook short-term changes in the value of a security because they decide to call themselves a long-term holder.

No. 1 Audience

The rules should also “improve the decision usefulness and relevance of financial reporting for stakeholders, including prudential regulators,” according to a document issued last month by the Basel Committee on Banking Supervision, a group whose members are central banks. In other words, investors should no longer think that they are the main audience for financial statements.

The practical result of such approaches would be to allow banks to report smoother results that supposedly reflect their long-term prospects. For banks, smoother profits would presumably lead to higher share prices. For regulators, less volatile results would supposedly make it easier to maintain financial stability.

The problem, as investors know, is that life, and markets, aren’t smooth. Conditions change, as do financial values.

Because of this, investors need financial statements that provide information about the current state of a company’s business and worth. The past two years, replete with unexpected failures of supposedly solid firms like Lehman Brothers Holdings Inc., have shown how vital that is.

Creditors Count

Plus, investors aren’t just shareholders. They include creditors such as bondholders, who need to know what a company is worth today in case it goes under.

Banks argue that their intent should matter. If a bank plans to hold, rather than trade, a security, it shouldn’t have to worry about daily fluctuations in its value, they say.

Both the IASB and FASB have given ground to this business- model view, although the FASB’s changes aren’t as onerous for investors.

The IASB, on the other hand, wants to give banks more chances to show holdings at their historical cost. In doing so, it also plans, unlike the FASB, to allow banks to completely ignore changes in the market value of some securities.

This may result in banks reporting puffed-up equity, giving investors a false sense of comfort. Two banks, for example, may hold the same AAA-rated security, which has fallen, say, $5 from a face value of $100. One might report a value of $95, the other, $100. This would make it difficult for investors to make apples-to-apples comparisons among companies.

Predicting Trouble

It may also leave investors in the second bank smarting if it turns out markets correctly predicted looming trouble for the bond’s value.

Oddly enough, the IASB has still come under fire from banks and regulators who argue the board is looking to increase, not decrease, the use of market values. This is because the IASB’s business-model approach won’t be allowed for securities that have low credit ratings.

This reflects banks’ true desire to record the value of all holdings based on their own view of how the economy and business conditions will play out. That may suit their purposes and those of regulators who will countenance any fiction if it means markets are momentarily calm.

It won’t do much for investors. They’ll quickly discover that when bankers paint pictures of rainbows, there probably isn’t a pot of gold at the end of it.

 

Mark to market has been taken too far, if the market is a fraud and sometimes it is, it can bring a viable business down just because of rules that says it has to have on paper a certain minimum capital requirement . That's nonsense. That's the real fraud.
A loan's market value is meaningless if all you are interested in is payment of interest and return of principal. A loss should only be recorded when it becomes clear the borrower defaults.

 

A loss should be recorded when a buyer defaults. There are a lot readers discussing that foreclosures are being gamed 6 to 12 months by banks to avoid recording losses. This clearly fraudulent behavior, apparently spreading.

Substantial writedowns should occur at 90 to 120 days of nonpayment in conditions like this year.

 

FASB Looks to Expand Mark-To-Market Rules - To Be Stronly Opposed by Banks


Accounting-rule makers are considering expanding the use of mark-to-market accounting, a move that is likely to be strongly opposed by banks because it could make their earnings more volatile and potentially force them to take big losses.

Many financial assets already must be marked to market, meaning their value is pegged to the ups and downs of the market. The new proposal being weighed by the Financial Accounting Standards Board would apply mark-to-market rules to all financial instruments, including loans, which make up a big chunk of banks' balance sheets and typically don't have to be marked to market.

FASB discussed the plan last month and is slated to do so again Thursday, though a formal proposal from the board on the issue isn't expected until late this year or early in 2010.

"It's a controversial idea and there's an awful lot of process ahead," said FASB spokesman Neal McGarity. "We're technically not even at square one yet."

The move would be intended to make a company's true financial condition clearer to investors and other users of financial statements, Mr. McGarity said.

But the banking industry, which successfully pushed to get the rules eased earlier this year, is likely to oppose such a change. Banks contend the mark-to-market rules unfairly punished them by forcing them to take big write-downs when their investments lost value in the market even though the market downturn was only temporary.

FASB softened the application of its mark-to-market rules earlier this year after complaints from banks and members of Congress -- a move that has boosted some banks' earnings and led mark-to-market supporters to allege that the board had caved to political pressure.

But Mr. McGarity said that the latest, tougher move isn't a reaction to that criticism, and that FASB had been discussing an expansion of the rules long before that.

If enacted, the move could cause banks' asset levels, and thus their book values, to fluctuate as assets that are now marked to market gain or lose value. In some cases, those gains or losses would count as part of net income; in other cases, they'd go into "other comprehensive income," a catch-all for various types of gains and losses that don't immediately filter into earnings.

FASB is working with the International Accounting Standards Board on the issue. The two boards plan to hold public roundtables next month.

Banks are already gearing up to oppose an expansion of mark-to-market. In a letter last week to FASB and IASB, the American Bankers Association said it was "deeply concerned" about the direction the two boards were taking on the matter.


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