Bankers Cry Uncle

The world's leading banks are demanding stock market and accounting regulators relax controversial accounting rules in order to stop the "downward spiral" of huge writedowns during the credit and housing crisis, $335b and counting.

These massive writedowns have led to emergency fundraisings of $260b and garage-sales of assets. The proposals were sent to US and European central banks, governments and accounting watchdogs, the Financial Times reports.

It's a controversy roiling the stock market and Wall Street, a serious debate I've warned you about already in prior blogs. The controversy has to do with mark to market rules, cheekily called "mark to myth" or "mark to make believe" as the rules let bank executives come up with their own internal models to arrive at these valuations for their asset-backed securities, ("The Reality Check That Bounced," "The Answer to Who's Next on Wall Street," and "What's Really Rocking the Stock Market").

The FT says the Institute of International Finance, an alliance of 300-plus companies chaired by Josef Ackermann, Deutsche Bank's chairman, is promoting a plan that would let financial companies soften the blow of financial crises by valuing illiquid assets using historical, rather than market, prices.

The IIF says: "The writedowns required under current interpretations [of the accounting rules] may be substantially in excess of any actual or reasonably probable loss on many instruments."

It's a controversy now on the radar screen of top officials in Congress as well as the Federal Reserve.

Chairman of the House Financial Services Committee Barney Frank, (D-Mass) has already said that there is an urgent need to review the "mark-to-market" rules as he says they are exerting a "downward pull" on the economy. Federal Reserve Chairman Ben S. Bernanke and Senator Charles Schumer (D-NY) at a Senate hearing several months ago debated the accounting rules as well, (Schumer suggested a six-month grace period on the mark-to-market rules, or use of some kind of moving average price instead, because "you really don't know the value of the asset, and if you undervalue it, you may be hurting things as much as if you overvalue it.")

The IIF plan would also let banks decide whether to hold asset-backed securities for as long as they want, freed from accounting rules that would force the banks to hold them to maturity. Instead, they would be able to book these securities on the balance sheet without taking the hit to profits, and then sell them after two years.

The bankers want the moon here.

I've told you already that Merrill Lynch used a neat end run, similar to what these bankers now demand, though the bankers now are clearly asking for more.

The move is perfectly acceptable under US accounting rules, which effectively lets companies bury some losses from their bad asset-backed securities on the balance sheet without taking the hit to profits. Merrill kept a recent writedown down to $6.5b by sluicing $3.1b in net pretax writedowns for securities backed by shaky Alt-a residential mortgages held at its US banks through an obscure financial statement line item called "other comprehensive income." That $3.1b would have brought the $6.5b up to $9.6b, but here's the thing. By slotting that amount in this line item, Merrill doesn't have to book the writedown in earnings. Instead it goes to the balance sheet and hurts book value.

A number of banks are copycatting this move, Bloomberg News says, avoiding a total of $35b in profit hits.

Back to what the IFF bankers want. Senior bankers have long sought a change to the accounting rules, arguing that the requirement to mark the value of assets to the market price even when markets are illiquid or frozen creates a vicious circle of excessive losses, capital depletion and forced asset sales.

So far, US and European accounting standard-setters have not caved in to demands to throttle back on the fair value rules. And while these securities may very well have decent assets tossing off cash flow, the truth is, bankers enjoyed sweet profits--and outsized compensation in many instances--due to these very same rules while the bubble was inflating.

So the question is: How did the rules help create the housing and credit bubble? Are they overstating losses? Is it fair then to stop the rules now?

To be sure, as I've already reported, the use of the "mark to market" rules gets even crazier on closer look. I'm going to relay back to you what I've already reported to you on this subject.

Companies and their auditors typically use a market index to get values for bonds backed by subprime mortgages. Banks generally use the ABX index, a thinly traded index that is barely two years old and is thought to be behind the chaos.

The ABX is a synthetic credit derivative index, or a basket of credit default swaps that are basically high-priced gambling bets on where investors think the direction of the underlying bonds backed by subprime mortgages are headed.

I know this is complicated, but bear with me, it's important. The swaps in the ABX are basically bets on the prices of the 20 supposedly most liquid (not saying much) subprime mortgage-backed bond deals. It's an understatement to say booking prices based on this index is accounting that is more art than science.

It's not just that the index was historically used to grab a quote, and not as a regulatory cudgel deployed by auditors.

Can an index based on values for just 20 bond deals legitimately be used for an asset class approaching $1.3tn in size? An index that historically undervalues the cash bonds it purportedly represents? An index noted for its negative sentiment and one that is routinely used by short sellers to attack these securities?

An index, depending on how you look at it, that is tossing off wildly different ranges of losses for the financials, anywhere from $220bn to $300bn to $400bn? An index that seemingly doesn't take into account that the underlying assets, that the houses, still exist?

The ABX is essentially throwing off prices based on perceptions, the perceptions of traders who are looking at the credit rating agencies who are looking at the auditors who are looking at the banks who are looking at the traders. All locked into a claustrophobic graveyard spiral. All calamitous for stocks.

And many asset-backed bonds are being wiped out even though they have no link to subprime--just look at the commercial-backed market in the United Kingdom, where no deals have been done since last summer, the worst since 1991.

So should the banks be allowed to book values for these securities based on the date they were issued or bought? Too inflated, yes, a rational argument, of course, don't allow bubble prices.

But how about a percentage of that value based on estimates of where housing is headed, given that the price-tags now being used are based on estimates anyway?

When auditors, no lie, are allowed to make "assumptions about assumptions market participants would use" when determining values, as certain accounting guidance reads?