Banks Get to Hide The Truth A Little Longer

The financial crisis on Wall Street has frightened the SEC enough.  They elected this week to allow the banks to use more optimistic valuations for their mortgage-backed securities.  The ostriches are winning.

I have talked about these proposals all year, for example here and most recently only last week.  To recap, banks are were required to account for some of the assets on their books (although not those held purely for investment) at resale value.  In the current market, the value of many of the mortgages in those portfolios have fallen through the floor, if there even is a market for them.  That has forced banks to raise capital in order to meet their regulatory requirements as well as to meet withdrawals by depositors.  But it has meant that banks have been forced to be bluntly honest about the current value of their assets.

The banks asked the SEC to allow them to change the method they use to value these ‘toxic’ assets and the SEC partially caved in this week.  The banks will be allowed to use a valuation method which, in effect, is an educated guess about the probability of the loans being paid off and what that stream of payments is really “worth.”  Of course the bank would not hold these loans if they didn’t think they would be paid by borrowers.  And of course in normal circumstances someone would be willing to buy the loan from the bank if they believed tat was really true.  So someone — either the bank or the potential buyers of mortgage-backed securities — is wrong about how to value these assets.

Traditionally Americans like to have the market decide what something is worth but, in this case, the SEC feels bank managers will be able to put a better value on the asset.  The same managers who hope to keep their jobs by keeping the bank afloat.

The changes in accounting rules presaged ’suggestions’ by Congress in the bailout bill passed today.   There is considerable disagreement among many about how good or bad these changes will be.  In Wednesday’s Wall Street Journal, David Reilly’s “Heard on the Street” column said,  “Put another way, if banks could pretend there isn’t a problem, maybe there wouldn’t be one.”  In the same issue, the Journal’s Holman Jenkins said:

A mere accounting rule can’t alter the underlying economics…- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics.

The fantastic — as in fantasy, not wonderful — belief that somehow investors will suddenly be more willing to invest in banks because their accountants and managers say they are in better shape beggars the imagination.  The one true thing about “mark-to-market” accounting was that it was brutally honest and did not allow for any “fudge” factors that might cloud the reality.  If an investor anticipated that the mortgages would be paid off, then they might see a buying opportunity in beaten-down banks.  Or want to run for the hills.  By changing “mark-to-market” to “mark-to-hope-for” accounting, the SEC has in effect said banks can cloud the picture with the goal of avoiding a day of reckoning.

And maybe get a few suckers to invest in bank stocks so the smart money can get out?  Only time will tell.

Related posts:

1. Lehman Tells the Truth and Has To File Bankruptcy
2. Banks Want Out of Tough Accounting Rules
3. Why can’t I get a mortgage modification?