American banks are filing their quarterly financial statements this month, a process that normally draws little attention from the general public. But these days, a lot of banks are in trouble. Wachovia's newest financial statement includes a loss of $24 billion.
Some banks insist the situation isn't as dire as their balance sheets suggest. They blame a bookkeeping rule known as mark-to-market accounting — a rule that regulators may soon change.
The issue came up again when Martin Sullivan, former president and CEO of the insurance giant AIG, testified before Congress about his company's collapse. AIG had just received an emergency loan for $85 billion, with more to come, from the Federal Reserve. Sullivan could have blamed the housing market or poor choices by management, but he trained his sights elsewhere.
"To assist the committee, I would like to focus on one particular factor, the role played by one accounting rule applied to corporations," Sullivan told lawmakers. The rule requires companies to value any given asset according to what they believe someone else would pay for it. They then record, or "market," this "market value" on their financial statements.
The problem, Sullivan explained was that some of AIG's assets simply were no longer trading. AIG sold credit default swaps, for instance, basically insurance policies on bonds. In September, when the credit crisis struck, no one wanted to own a credit default swap. It would have been like insuring beachfront houses as a hurricane bore down.
If AIG had been forced to sell its credit default swaps then, Sullivan said, the price would have been artificially low. With the market value plummeting, he argued, mark-to-market accounting turned AIG's balance sheet into a nightmare. Suddenly, a company with $1 trillion of assets was reporting tens of billions in unrealized losses.
As part of the $700 billion bailout, Congress ordered the Securities and Exchange Commission to review the requirement for mark-to-market accounting. The language in the Troubled Assets Relief Program, or TARP, gives the SEC the authority to suspend the rule.
Not everyone thinks that would be a good idea. "It would be a terrible mistake that would make the current crisis worse, rather than better," says Barbara Roper, director of investor protection at the Consumer Federation of America.
Roper says mark-to-market accounting makes it possible for investors to trust what companies report about themselves. "If people don't trust financial statements — and today, people do not trust financial statements — they're not willing to invest and not willing to lend," Roper says. "Part of the reason banks haven't been lending to each other is they don't know who the next to fail is, and they don't trust the information they're getting on bank balance sheets."
She has a name for the alternative to mark-to-market. She calls it "mark-to-myth."
In an odd twist, the current regulation doesn't require mark-to-market accounting in every situation. Banks are allowed some leeway to use computer models in gauging the real value of assets that, for whatever reason, aren't trading. The question is when they can exercise that leeway, and when they can't.
Some bankers insist that occasionally varying from the normal practice makes sense.
"I think the people that think mark-to-market accounting is the end-all and be-all have never tried to run a financial services company," says Sarah Moore, chief financial officer of Alabama-based Colonial Bank. "Banks have to use their own judgment about when to use mark-to-market."
Moore says that strict mark-to-market accounting tends to make balance sheets look overly rosy in good times, when the market overvalues things. In bad times, she says, the rule sends balance sheets into an overly steep decline.
Like a lot of banks, Colonial Bank holds some mortgage-backed securities — the kind of assets that investors are fleeing. Moore says Colonial doesn't plan to sell those securities right away. She plans to keep holding them in the hopes that the market will recover and their value will rise. Why be tied to what the market thinks at the moment, she asks?
"Say you're a dentist, and you have a building that you're running your dentist office [out of], using that building," Moore hypothesizes. "You have no intent to sell that building. That building is housing your practice — you don't intend to move. But if you had to mark that building based on what you could receive for it, the financials of your dentist practice would look a lot worse."
The government may be as divided on the issue as bankers and watchdogs. Within the past few weeks, two government agencies issued competing "clarifications" of the mark-to-market rule. The American Bankers Association liked one but thought the second made things more confusing.
As the debate over mark-to-market accounting continues, investors wanting to know how bad a bank's losses really are will have to consider the very fine print in the latest financial filings.