The GAAP between politics and economics

Congress has thrown everything it can at the financial crisis, and has left appropriate concerns -- whether moral hazard, corruption, subsidies, or upholding contract law -- to the side. This may well be a sensible approach: with workers out of work and the financial system collapsing, Congress and the Administration had to step in to prevent a potentially devastating negative cycle. But one must question a break for the financial system that occurs by deliberately obscuring the truth, which is exactly what Congress's call to suspend mark-to-market accounting did.

Mark-to-market, the process of valuing assets at the price of the last sale in the marketplace, has been a staple of accounting for financial assets under Generally Accepted Accounting Principles (GAAP). Congress, in arguing the practice should be suspended, is agreeing with financial firms that claim mark-to-market is creating the appearance that banks are losing money on assets when in fact the assets continue to perform as expected. This is particularly troublesome for banks that have to maintain capital buffers above expected losses -- the marks cause bank capital to fall, eliminating buffers and requiring banks to raise new capital. The financial industry, and their lobbyists to Congress, want to eliminate the need for new capital by failing to mark assets to the appropriate value.

This point of view makes sense from a regulatory capital perspective. If banks are holding these assets to maturity (as opposed to trying to sell them now), the assets make continue to perform and make required payments, posing no capital adequacy issues. However, mark-to-market accounting is not simply used for regulatory purposes; it is also used by investors. For this purpose, mark-to-market makes infinitely more sense. Instead of buying assets from a bank, an investor could buy those assets in the marketplace at the current lower price. If instead they buy a bank with the same assets, one would reason that the assets should be thought of at the current market price. Pundits cite this logic when arguing against suspending mark-to-market.

This creates a gap (sorry!) between GAAP accounting for investors and regulatory accounting. Congress is attempting to provide regulatory relief to the firms, but is inadvertently (or perhaps deliberately) making it difficult for investors to assess the value of financial institutions. Furthermore, and even more troubling, the alternative to mark-to-market is to leave valuation to the discretion of bank management. From this, troubles abound -- leaving accounting to judgment is inviting abuse. A little short on profit this quarter? Presto chang-o! Remark some assets! About to have regulatory problems because your bank issued bad loans? Zam! Not any more, we just changed our "judgment" on the value of some assets... and so on.

Alas, the banks won the issue, and Congress threatened the accounting industry (specifically, the Financial Accounting Standards Board, FASB) with legislation to change GAAP. Congress has done this before, on stock options expensing, with high-tech firms arguing it would spell the end of Silicon Valley. Last we checked, the Valley is doing fine, even now that they have to tell the truth about their financial condition -- and FASB told Congress tough luck and implemented options-expensing. Perhaps FASB sensed more was at stake here, but this blog thinks they would have been better off to dare Congress to intervene in independently set accounting standards.