Friday, April 03, 2009

Bankers: After accounting rules change no more excuses

National Lead, follow or get out of the way: In a bow to industry and Congressional pressure the Financial Accounting Standards Board (FASB) change the accounting rules governing banks and other financial institution by weakening the Mark-to-Market rule. The Mark-to-Market rule has been criticized by many in the financial press as the prime cause for the financial meltdown that occurred last fall.

The previous interpretation of the rule stipulated that if there is no market for a security then its implicit value on a banks balance sheet is zero. This makes a great deal of sense when we are dealing with items like Asset Backed Securities whose underlying value cannot be determined or Credit Default Swaps whose market has evaporated. When the mortgage bubble burst a large number of very large financial institutions discovered that when the Mark-to-Market rule was applied to their balance sheet they were technically bankrupt. This was the immediate cause of the financial gridlock that occurred in October 2008.

The new rule by the FASB allows greater latitude by banks in interpreting the rule. FASB said that the objective of the rule change was to allow banks to determine what an asset could fetch in an "orderly" market but would not include "distressed" or fire-sale transactions. In other words, banks are now free to fantasize what an asset might be worth if an "orderly" market can be found. The U.S. Government is attempting to create a market for these "toxic" or "legacy" assets. One dissenting FASB member said, "I’m afraid that this change will result in fewer impairments being recognized, and I don’t think it will help the investor have confidence in the balance sheet."

The FASB is charged with setting accounting rules for American industry. The rules often have unintended consequences such as the financial industry meltdown of this past fall. Since the IRS recognizes FASB rules as defining how a company recognizes profit and loss a change in FASB rules can have far reaching effects.

A FASB rule change in the early 1990’s virtually eliminated the equipment leasing industry. Equipment leasing is halfway between renting and finance and the FASB has long struggled with how to interpret this. For example with equipment rental the rental company depreciates the equipment and recognizes rental income as ordinary income. With equipment finance, the purchaser of the equipment gets to depreciate the equipment and deduct the interest expense while the bank must amortize the income over the life of the mortgage. Leasing is just like finance except the leasing company still owns the equipment until the lessee buys it at the end of the lease. In a typical lease, a lessee pays two or three month of the lease upfront – this is the typical profit fro a leasing company. The leasing company would then sell the cash stream generated by the lease to a bank while retaining ownership of the equipment. Thus a leasing company would recognize income upfront and the "residual" at the end of the lease when the lessee purchased the equipment at "fair market value," typically 5-15% of the initial cost.

A FASB rule change required leasing companies to amortize their profit (typically the first 3 months payment) over the life of the lease while also recognizing income from the residual over the life of the lease as well. Thus leasing companies had phantom income from residuals while not being able to recognize income when they received it so while a leasing company might be flush with cash they showed an immediate negative balance on their books while at the same time owing taxes on income they may or may not ever receive. Thus with a small accounting change the FASB put most equipment leasing companies out of business.

Banks Get New Leeway in Valuing Their Assets

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