William Isaac, former chairman of the FDIC and chairman of consulting firm LECG's global financial services unit, expects banks to react very negatively to the Financial Accounting Standards Board's (FASB) recent proposal to add loans to the list of financial instruments that banks are required to report at market value.
Isaac told AccountingWEB in a telephone interview that, "Banks will respond very negatively and will pull back from long term lending.
"FASB's proposal is incomprehensible and irresponsible," Isaac said. "There is a high risk that just proposing that loans be reported at market value can cause banks to tighten up even further on lending than where they are now. They will become extremely reluctant to lend to small and medium-sized businesses in an already weak economy that is dependent on these businesses for growth, especially in employment.
"The three members of the board who voted in favor of this proposal are like religious zealots worshipping at the altar of fair value. Not only is this proposal bad for the economy, it is bad accounting because it doesn't recognize the banking business model," Isaac said.
FASB issued the Accounting Standards Update last week "to bring more transparency into financial statements by incorporating both amortized cost and fair value information about financial instruments held for collection or payment of cash flows." Changes in the market value of the loan portfolio would be recognized in the statement of position.
Currently, banks' balance sheets carry loans at historical cost, less an estimate of the portion that is uncollectible, and give fair value information in the footnotes.
"Over a very long time the banking business model has been that banks take money that individuals and businesses deposit for the short term, expecting to earn a modest but safe return, and loan it to homeowners and businesses for the long term at a higher rate," Isaac said. "Banks function as an intermediary and absorb the credit risk and in many cases the interest rate risk. Now banks must value a loan as if they were going to sell it today, even though they don't intend to sell it – they are holding it to the end of its term and it is fully performing.
"For example, under current rules, when the bank makes a $1,000 loan to Mrs. Smith, they ask if Mrs. Smith can repay that loan. If the answer is yes, she can repay with full interest in five years, they value the loan at $1,000. If she loses her job and has no assets, like a home, the answer is no, and the bank will be lucky to get $200. The bank will immediately write off all or nearly all of the balance of the loan.
"The new FASB proposal will force the bank to determine what someone might be willing to pay to purchase Mrs. Smith's loan and write it to that value on a continuous basis. This is insanity. Banks are going to stop making loans and simply hold short-term investment securities. That is what they did in the Great Depression, which led President Roosevelt in 1938 to order the bank regulators to stop using market-value accounting and instead use historical cost accounting. FASB board members have no clue about the economic destruction they are causing.
"Accountants probably favor this proposal because it protects them from liability in valuing the assets. Regulators sued the big firms during the 80s and 90s for not valuing assets properly up or down and, while they never acknowledged culpability, they lost a lot of money. They do not want to go through this again.
"But what accountants really need is to be shielded from liability. They cannot guarantee an income statement. They are no more able to see around the corner than the rest of us.
"What accountants also need is a decent accounting system that allows for the banking business model – the historical cost-based accounting model. It is fine to disclose fair value in the footnotes, but it should not run through the income statement.
"It is hard to see how this ruling will benefit investors either, with the exception of short sellers, who love the pro-cyclicality that will result," Isaac said.
"It is also hard to understand how this helps convergence either. How do you get to convergence with what FASB is doing with fair value?" Isaac asked. "It will make it harder to get to IFRS, put a roadblock in the way. Why now?"
The proposed ASU was issued by FASB as part of a joint project with the International Accounting Standards Board (IASB) intended to improve financial reporting of complex financial instruments that would lead to development of a single converged financial reporting model.
FASB acknowledges that the two boards are far apart in their approach. FASB has taken a comprehensive approach – looking to apply market value in a consistent manner to all financial instruments, while the IASB has not fully embraced fair value and has been replacing its financial instruments requirements in a phased approach.
"The IASB has tentatively decided to retain existing guidance for financial liabilities except for financial liabilities measured at fair value under the fair value option," the FASB states in the ASU. IFRS currently measures most financial liabilities (including core deposit liabilities) at amortized cost if they are not held for trading.
Isaac also challenges FASB's claim that mark-to-market accounting leads to greater transparency. "Valuing assets according to current market values is so incredibly complex that it doesn't result in transparency – the information is anything but transparent," he said.
"I recently asked a top ten bank to estimate the impact mark-to-market accounting had on the banking system in 2008. They responded that they could tell me what impact it had on their bank but they had no way to know the impact it had on other major banks," Isaac said. "This was a very large and sophisticated bank and they could not look at the financial statements of competitor banks and determine how much their earnings and capital were affected by mark-to-market accounting. All of the major institutions, by the way, continued to perform reasonably well on a cash-flow basis throughout the crisis.
"An example of misleading conclusions that can be drawn from market value accounting would be, when, in the first quarter of 2009, I believe, Citigroup's bonds went down in value by a billion dollars or so and Morgan Stanley's bonds went up in value by a billion dollars or so. Most people would look at those two facts and conclude that Citi's troubles were deepening and Morgan Stanley's situation was improving. But market value accounting allowed Citi to add $1 billion to its income and capital on the theory that it could retire its debt for $1 billion less while Morgan Stanley had to deduct $1 billion from its earnings and capital because its bonds went up in value. This is not transparent and does not reflect the business model.
"It is very hard to understand why FASB did this at all, even more so at a time when they are so vulnerable politically. Under normal circumstances it is not easy for both houses of Congress to start from scratch with a measure subjecting FASB to oversight, but right now the legislation is there and they would only have to insert a few sentences."
Isaac said that he had been fighting hard for systemic risk oversight on FASB and the SEC. Last year, he participated in the same hearings before the House subcommittee on Capital Markets, Insurance, and Government Sponsored Entities as FASB Board Chairman Robert Herz, who said that the board would issue new guidance on mark-to-market rules, allowing financial firms some flexibility in accounting.
In that hearing, Isaac testified that immediate suspension of a mark-to-market accounting rule known as SFAS 157 was his highest priority, because "we needed to stop the senseless destruction of bank capital. I believe firmly that if the SEC and FASB had suspended this rule nine months ago – in favor of marking these assets to their true economic value based on actual and projected cash flows – our financial system and economy would not be in anywhere near the crisis that they are in today."
Isaac also testified that he believed there was an urgent need to change our system of setting accounting standards. He said that a proposal before the committee at that time to grant authority for setting accounting standards to a five member board (Public Accounting Oversight Board) consisting of the chairs of the Federal Reserve, the SEC, the FDIC, and the PCAOB, plus the Secretary of the Treasury, "had much to commend it."
The proposal was subsequently defeated.