Wall Street’s Dishonest Accounting

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by Jim Rickards, Daily Reckoning:

This article is not a lesson on banking (I don’t want to put you to sleep!).

But it’s important to understand some basic banking rules in order to realize why the current banking crisis, which began in March, isn’t over.

Let’s start with what’s called mark-to-market accounting. It’s critical when it comes to determining asset prices and stock prices in particular.

The concept of mark-to-market accounting is fairly simple. Every bank or company has a balance sheet. On one side are assets — cash, stock, inventory, accounts receivable, real estate and a lot more.

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On the other side are liabilities — debts, accounts payable, leases, deposits (if you’re a bank) and much more.

When you subtract liabilities from assets you get net worth or the so-called book value of a company as accountants see it. Actual market value can be much higher or lower than book value based on investor expectations and other intangible factors.

Mark-to-market accounting is simply the use of market prices to value your assets. Everything else flows from that.

The Pros and the Cons

The case in favor of mark-to-market accounting is that it allows investors to see the real net worth of the companies they are investing in and to judge the solvency of banks they are putting money in.

When a company has a negative net worth (liabilities exceed assets), you might not want to invest in it. When a bank has a negative net worth (for example, where the deposits are greater than the assets), you probably want to put your money elsewhere.

The case against mark-to-market accounting is that in highly volatile and crisis situations, valuations can go to extremes, and this can create a distorted view of what are actually solid enterprises.

The extreme fluctuations in value can take a volatile market and turn it into a panic.

At certain times, banks have assets that are in good standing and likely to pay off in full at maturity but that go to extremely low valuations in a panic or fire-sale conditions.

Historic Cost

Another way to evaluate asset prices is through what’s called historic cost. Historic cost is what you paid for the asset when you bought it. Using historic cost accounting helps the bank to appear solvent and to get through temporary panic conditions.

Banks can use historic cost accounting for securities “held to maturity” but must use mark-to-market accounting for securities in a trading portfolio.

Various regulatory bodies such as the SEC and the Fed are responsible for applying those rules to specific entities under their jurisdiction or supervision and can create further exceptions.

We’ve seen this tension between historic cost accounting and mark-to-market accounting play out in real life over the past 25 years.

In the aftermath of the Enron and WorldCom scandals (2001), there was a view that the companies had used historic cost accounting to cover up losses and defraud investors. That led a movement to mark-to-market accounting that was reflected in the Sarbanes-Oxley Act (2002).

But by the time of the global financial crisis (2007–2009), there was a view that mark-to-market accounting was causing financial panic because subprime mortgages were crashing in value and taking the banks with them.

At that point, the pendulum swung the other way and mark-to-market accounting was eliminated for all financial assets except actively traded securities. This allowed banks to put their mortgages in the held-to-maturity account and sweep the problems under the rug.

A Green Light for the Banks

One fascinating aspect of the switch to historic cost accounting is that it coincided almost exactly with the bottom of the stock market crash in 2008–2009. Technically, regulators didn’t abandon mark-to-market accounting. Instead, they said the “market price” could be based on orderly markets rather than panic markets.

That gave banks and other companies enormous leeway in deciding what their assets were worth, and, by extension, what their stock price should be.

The decision was widely expected to be adopted by March 2009. That was the exact date when the stock market hit bottom — March 9, 2009.

In other words, big investors understood that regulators and the government were going to cover up the problem by changing the accounting rules in favor of banks. That was a big green light to buy stocks. The stock market rally has been going on ever since.

Lesson to investors: Don’t worry about fundamentals; just watch how the government rigs the game.

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