Fix the Accounting, Then Fix the System

Almost all of the bailout plans being discussed fail to consider a simple fact: without the homogenization of accounting rules, any plan will represent a piecemeal approach to the problem. Some banks are holding out their hands to get TARP funds; they are on the brink of failure and are seeking a lifeline. Others are saying “Nah, we don’t want them (TARP funds),” because they don’t want the more stringent oversight applied to TARP recipients. In both cases, the motivations are less than pure, and neither facilitates greater lending to stimulate the economy. The system is broken, and current proposals do nothing to address the overarching issue: we don’t know the true tangible book value of ANY financial institution, and therefore are unclear as to which have strong capital positions, which are on the verge of failure, and which are essentially bankrupt but have been propped up temporarily with taxpayer dollars. As has been suggested by many, draconian steps must be taken to repair the system. Problem is, the only thing draconian so far is the damage done to the wallets of every US citizen today and tomorrow.

What needs to happen, right now, is to make EVERY financial institution apply mark-to-market accounting to their portfolios. No readily observable market? Have an administrator apply an independent third-party valuation that takes into account polling possible buyers. The only circumstance under which mark-to-market accounting can be avoided is if an institution has the intention of holding an asset to maturity and has the term financing in place to carry it. The two biggest problems with the current accounting regime relate to leverage and illiquidity. Banks have been financed largely with short-term capital, piled on top of a sliver of equity. But when assets have maturities extended either due to a changing rate environment (e.g., rising term rates cause mortgage-backed securities to experience longer maturities) or to rising illiquidity (e.g., CDOs, CDS’, high-yield bonds, leveraged lending commitments, etc.), the lack of term capital puts them in a very precarious position almost overnight. These kinds of surprises could have been avoided by forcing mark-to-market treatment, as we would have seen a precipitous decline in carrying values much faster than we did and dealt with the problem far more quickly.

As it stands today, those who argue against mark-to-market treatment say “This will just exacerbate the capital problem at troubled banks. And after the markets unlock, those assets will be salable at far higher prices.” Exactly. Let’s smoke out the problems NOW, and figure out the magnitude of the problem NOW. The fact that assets might fetch higher prices in the future is immaterial if you don’t have the balance sheet to get to the future, and it is certainly not the taxpayer’s responsibility to support those institutions’ common stockholders and bondholders in this mission.

On Monday, President Obama should get together with Mary Schapiro of the SEC and insist on a clean accounting of all financial institution balance sheets – IMMEDIATELY. We can then truly put a good bank/bad bank plan into motion that will be built on a strong foundation, instead of continuing to pump money into the Citigroups and Bank of Americas, firms with hopelessly distorted capital structures that need to be redone. NOW. People – Congresspeople, pundits, economists, bankers, President Obama, and everyone else with a vested interest – needs to get over themselves about what it means to be American. We screwed up – big time. Americans are an optimistic, can-do people. But in the absence of policy clarity, aligned motives and strategic thinking, we will limp out of this crisis like a terminally wounded animal. Alive, but destined to never regains its former swagger. We can get our swagger back, a better swagger, a swagger built on real value and not on vapor, if only we have the guts to effect real change. And it all starts with something as mudane as accounting. But sometimes the most complex problems can be addressed with the most simple solutions. And the beginning of our journey of healing has to be the marking-to-market of financial institution balance sheets. We simply can’t afford to wait any longer.

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