Fictitious capital and mark to market accounting

FASB, the accounting entity responsible for setting basic rules of the road for financial statements, bowed to political pressure today and in a 3-2 vote gave breathing room to the same bankers who caused the mess we are in.

Let me explain.

Currently, banks must “mark to market” their assets including now toxic loans they made to subprime borrowers. Thus, if the bank made 100 in loans and then found those borrowers defaulting or late in their payments the value of those loans would fall, as it has in some cases to, let’s say, 30.

Now if a sample Bank A had borrowed 60 and secured equity financing of 40 to make the original loans of 100 then if those same loans are valued according to their market price – the price a willing buyer would pay for them – that is, 30, then Bank A is insolvent, would have to file for bankruptcy (slightly different for banks than, let’s say, GM) or be taken over by the FDIC.

Then the bank would get new management and be resold over time to another bank or broken up and sold off in pieces. It happens every week in the US and has been going smoothly as in cases involving WaMu and IndyMac.

But with the new FASB rules, Bank A can do its own internal analysis and tell investors that voila the loans made at 100 are worth 70 because their own analysis suggests some time in the future those loans will get paid off with interest.

According to The New York Times: “One of the dissenters, Thomas J. Linsmeier, argued that accounting rules already allowed the ‘fiction all banks are well capitalized,’ adding that the changes would ‘make them seem better capitalized.'”

Now apparently the FASB rule which allows this form of fictitious capital to be created (from 30 to 70 despite what the market says) is balanced by better disclosure to the market of the content of the bank’s analysis. That means that outside lenders and shareholders of the bank can have greater transparency into the bank’s real financial condition.

In theory then the market could do its own mark to market accounting of the overall value of Bank A if it thought the internal analysis were overly optimistic.

But notice what happens here: whereas under the current mark to market rules Bank A would be insolvent and the managers of that Bank would likely lose their jobs, under the new rules the managers get to stay in place!

FASB has just rewarded the very people responsible for getting us into this mess in the first place! And along the way the banks now lose their incentive to sell off the now inflated toxic assets to private firms as proposed by Secretary Geithner.

Does the right hand know what the left hand is doing here?