Obama's Regulation Success Depends on Accounting

The Obama administration's new financial regulatory paradigm may not have the desired effect if transparent accounting standards are not developed.
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As the Obama administration unveils a new regulatory paradigm, one critical but oft-overlooked component will be setting definitive and transparent accounting standards.

So-called "toxic" assets, their ambiguous values and firms' exposure to them are at the heart of the crisis. They still plague balance sheets, and threaten to do so until a solution is reached.

The four largest banks in the country,

Bank of America

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JPMorgan Chase

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Wells Fargo

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, reserved $114 billion against potential losses on loans and other assets. However, it's nearly impossible to tell what metrics were used to determine how much they should be reserving for.

The banks are not required to use the same assumptions of economic conditions that could impact the value of their loan books, or view similar types of loans the same way. That's partially evident in the banks' ratios of reserves to the assets covered by those reserves, which ranged from 2.71% at Wells to 4.82% at Citigroup -- a wide gap.

"You can drive a truck through the variance between one bank and another bank," says Jeffrey Curry, who advises financial firms on accounting practices at the consulting firm LECG.

The Obama administration's white paper on regulatory reform, unveiled Wednesday, addresses the issue by recommending that the three "accounting-standard setters" -- the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB) and the

Securities and Exchange Commission

-- come up with a plan by the end of 2009. The rules will have to handle impairment and long-term loan-loss provisioning with the goal of providing investors with "both fair value information and greater transparency regarding the cash flows management expects to receive by holding investments."

Banks have bristled against straightforward regulatory moves, including placing all bank supervision under one regulatory roof; forcing firms to place all assets on balance sheets, rather than obfuscating some in qualified special purpose entities, or

QSPEs; or using clean, standardized metrics for loss assumptions, as the government stress tests did.

Several industry groups, including the American Securitization Forum, Financial Services Roundtable, and the Securities Industry and Financial Markets Association (SIFMA), each issued supportive statements about the administration's broad goals, but none of them specifically mentioned accounting standards. And of course, with any type of reform, all parties agree that something needs to be done for long-term stability and improvement, but the devil will be in the details.

The industry argues that each company's balance sheet is a different animal, a product of different lending standards, asset mix and regional exposure. Individual companies know best how to treat loss assumptions, they say, and stress tests warped results by being overly conservative on some metrics and too optimistic on others.

However, it's little surprise that the stress tests were seen as a relief by investors, despite findings that banks would need another $75 billion worth of capital to withstand an economic maelstrom. (That doesn't include the extra cash they will need to get out from under the Troubled Asset Relief Program, or TARP.) Finally they were able to see what would happen when the same assumptions were used to determine loan losses and capital adequacy.

It seems to make sense that regulators would standardize accounting measures with a broad stroke, creating more transparency and, in effect, identifying "winners and losers" in the sector. But politics clearly come into play as well, as the Obama administration and their regulatory charges seek to boost confidence in a sector that still has troubles ahead.

The argument against mark-to-market accounting -- that the method is meaningless when a market doesn't exist -- has some merit. The easing of such accounting rules helped boost financial firms' first-quarter earnings, a boost that some analysts warn was based on anything but core earnings growth.

"I have always hated mark‐to‐market accounting," Richard Bove, an analyst at Rochdale Securities and vocal critic of the accounting standard, said in a report earlier this year. "It has seemed to me it obscures cash flowing through a bank and, therefore, creates a misinterpretation of banking results."

Still, changes to mark-to-market were temporary, with no indications yet on how the issue will be handled going forward.

An article in this month's

Harvard Business Review

by H. David Sherman, Dennis Carey, and Robert Brust takes a look at the challenges these issues pose to audit committees on companies' boards. The authors note that as mortgage-backed securities and collateralized debt obligations lost immense value in the frozen markets last year,

Merrill Lynch

changed its initial $4.5 billion writedown estimate to $7.9 billion in a matter of weeks. It then wrote down another $11.5 billion worth of securities the following quarter.

"What do these figures signify?" they write. "Was the original $4.5 billion estimate the low end of a range? Was the subsequent $7.9 billion the higher end? Was the additional $11.5 billion a result of deteriorating market conditions, poor forecasting, or biased estimates?"

Unfortunately, there is no definitive answer to those questions yet. And until a framework is in place, valuations will vary based on the manager overseeing valuation and risk.

Sherman, Carey and Brust note that it "certainly" provides an incentive to "show results in the most optimistic light." But amid the negative attention cast on front-page accounting scandals, and with populist rage running high, few of the best and brightest are eager to join audit committee's ranks.

"Join the board of directors? Yes. The audit committee? No," they write. "That's been the typical response from executives the world over."

While the Obama administration is trying to address these issues, a recent report in the

Washington Post

about political pressure at

Freddie Mac

has given regulators a black eye on several other counts. According to the article, officials at the Federal Housing Finance Agency may have advised Freddie to gloss over the fact that government programs to support troubled homeowners could cost the company another $30 billion.

Ultimately, using another accounting method, Freddie decided that wasn't the case anyway. But there was still tussling over whether or not to disclose the finding to the SEC -- in other words, to investors.

Another troubling fact is that while both Freddie and its sister company,

Fannie Mae

are effectively owned and operated by the government, and hold identical types of loans on their books, Fannie's accounting methods were different enough to come up with different results as well.

The Obama administration has done a stellar job at shoring up confidence in the system and greasing the wheels for an economic recovery. But over time, politics and economic conditions will change. Standards need to be in place for banks to value all types of assets, and firms need to be more transparent about what, exactly, they own.

Curry, a former senior capital markets officer with Fannie and Freddie's prime regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), notes that officials from the Federal Reserve spent a fair amount of time negotiating stress-tests assumptions and results with top banks. Whether or not that implies the Fed was doing homework for a future role in accounting oversight is unclear.

"You're never going to get the same number at every institution," he says, "but you're going to have to get to some point where you can reconcile the differences. It's got to be looked at because this process doesn't work."

Even some who are averse to overregulation agree that some type of reform and definitive standard is needed.

"You cannot regulate models -- these are pretty complex assets," says Andrey Krakovsky, chief investment officer of the hedge fund Tacticus Capital and a

Morgan Stanley

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alum who has worked on valuing subprime CDOs and asset-backed securities. However, he adds, "there needs to be something -- some kind of language -- that ensures that there's a common denominator in valuing these securities across the board."

Otherwise, when confidence fades, investors will still have to make judgments based on nothing more tangible than sentiment.

Banking analyst Meredith Whitney said earlier this week at an economic conference that she expects to see some "funky stuff" occur on bank balance sheets for the next couple of quarters, at least under current accounting standards. Banks' use of deferred tax assets, combined with capital from the Troubled Asset Relief Program, and other federal support of the markets will make things look good for awhile, but the reality of the situation is far different, she says.

"I think you're going to see a lot of manufactured growth, but not core, earnings growth" until 2010, says Whitney.

She adds: "It's just simple math."