Posted by Joseph Y. Calhoun, III

Mark to market accounting rules were relaxed earlier this year to allow banks more leeway on how they value the illiquid assets on their balance sheets. How they were able to convince the FASB to change the rules is a lesson in how things get done in our “mixed” economy (via the WSJ):

Not long after the bottom fell out of the market for mortgage securities last fall, a group of financial firms took aim at an accounting rule that forced them to report billions of dollars of losses on those assets.

Marshalling a multimillion-dollar lobbying campaign, these firms persuaded key members of Congress to pressure the accounting industry to change the rule in April. The payoff is likely to be fatter bottom lines in the second quarter.

The accounting issue lies at the heart of the financial crisis: Are the hardest-to-value securities worth no more than what the market is willing to pay, or did the market grow too dysfunctional to properly set values?

Banks didn’t complain about mark to market when asset values were rising and it allowed them to mark assets up (and therefore increase their leverage and profits), but when it was time to mark the losses, they decided they needed relief. It is true that many of these assets do not have functioning markets and are therefore hard to value, but why is the market not functioning? Is it the fault of the potential buyers who want to buy low or the fault of the sellers who want to sell high? Or more accurately, the sellers who can’t afford to sell low? It takes two to tango and the buyers want to dance; it is the sellers who don’t want to dip and are freezing the market. And as long as the government allows them to remain wallflowers, that is exactly what they’ll do. That’s also why the Treasury Department’s PPIP is doomed to failure. With new mark to market rules allowing them to value these securities at relatively high prices, there is no reason to enter the market - even one artificially pumped up by government leverage - and discover that the price is lower than the current mark.

So how much did the firms spend and what did they gain?

Earlier this year, financial-services organizations put their lobbyists on the case. Thirty-one financial firms and trade groups formed a coalition and spent $27.6 million in the first quarter lobbying Washington about the rule and other issues, according to a Wall Street Journal analysis of public filings. They also directed campaign contributions totaling $286,000 to legislators on a key committee, many of whom pushed for the rule change, the filings indicate.

Rep. Paul Kanjorski, a Pennsylvania Democrat who heads the House Financial Services subcommittee that pressed for the accounting change, received $18,500 from coalition members in the first quarter, the second-highest total among committee members, according to Federal Election Commission records. Over the past two years, Mr. Kanjorski received $704,000 in contributions from banking and insurance firms, the third-highest total among members of Congress, according to the FEC and the Center for Responsive Politics.

A spokeswoman says Rep. Kanjorski believes the accounting industry’s rule-making body, the Financial Accounting Standards Board, or FASB, made the right move since neither mark-to-market critics nor advocates are “entirely pleased with the outcome.” She says campaign contributions didn’t factor into the congressman’s thinking.

Congressional Attention

During a March 12 hearing before the House subcommittee, FASB came under intense pressure from committee members. “If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself,” Rep. Kanjorski said in his opening remarks.

“We want you to act,” Rep. Kanjorski told Robert Herz, FASB’s chief. Mr. Herz waffled about how quickly the standards board could act. Rep. Kanjorski leaned over the dais. “You do understand the message that we’re sending?” he said.

“Yes,” Mr. Herz replied. “I absolutely do, sir.”

FASB made speedy revisions to its rules. In an interview, Mr. Herz said FASB merely accelerated the matter on its agenda, and tried to be responsive to input from investors and financial-services firms.

The change helped turn around investor sentiment on banks. Financial firms had the option of reflecting the accounting change in their first-quarter results; they will be required to do so in the second quarter. Wells Fargo & Co. said the change increased its capital by $4.4 billion in the first quarter. Citigroup Inc. said the change added $413 million to first-quarter earnings. The Federal Home Loan Bank of Boston said the shift boosted its first-quarter earnings by $349 million.

Robert Willens, a tax and accounting analyst, estimates that the changes will increase bank earnings in the second quarter by an average of 7%.

So an expenditure of $27.6 million yielded over $5 billion in capital for just three banks. Obviously, the total for the banking industry as a whole was a large multiple of that. Not a bad investment for the banks. The lobbying extended to the SEC as well:

Conrad Hewitt, then the Securities and Exchange Commission’s chief accountant, says financial-services representatives, including the ABA’s, called his office repeatedly. He says he met with executives of Citigroup and Wells Fargo, among others.

Last year, Mr. Hewitt recalls, he challenged ABA lobbyist Donna Fisher and a Wells Fargo executive on their valuation complaints. “If you say you’re required to value the securities at 50 cents,” he recalls asking, “and you believe that the securities are really worth 80 or 90 cents, do you have a lot of buyers because of this unusually low valuation?”

The two responded that there were no buyers, according to Mr. Hewitt.

“Then maybe the securities should be valued at less than 50 cents,” Mr. Hewitt says he responded.

Ms. Fisher declined to comment, as did Wells Fargo. Mr. Hewitt now is a consultant to financial firms.

Notice that last sentence. I don’t know what role Mr. Hewitt played in getting the rules changed, if any, but his time in government service seems to have at least been a good place to make some contacts that might be useful in his new role as a consultant.

How did Congress get the supposedly independent FASB to change the rules? Intimidation:

Mr. Yingling, the ABA president, says his organization assigned at least four of its roughly dozen Washington lobbyists to meet with members of the House Financial Services Committee.

“Their instructions for the early part of this year were to talk to as many people about ‘mark to market’ as they can,” he says.

In late January, Mr. Yingling says, he met with Rep. Ed Perlmutter, a Colorado Democrat. Mr. Perlmutter said he was “very concerned” about the mark-to-market accounting issue.

The ABA sent campaign contributions, ranging from $500 to $5,000, to the 33 committee members. The ABA’s political action committee, Mr. Yingling notes, was focusing on dozens of issues in addition to mark-to-market accounting.

Rep. Perlmutter received $2,500 from the ABA, according to public filings. He says he believed the accounting rules were causing “a drastic loss in capital that never should have occurred.” He says the ABA money “had no influence” on his thinking.

Rep. Frank Lucas, an Oklahoma Republican, also received $2,500 from the ABA, the filings indicate. He says the contributions didn’t sway his thinking and that the rules were making it difficult for even healthy banks to weather the downturn.

On Feb. 18, FASB said it didn’t expect to complete its examination of mark-to-market standards until the end of June.

Banks, credit unions, Federal Home Loan Banks and insurance company trade associations launched in late February what they called the “Fair Value Coalition.” Its goal was to change the accounting rules. The coalition itself raised no funds, leaving it to its members to make political contributions.

On March 5, Reps. Perlmutter and Lucas introduced legislation to broaden oversight of FASB, putting it under the purview of not only the SEC, but also the Federal Reserve Board, Treasury Department, Federal Deposit Insurance Corp. and the Public Company Accounting Oversight Board.

Four days later, the Fair Value Coalition wrote to Rep. Barney Frank, the Massachusetts Democrat who heads the House Financial Services Committee, and to Rep. Spencer Bachus, an Alabama Republican who was an early advocate of changing the rules. The letter, signed by 31 institutions and trade groups, called on Congress to use the hearings to address the “unacceptable” pace of FASB and to “correct the unintended consequences” of mark-to-market accounting.

In an interview, Rep. Frank, who got $8,500 from coalition members in late March, said a “wide range of people concerned about the economy, not just banks, were pushing for this.”

Rep. Kanjorski scheduled a hearing on the issue for March 12. Bank lobbyists jammed a congressional hearing room. In his opening remarks, Rep. Kanjorski threatened that Congress would get involved if FASB didn’t act. Rep. Perlmutter said mark-to-market accounting was “exaggerating and multiplying” the economic slump. “We have been dithering while this patient’s been sick,” he said.

Speedier Timetable

Rep. Gary Ackerman (D., N.Y.) and Rep. Kanjorski pushed Mr. Herz to agree to a speedier timetable. They repeatedly cited Rep. Perlmutter’s legislation to broaden oversight of FASB.

“It will be done in three weeks. Can and will,” Rep. Ackerman instructed Mr. Herz.

“Yes,” Mr. Herz replied.

“Can and will,” Rep. Ackerman repeated. Rep. Ackerman declined to comment through a spokesman.

A FASB director, Lawrence Smith, said at the time that FASB had little choice but to act. “We can’t ignore what’s going on around us,” he said.

On April 2, FASB introduced the changes that lawmakers sought. In a draft proposal, FASB changed its rules to say that financial firms could “presume” markets were dysfunctional unless there was ample evidence otherwise. Then they could use internal models to set values, rather than market prices. Their models are not fully disclosed to investors.

You either play by Congress’ rules or you get a little more “oversight”.

I am of the opinion that banks - and all companies for that matter - should be allowed to use whatever accounting methods they so choose and let the market decide who is cooking the books. That’s pretty much how things work anyway; the stocks of the bad banks got punished a lot more than the good banks.

If we are to have accounting rules though, they need to be consistent so that investors can evaluate the securities of issuers. Changing the mark to market rules had real world economic consequences. A bank that would have had to raise new capital under the old rules was relieved of that requirement under the new rules. Existing shareholders got a windfall because an expected dilution did not take place and those who sold based on the old rules were, in a sense, duped into selling their shares at lower prices based on the potential dilution.

In the long run, if investors are unsure of the rules, they will invest less in the financial industry. That has consequences for the industry and our economy. The bankers and their political enablers may one day regret their shortsightedness, but by then the CEOs will be safely retired and the politicians will be safely re-elected. Then it’ll be time for the next fix and another round of graft. As the government becomes involved in more aspects of the economy, this type of activity will only increase. It benefits the established companies and the politicians, but the effects on the economy as a whole are anything but.