Posted by Joseph Y. Calhoun, III

Bloomberg carries this story about a recent preliminary decision of the FASB:

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.

For those of you who don’t remember, fair market accounting is also called mark to market accounting and contributed greatly to the recent financial crisis. Back in April, the FASB relaxed the rules regarding fair market accounting so banks could continue to carry some of their toxic assets at historical or mark to model values. One of the side effects of this is that the PPIP was essentially rendered useless. Banks no longer have any incentive to sell their bad assets through PPIP since they can carry them on their balance sheets at values greater than they would realize by selling them.

Fair market accounting sounds like a good thing as it provides more transparency about the value of assets on the balance sheet. However, we should not forget that fair market accounting also played a role in the leveraging of bank balance sheets when the value of mortgages was rising. As the mortgages rose in value, banks marked them up and added more leverage based on the new higher values. When the values crashed, they had to mark them down. Banks had no problem marking to market when the values were rising but when they crashed they decided mark to market somehow wasn’t fair.

Fair market accounting does make balance sheets more volatile in both directions so while there is some gain from the increased transparency, there is an offsetting loss when it comes to volatility of earnings. The quarterly change in the value of loans being held to maturity (if banks truly intend to hold them to maturity) is basically irrelevant if the borrower is current, so I don’t see what is accomplished by requiring banks to value them so frequently. If the loan is ultimately paid off, what difference does it make if the value dropped from one quarter to the next?

On the other hand, the way the FASB is approaching this may be the only way to cut this gordian knot. Not all loans will have to be included in the income statement but instead will be included on a new line item  called comprehensive income. The information on loan values which was once buried in the footnotes will now be raised to a more prominent place on the financial statements. Investors can then choose how to use this information. In some cases, it might be an early warning sign of coming trouble while in others it might just be a interesting piece of information that needs to be tracked.

It seems to me that the FASB and the regulators need to get together and decide how relevant this information is for regualtory purposes. One of the goals of the new regulations being considered is to make them countercyclical. When times are good, banks will be required to reserve more for the inevitable bad times. Fair market accounting is pro cyclical in that it allows banks to mark up assets in good times and requires them to mark them down in bad times. In other words, the fair market accounting rules will work against the potentially new bank capital rules. That needs to be resolved.