Here's a stupid way to fix the banks: Change the rules!

Wall Street cheers up after accounting standards are weakened. Presto: Sick banks stage a miraculous recovery.

Published April 2, 2009 4:17PM (EDT)

You doesn't have to be a rocket scientist or Wall Street high-flyer to understand why the stock market has gone happily bonkers this morning. Giving into intense political pressure, the Financial Accounting Standards Board announced on Thursday that it would ease so-called "mark to market" rules. The bottom line: Financial institutions will now have more leeway to decide on their own how bad their toxic assets really smell.

I first ranted on the folly of this ultimate paper-over-your-problems accounting strategy last September, and then moderated my views slightly a few days later after talking to economist Mark Thoma. There is a legitimate issue here: When markets in a given asset are not trading actively, but a financial institution is forced to sell those assets anyway to raise capital, the resulting price may not actually be a "fair" representation of what that asset is worth. But according to accounting regulations in place since 2006, the price resulting from such a sale is then used as the standard by which to measure the value of any similar assets still on the books.

The new FASB regulation proposes a two-step process for determining whether a given market is inactive, and whether the sale of an asset can be considered "distressed." If so, the "reporting entity" is then allowed more flexibility in how to cook its books.

After evaluating all factors and considering the significance and relevance of each factor, the reporting entity shall use its judgment in determining whether the market is active.

Italics mine. Now, a legitimate argument can be made that the changes enacted by the FASB in 2006 might have gone a little overboard and resulted in exerting an undue amount of extra pressure on the banking sector. If we could be confident the the new rules are a smart refinement of existing regulations that represent an improvement in the status quo we could all sleep easy. But it's also all too obvious that banks have a huge incentive to abuse these rules to make their books look better. After the mess made by Wall Street over the last decade, do we really trust these jokers to be fair judges?

Some observers have suggested that the rule change will end up making investors more nervous than they already are, as they will now have even less clarity as to the true state of banking finances. So far, however, that doesn't seem to be the case. The market loves the new rules. As of this writing, around mid-day EDT, all the major indexes were up sharply. And that alone should be cause for misgiving.

One last note: This particular Wall Street-friendly rule-change can't be pinned squarely on the White House. The original bailout bill passed last fall required the SEC to investigate mark-to-market rules. The SEC recommended changes and legislators from both parties have been vocal in calling for a weakening of the mark-to-market standard. If anything, the new rules may actually work at cross purposes to the Geithner plan for creating new markets for toxic assets, as it gives banks an incentive not to sell at prices they deem too low -- or "unfair."

Investors may be happy today, but it's hard to see how this does anything besides prolong the pain, and create further problems down the road.

UPDATE: Bloomberg reports:

Accounting analysts say the measure, which can be applied to first-quarter results, may boost banks' net income by 20 percent or more.

(Found via Calculated Risk.)

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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