How the U.S. Banking System Was Madoffed by the FASB

In 2007, the FASB, who sets the accounting rules for US companies, issued FAS Statement 157, “Fair Value Measurements” and mandated companies to adopt the rule. I believe this rule had a devastating impact on the banking industry and the overall economy. The rule requires companies to mark their securities based on the exit price (for an asset, the price at which it would be sold (bid price)) rather than an entry price (for an asset, the price at which it would be bought (ask price)), regardless of whether the entity plans to hold the asset for investment or resell it later. There is a fundamental flaw with this approach because it assumes that markets are efficient. The truth is that markets are enormously inefficient despite what the academics believe. To understand How FASB Madoffed the US banking system, you first have to understand what money is, and what banking system is.

What’s money?

Nobody tells this, but it’s true. Money is debt. Money is created when a debt is created. When some one has x amount of money, it means somebody else owes him same x amount of money. The fact US is by far the most indebted nation on the planet. It’s also true we are also the wealthiest nation. Poor countries like Somalia have very little debt, but Somalis is also the poorest nation on the earth.

How is money created?

Most people think of money, they think of the printing press at the Federal Reserve. In the real world, money are created when banks make a loan. Money supply increases when banks make more loans, and it contracts when loans are being pulled back. During the depression, money supply decreased by 37%, and unemployment rate spiked to 25%.

Old American Banking System

For decades, the banks and other saving institutions lent money to businesses and consumers. They basically borrowed money at short rates and lent out at long rates. Money is made on the spreads between the short and long rates. This model was broken down in the late 70s and 80s due to inflation. Before this inflation period, banks lent money out at 8% when they borrowed at 4%, and everything was fine. But when inflation picked up and the Fed jacked up short term rates to double digits, banks' funding costs suddenly were higher than what they could get from the loans, and thus thousands of saving & loans and banks failed in the 80s and 90s.

The New Banking system

Instead of holding the loans on the books, banks in 1990s changed their business models by originating loans and selling them to investors through securitization. Banks no long actually lent money, capital markets were the true lenders. Business loans, personal loans, home equity loans, credit card loans were all funded by securitization market. The buyers of the securitization markets were pension funds, foreign and American banks, hedge funds and other investors. Even though some people called the system the shadow banking system, in fact it was THE banking system. The system worked fine, and from 1992 until the FASB adopted the new rule in 2007, we had almost uninterrupted economic growth for 15 years. The 01 recession was so mild, people barely felt it.

How FASB destroyed this new banking system

Before FAS.157, banks were required to take a loss when a bond stopped paying interests. We accountants called it an impaired loan, thus it must be charged off. For example, if a bond is bought by a bank as an investment, the bank recorded it at historical cost; i.e. if you pay $1000 for a bond and it pays you 6% per year, as long as the bonds pay you the 6%, no impairments are recorded. Then the new rule was adopted in late 07 and 08. The problem with the new rule is that it forces investors to recognize loss if the price of the bond falls regardless whether the bonds pays interest or not. With the new rules, it had a devastating impact on the market. Investors stopped buying asset-backed securities altogether, because they might have had to realize losses even if the bonds paid interests. When investors quit buying asset-back securities, banks stopped originating loans to sell them. Lending came to a halt in September. My neighbor is a finance manager at a local Toyota (TM) Dealership who told me that in September, Wells Fargo (WFC), HSBC (HBC), Citi (C) and other big boys completely pulled out of auto loan markets. Auto sales felt off a cliff since September.

The culprit if the current recession

The culprit of this recession is a shrinking money supply due to unwillingness of investors to purchase bonds. When investors quit buying bonds, in effect, liquidity in the economy disappeared. This unwillingness is a direct result of FAS 157

Banks are much healthier than they were reported to be

To figure out true earnings at a company, one must look at how much income taxes the company actually paid to the IRS. Large businesses were audited by the IRS once every three years, and company officials would go to jail if they defrauded the government; therefore, a company CEO or CFO have very little incentive to mess with the IRS. The best example would be Enron - even it reported lots of money to investors, but it reported no incomes to government. The same thing would be true for Indymac and Countrywide - they did not report income to the IRS, therefore, they paid almost no money to the government Last year, Citigroup reported 32 billion in losses to investors using GAAP. Take a guess how much it reported to the IRS? It reported $10 billion in profit and it PAID $3.5 billion to government. NO idiot would pay money to IRS if it didn’t have to.

Conclusion

If mark to market rules are modified or suspended today, I expect the US economy could grow above 8% in the 3^rd quarter.

Stock position: None.

Comments

[Bill Herbert:]

Excellent article. The credit function is critical to our economy, and as you say, the ill-fated FASB rules played a very large part in the system breaking down.

But it's also true that the massive corruption on Wall Street and in the mortgage origination business, both basically un-regulated by the Bush administration for eight long years, was a huge force in misdirecting investment, rewarding criminal behavior, and destroying investor confidence.

Mar 13 06:55 AM

[Willie Makeit:]

Frank, you support the model of mark-to-myth. An asset is worth what it is worth when it is sold ( whatever someone is willing to pay for it ) and not before.

FASB 157 didn't destroy the financial system. The Keynesian economic model which is a complete fallacy did.
You are applying Autrian economic model thinking to a fiat money system.

You're rong.

Mar 13 08:15 AM

[oldbanker:]

You miss the larger issue. Why are the banks holding this stuff (nicest word I can use)? If you walked into the bank and asked for a loan with these "securities" as collateral, they would throw you out on your ear. I guy from Wall Street shows up and they throw many at him for the same "assets". A bank should only be allowed to hold a very limited amount of they assets in unpriced securities.

Mar 13 09:26 AM

[Albert Meyer:]

If mark-to-market is such a great thing, why doesn't FASB mandate that stock options (warrants actually) be marked to their intrinsic values every quarter instead of using models that are utterly flawed? Because that way, shareholders would learn on a timely basis how much money executives are stealing from shareholders.

At least, on exercise of options (warrants), the intrinsic values should be compared to the values that were accrued at grant date and the numbers should be trued-up to correct the accruals. That's what we do with valuation allowances and other such estimates. But ah, stock options (warrants) are the executives’ pet scam and we are not going to bite the hand that feeds us. FASB is in cahoots with the “scamsters.” The "F" is FASB stands for "fraud." OK, a bit harsh, but I hope you get the point.

FASB is inconsistent and politically compromised, hence these glaring contradictions. You can't mark assets to market when no market exists. (A market for employee options exists. Telefonica buys call options to cover the option grants they make to employees. Consequently, they accurately account for the cost of options and also avoid shareholder dilution. The best of both worlds with the compliments of the Spaniards – shame on us.) I think FASB misjudged the doomsday devise they concocted and then their pride would not allow them to back down.

Mar 13 09:27 AM

[Ed-M:]

Frank, if the banks are allowed mark-to-model, they will invariably mark-to-fantasy, using flawed models backed up with shoddy data unless directed otherwise by regulators. This is what helped lead to the unhappy results in the stocks, bonds and credits markets that are still bedeviling us today. Any mark-to-model regime must reveal all model and data used; any deviation by the market from the model greater than -5% from model value must trigger mark-to-market IMO.

Mar 13 09:29 AM

[petyaczar:]

Sarbanes Oaxley begat Mark to Market in response to Enron.
The U.S. Congress begat Enron when they deregulated essential gas and electricity and opened it up to speculators.
The politicians are the handmaidens of FASB 157
The Politicians are the root cause of this accounting crisis (FASB 157) that created a financial panic and the subsequent credit squeeze.

At its core, Mark to Market requires someone who has no interest in selling a performing asset (A willing owner and jence an unwilling seller) to discount said asset to the point at which an unwilling disinterested party (buyer) MIGHT become interested.

THIS IS BEYOND STUPID.

Kill Mark to Market and FASB 157, drive a stake thru its heart, cut off its head,burn the corpus delecti.
The politicians have used Mark to Market to pull off a Coup de Tat and destroy the capitalist free market system.

The politicians are using this "crisis" to expand government power as they bring America into a socialist state.

Never allow politicians to mess with the accounting system, else before you know it 2+2 is redefined as equaling 1.3 - or some such.

Never confuse accounting with reality.

Solve the root cause of this problem and the economy will be restored as the financial system is restored and markets will soar as credit begins to flow when confidence in balance sheets is restored

1)Get rid of Sarbanes Oaxley = Mark to Market
2)Get rid of FASB 157
3)Reinstate Glass Steagall Act
4)Reinstate the uptick rule on short sales
5)Increase margin on commodity futures trading to 50%
6)Make it illegsal for politicians to mess with the accounting system.

IMO

Mar 13 09:32 AM

[mark ferraris:]

Well said. I hope the board members at FASB read it. A little Econimics 101 refresher course for them.

Mar 13 09:59 AM

[Albert Meyer:]

7) Change the tax code code to get rid of stock-based compensation as a tax deduction for corporations. No such deduction in Canada and other countries

8) In financial statements, expense the intrinsic value of stock options (as it is currently done for tax purposes), i.e., trash Black-Scholes for option accounting

9) Lower corporate tax rate to 25%. China's corporate tax rate is 25% - a communist country; oh, the irony...



On Mar 13 09:32 AM petyaczar wrote:

> Sarbanes Oaxley begat Mark to Market in response to Enron.
> The U.S. Congress begat Enron when they deregulated essential gas
> and electricity and opened it up to speculators.
> The politicians are the handmaidens of FASB 157
> The Politicians are the root cause of this accounting crisis (FASB
> 157) that created a financial panic and the subsequent credit squeeze.
>
>
> At its core, Mark to Market requires someone who has no interest
> in selling a performing asset (A willing owner and jence an unwilling
> seller) to discount said asset to the point at which an unwilling
> disinterested party (buyer) MIGHT become interested.
>
> THIS IS BEYOND STUPID.
>
> Kill Mark to Market and FASB 157, drive a stake thru its heart, cut
> off its head,burn the corpus delecti.
> The politicians have used Mark to Market to pull off a Coup de Tat
> and destroy the capitalist free market system.
>
> The politicians are using this "crisis" to expand government power
> as they bring America into a socialist state.
>
> Never allow politicians to mess with the accounting system, else
> before you know it 2+2 is redefined as equaling 1.3 - or some such.
>
>
> Never confuse accounting with reality.
>
> Solve the root cause of this problem and the economy will be restored
> as the financial system is restored and markets will soar as credit
> begins to flow when confidence in balance sheets is restored
>
> 1)Get rid of Sarbanes Oaxley = Mark to Market
> 2)Get rid of FASB 157
> 3)Reinstate Glass Steagall Act
> 4)Reinstate the uptick rule on short sales
> 5)Increase margin on commodity futures trading to 50%
> 6)Make it illegsal for politicians to mess with the accounting system.
>
>
> IMO

Mar 13 10:01 AM

[henarl:]

Mark to market is not the sole culprit of our banking problems but it is certainly a big part of the them. In spite of the M2M nazis, we need to suspend it now so we can put the banks back in the lending business and get the economy moving again. We can argue about a better pricing method for loans later.

Mar 13 11:54 AM

[Amitabha Mu...:]

The one strong point which most of the people are missing that all these happened because the world financial system has come to a road crossing. If we think out of the box we will find that everything was running smoothly untill the fall of Lehman Brothers. It suddenly came to light that there was a big rot happening for quite some time which no body could notice. Now why it happened that way?. Because even long after the cancer was eating the body of the patient the patient did not report it. When it was ultimately reported then there was nothing that could be done.
It is of paramount importance that allround extension of credit was necessary. Otherwise it would not be possible to create unprecedented wealth. But in the new financial system as soon as a bad debt is generated it should be immediately informed to the central bank and then an equivalent amount of freshly printed money to be sent to the affected bank.Then when the home owner would start paying at a softer rate that money should be directed to the central bank which again would burn the money. This way this huge financial tsunami could be avoided.

Mar 13 03:34 PM

[petyaczar:]

Henari,

Mark to Market is the Primary culprit and the root cause of our financial crisis. Unless one considers the idiotic, ignorant, arrogant, and totally out of touch politicians on both sides of the aisle in the U.S. Congress as the root cause.

They changed the accounting system. It became a 3 inning game scored by ever changing an irrelevant rules that had nothing to do with anything.

IMO

Mar 13 05:02 PM

[Ransome:]

If we have a CDO cubed made up of several tranches of 10,000 ALT-A loans that were originated under different standards such a NINJA, how do you value it? Perhaps the securities are too complex. Our financial products are so complicated that risk cannot be assessed. Theoretically, you did not need to assess risk carefully if you could buy protection. Look at the results of AIG mis-assessing risk. Will this become the norm? No one will touch these things unless at a steep discount because of their structure. These securities were not meant to be held by the broker dealers, hence the shoddy origination standards.

Correct me if I am wrong but M2M establishes the rough value of a company and is used to determine capital requirements. How do you determine capital requirement and assess risk with M2Myth? Both will become important in the future with respect to Regulators. Where are the examples of securities that are grossly mis-priced using M2M? Certainly by now they have a track record of returns so why not M2Model? Why change the accounting?

Mar 13 06:29 PM

[gtmcduffy@g...:]

FASB 157 was issued in Sept 2006, not in 2007.

www.securitization.net...

I didn't read the rest of your article because you couldn't even get the date of issuance correct. If you're going to write an article on this very important subject matter- at least do some basic research.

bloggingstocker.blogsp...

Mar 14 07:04 AM

[waldipup:]

"Money supply increases when banks make more loans, and it contracts when loans are being pulled back. During the depression, money supply decreased by 37%, and unemployment rate spiked to 25%."

How much has the money supply been shrinking right now based on less current lending?

Separately , the marked to market rules are not that simple to quantify fairly .

How can you just ignore an inventory that is currently selling for half its former value?

How do you decide if it is a temporary "ignorable" drop , worthy of being overlooked per overall valuation accounting policy,

Or a valid long term revaluation (rangewise , anyway) ,

Making it fantasy to simply ignore it? .

Mar 16 01:35 PM