Accounting Rule Changes Creating False Rally in Financials

Includes: BAC, C, GE, GS, JPM, MS, WFC, XLF
by: Rakesh Saxena

On Friday, a veteran Wall Street analyst predicted that, despite recent gains, bank shares now incorporated significant further upside. “Within weeks, we will see major changes to mark-to-market and fair-value rules,” she told CNBC. “The changes will enable the banks to rationalize solvency ratios in the current climate, to get on with their business and to post higher operating profits.”

Her comments followed a day after the House Financial Services subcommittee warned the Financial Accounting Standards Board (FASB) and the SEC in no uncertain terms to alter the manner in which assets are valued within weeks or face legislative action on the issue. (The SEC interprets and enforces FASB standards). Congressmen apart, numerous key participants in the capital markets, including publisher Steve Forbes, are convinced that the mark-to-market rule itself was the principle reason for the financial meltdown. Edward Yingling, president of the American Bankers Association, says that House subcommittee’s proposition addresses “systemic risks that accounting standards can have on the economy.”

But accounting methodologies don’t create systemic risks; systemic risks are generated when leverage and counterparty risks collide, particularly in circumstances where key economic indicators (like joblessness, household net worth and consumer demand) turn decisively negative. Mr. Yingling is not alone in attempting to give Americans the impression that the banking crisis is not a consequence of irresponsible lending, poor risk management practices and derivatives-induced leverage. Wall Street’s bankers have also started to publicly claim that the “maturity value” of the assets on their books is much higher than valuations implied either from marking those assets to the market or from unduly conservative measurements of illiquid holdings (Level 3, FAS 157).

The first problem is that when asset values, including home prices, were breaking one record after another, the same bankers were quite happy to work with the mark-to-market rule; in fact, the rule enabled Wall Street’s financial institutions to expand leverage, to declare impressive profits and to structure credit default swaps and collateral debt obligations by relying on counterparty risk guidelines established by the rating agencies.

The second, and more serious problem, is that the largest components of systemic risk today are rooted in status of counterparty credit, domestically and internationally, with respect to trillions of dollars of currency swaps, structured notes, index puts and far-forward foreign exchange contracts; this exposure is outside the CDS and CDO matrix. Financial policy makers within the Obama Administration appear to have decided to defer the true assessment, and public disclosure, of such systemic risk by essentially manipulating accounting standards. Two weeks ago, the focus was on “stress tests”. Now, for good reason, there is silence on that front.

Because any credible stress test must incorporate two fundamentals: inputs on the future shape of the underlying economy and variations in counterparty risk. A Citigroup (NYSE:C) risk manager told this writer yesterday that, “in broad terms, counterparty risk will improve with an economic turnaround, that's what we are assuming.” That may or may not be the case.

Information from Eastern Europe, for example, suggests that by the time any economic turnaround becomes a reality, hundreds of counterparties will simply walk away from derivative contracts and structured products. A number of corporations in India have stopped complying with margin calls for swaps and forwards. The biggest shock waves in the counterparty risk area are due from the impending collapse of the Eurozone. Noticeably, Citigroup CEO Vikram Pandit, in his email letter to Citi employees on March 9, 2009, did not reveal if counterparty risk was included in stress tests his bank conducted.

Bulls and value investors on Wall Street have been busy this weekend selling the notion that the forthcoming changes in accounting rules, and the fiscal and monetary solutions to be agreed upon at a G-20 Summit in the first week of April, make a solid case for aggressive purchases of Bank of America (NYSE:BAC), Citigroup, JPMorgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS) and Wells Fargo (NYSE:WFC). One hedge fund manager is looking at an 80-100% rise in BofA and Citi, and 30-50% gains in JP Morgan, Morgan Stanley and Wells Fargo, by the end of this month.

Without doubt, since fully-informed investors form only a small proportion of the capital markets, the spin and hype surrounding the “inherent evils” of the mark-to-market rule and Level 3 measurements could well take bank shares significantly higher this week. If that happens, this writer will re-initiate shorts. The determination of influential Congressmen to legislate yet another bubble is frightening indeed; changes in accounting rules will reinstate (and substantively increase) the very systemic risks which Ben Bernanke has been seeking to eliminate, or postpone, since the tumultuous days of the Bear Stearns rescue.

Disclosure: Author holds short positions in GE, XLF