Accounting Is Too Important To Be Left To Accountants

EXECUTIVE SUMMARY

* Mark to market accounting is crippling the economy.
* Historical-cost accounting is more transparant.
* Accounting is too important to be left up to the accountants.

President Obama's highest priority needs to be reviving the economy. If he doesn't get economic policy right, little else on his agenda will be possible.

One step he should take immediately: Call upon the Securities and Exchange Commission to suspend without delay the system of mark-to-market accounting (specifically SFAS 157) adopted in 2006 by the Financial Accounting Standards Board. This rule is a major cause of the global financial crisis.

I confess that I considered advocating mark-to-market accounting when I was chairman of the Federal Deposit Insurance Corp. during the banking crisis of the 1980s. One of the many problems we faced then was the massive insolvency of thrifts due to their holdings of long-term, fixed-rate mortgages at a time of very high interest rates. I thought mark-to-market accounting might force banks to keep the maturities of their assets and liabilities in better balance.

The FDIC ultimately rejected the notion for three reasons. First, mark-to-market accounting could be implemented on only a portion of the asset side of bank balance sheets -- it was daunting to even contemplate the liability side. A system that captures one change in value without picking up other changes can be very misleading.

Second, we believed that mark-to-market accounting would impede banks in performing their fundamental function: taking short-term money from depositors and converting it into longer-term loans.

Third, we felt that mark-to-market accounting would be pro-cyclical, making it difficult for regulators to manage future banking crises. If we had followed mark-to-market accounting during the 1980s, we would have forced the nationalization of our largest banks, which were loaded up with Third World debt for which the markets were not functioning. Thousands of additional banks and thrifts would have failed because their long-term assets were under water due to exceedingly high interest rates. The country would have gone from a serious recession into a depression.

Mark-to-market accounting has destroyed hundreds of billions of dollars of capital during the past two years and has depleted lending capacity by 10 times that amount. We can't rebuild the economy unless banks are willing and able to lend again. Devotees of mark-to-market accounting cringe at the thought of suspending the rules. They argue it would result in a loss of transparency and an overstatement of values.

To the contrary, mark-to-market accounting has produced terribly misleading disclosures by valuing assets well below their true economic value. It is transparently bad accounting.

If the SEC suspends SFAS 157, banks and their regulators will value the affected assets the same way they value all the other assets on banks' books. They will consider the cash flows on the assets, the likelihood of defaults and the probable losses. Valuations and disclosures will be improved, not obscured.

Historical-cost accounting -- the cornerstone of generally accepted accounting principles -- is vastly superior. Under historical-cost accounting, marketable assets are carried on the books at their amortized cost, and the balance sheet contains footnoted tables showing the current market value of those portfolios. This gives investors all necessary information to evaluate the adequacy of a bank's capital and its earnings power.

Historical-cost accounting does not run market depreciation through the income statement and does not deplete bank capital (unless the decline in value is considered permanent). This system provides a more accurate financial picture of a bank than the SFAS 157 rules and does not destroy bank lending capacity.

The worldwide financial crisis demonstrates that major principles of accounting are much too important to be left solely to accountants -- or, worse yet, to an international board of accountants, as the SEC is considering.

We need to change our system of setting accounting standards to make it more accountable. Accounting principles affecting our financial system should require approval from both the Federal Reserve and the FDIC -- the two agencies charged with maintaining stability and picking up the pieces when a crisis hits.

It makes no sense to allow the SEC and the FASB to continue their senseless destruction of capital in our banks at the same time Treasury is using taxpayer money to recapitalize the very same banks.