To fix the banks, Washington needs to get toxic assets off their balance sheets. That's easily said but not so easily done.
One reason is an obscure accounting rule that is the subject of intense lobbying by representatives of the banking industry ahead of congressional hearings on Thursday on the matter. A change to that rule could drain some of the banks' red ink and possibly make it easier for them to off-load the toxic assets. (See 25 people to blame for the financial crisis.)
Fair-value accounting, also known as mark-to-market accounting, requires banks to price assets on their balance sheets according to what you can sell them for on the open market. Seems logical enough. But how do you mark to market when the market is effectively shut down?
At the moment, there are few buyers for the toxic assets that are poisoning Citigroup, Bank of America and other major financial players. The unsellable loans sit on the banks' balance sheets at a huge loss, priced from zero to an optimistic 60% of what they might have sold for before the crash.
It's not clear where the banks are getting their prices. Some of the firms derive the asset values from financial models. Others try to gauge how much a group of subprime mortgage loans might be worth by looking at a price index, called the ABX, of related credit-default swaps.
But at a time of pessimistic forecasts and rising fear, many toxic assets are probably worth more than the bank models or credit-default-swap indexes suggest. For example, a recent reading of the ABX index puts the value of even the highest-rated subprime mortgage bonds created in 2007 at only 27% of their precrunch prices. Yes, Americans are behind on their mortgages, but even the most pessimistic prognostications do not predict that 73% of home loans will become worthless. (See pictures of the dangers of printing money.)
That's why the banking industry has been lobbying furiously to alter the accounting requirement that forces it to continue to lower the value of those assets, even though many of the loans that back those bonds have yet to default and perhaps never will. Those losses are amplifying the bottom-line losses at a number of the nation's largest banks, wiping out their capital and putting them ever closer to collapse.
A growing number of regulators seem to think some relaxation of the rules may make sense. The top U.S. banking supervisor, Comptroller of the Currency John Dugan, tells TIME he is in favor of letting the banks mark back up the value of some of their toxic assets. "I think there are some changes that ought to be made," Dugan says. Mark-to-market accounting is a problem, he says, for illiquid assets because "those things have just stopped trading altogether." Dugan does not support doing away with mark-to-market entirely; not even industry lobbyists want that. But his deputy will argue at the congressional hearings on Thursday that limited changes affecting the pricing of illiquid toxic assets should be made.
Others seem to be coming around to the banking industry's position. On Tuesday, Federal Reserve Chairman Ben Bernanke said he would support changes in pricing illiquid assets. Also this week, investor Warren Buffett said in a CNBC interview that he would favor suspending the mark-to-market rules. Even the Securities and Exchange Commission (SEC), which has long backed these rules, recently asked the Financial Accounting Standards Board (FASB), a private group based in Norwalk, Conn., that sets accounting rules in the U.S., to look into the matter. FASB spokesman Neal McGarity says his organization is doing that, but the banking industry is skeptical and wants more pressure from the SEC. "SEC is refusing to act further on this issue," says Scott Talbott, a top bank lobbyist. (See the top 10 financial-crisis buzzwords.)
Why the resistance? The FASB and the SEC say mark-to-market accounting is a key to the economy's transparency, and want to proceed cautiously before changing the rules for illiquid assets. Investors are already skeptical of bank stocks. Add more uncertainty to their books, and the shares might fall further.
But with few options left to save the banks, government officials might see a change to mark-to-market rules as the most promising way remaining to bolster the banks and their bottom lines. What's more, relaxing the accounting requirement might make it easier for Treasury to iron out a plan to remove toxic assets from bank balance sheets.
The Treasury Department is looking into purchasing those assets, whether through a public-private partnership or through some other mechanism. Part of the stumbling block is price. Paying more than the banks are able to say the assets are worth would certainly lead to criticism that the government is providing another massive handout to the banking industry.
But if the banks are allowed to market the toxic assets back up to their original precrunch prices or close to them, that would give the Obama Administration political cover: Treasury can come in and underbid the value of the toxic assets, declaring before Congress and the taxpayers that it is driving a hard bargain with the banks.
What price might Treasury offer? Treasury Secretary Timothy Geithner is doing a "stress test" of the banks to determine how much capital they need to survive. Whatever number that ends up being might be a good price for the toxic assets. "We want to get the assets off our books," says Talbott.