An old expression says, "If wishes and buts were candy and nuts, then every day would be Christmas."
We've revised it for William Isaac, former head of the Federal Deposit Insurance Corp. and author of "Regulating systemic risk is a job for a council" (Accounting Today, July 20-Aug. 16, 2009, page 8) to be: "If his wishes and buts were candy and nuts, then there would have been no recession."
He's a wishful thinker who blames the financial crisis on mark-to-market accounting without acknowledging the role played by bankers who imprudently plunged into risky instruments. Simply stated, he's flat wrong.
A DOUBLE ERROR
Like a shortstop who drops the ball and makes a wild throw to first, he commits a mind-boggling double error with these words: "The Securities and Exchange Commission currently has oversight authority with respect to the Financial Accounting Standards Board, which promulgates accounting rules. This oversight authority could be transferred from the SEC to the [systemic risk regulation] council to ensure that accounting standards are not adopted without consideration of the potential systemic effects on the financial system."
His first blunder is declaring the SEC and FASB incompetent to set standards without supervision. His second is believing standards can and should be controlled politically to send false messages to capital markets.
To prove his point (and ours, unwittingly), he made this prodigious gaffe: "For example, accounting rules allowed the creation of off-balance-sheet special-purpose vehicles that resulted in increased leverage and risks in the financial system. Now that we are in the middle of a crisis, FASB is proposing to put those vehicles back on the books of banks, which will reduce their capital ratios and their ability to lend. These and other accounting rules are far too important to be left to accountants without proper government oversight."
Here are his mistakes: It wasn't rules that created excessive leverage, but the bankers' folly when they voluntarily drove truckloads of money through the loophole; his wish to leave this loophole open would produce glaringly false representations; and all good accounting will do is reveal how far bankers reduced their real capital ratios with excessive leverage. Isaac also bungled by saying FASB would put the vehicles "back" on the books, even though they had never been there before.
PROPAGANDA
In effect, Isaac urges a coup by a like-minded cabal that would propagandize the markets into believing everything is fine when it isn't. He doesn't grasp that the problem is that real capital ratios are low; instead, he faults financial reports for revealing just how low they are. He'd rather attack truthful accounting than secretive bankers.
This thinking is worse than wishful. In fact, it's muddled because it ignores the markets' inherent skepticism and insatiable appetite for more information. His positions aren't defensible because he wishes markets could be fooled by non-neutral standards. Beyond doubt, Isaac missed the strike zone.
WAIT, THERE'S MORE!
We didn't have to dig far to learn more about Isaac. On the Web site for his consulting firm (LECG), we found his March 2009 congressional testimony that unleashed a torrent of banalities blaming mark-to-market accounting for the collapse. He's put his thoughts out there attempting to shape public policy, so we're obliged to respond.
Isaac made these absurd claims: "There is nothing 'fair' about the misleading and destructive accounting regime promoted by the [SEC] and [FASB] under the rubric 'fair value accounting.' MTM accounting has destroyed well over $500 billion of capital in our financial system. Because banks are able to lend up to 10 times their capital, MTM accounting has also destroyed over $5 trillion of lending capacity, contributing significantly to a severe credit contraction and an economic downturn that has cost millions of jobs and wiped out vast amounts of retirement savings on which millions of people were counting. Taxpayers have been called upon to invest in our financial institutions to help repair the damage caused by MTM accounting."
No, Mr. Isaac, not really.
He might as well blame thermometers for hot weather or X-ray machines for broken bones. Here are the facts: Bankers took extreme risks without realizing it; when the markets finally assessed the risk, they pummeled the instruments' values; and GAAP required these facts to be reported. Rather than cope with clear reality, Isaac tried to drag others into his absurd world of denial.
He further mangled his credibility by falsely blaming the "MTM accounting rule known as SFAS 157" when he surely knows MTM gained general acceptance with SFAS 115, way back in 1993. All 157 did was standardize the value-measurement process. We speculate he hoped to demonize MTM by disingenuously suggesting it's something new.
LOPSIDED ACCOUNTING
Isaac described his resistance to MTM while he was FDIC chair because it applies only to assets. We concur about that shortcoming but endorse a completely different solution. Whereas he would balance lopsided accounting by reporting bad numbers for both assets and liabilities, we think balance demands reporting fair values for both.
The recession didn't send only bank asset values through the floor, but also discounted their debt values because they had become more risky. Since banks borrow short-term and invest long, they face disparity between debt gains and asset losses. Clearly, best practice reports both, instead of one or neither.
It isn't just us: FASB announced in late July that it would start working with the International Accounting Standards Board on applying MTM to liabilities.
WISHFUL THINKING
Isaac made this ludicrous claim in describing a real case (emphasis added): "The [mortgage-backed securities have] subordinated collateral of $172 million. The amount of subordinated collateral exceeds the worst-case loss projections, which means the bank does not expect to incur any losses on its senior MBS positions (positions that MTM rules have required be written down by $913 million). The MTM write-down required on this pool is more than nine times the maximum estimated lifetime losses."
Frankly, Scarlett, we don't give a darn about the difference between what bankers anticipated and what actually happened, except to question their competence when they exposed shareholders and the monetary system to huge risks without fully comprehending that the real worst case was nine times worse than they believed.
Instead of relying on wishful thinking about possible losses, mark-to-market accounting simply reports what unbiased market participants openly declare through transactions.
REAL OR NOT REAL?
He also said: "If we had marked those loans to market prices, virtually every one of our money center banks would have been insolvent." Excuse us for disagreeing, but a bank is solvent or insolvent based on facts, not financial statements. Good accounting principles will reveal whether it's solvent or not. Only bad principles can make an insolvent bank look solvent.
It's preposterous to report expected losses while acting as if the unexpected ones never happened. If that were possible, every Super Bowl would have two winners and Tom Watson would have won the British Open with an expected par on the final hole instead of his actual bogey.
WHO'S TO BLAME?
Isaac identifies this rogues' gallery of causes for the collapse: "Greed, inept regulation, rating agency incompetency, faulty monetary policy, unregulated mortgage brokers, and too much government emphasis on creating housing stock, particularly for lower-income borrowers. I believe one of the biggest culprits is MTM accounting."
We note that Isaac is unwilling to blame his own - the bankers who speculated in instruments without adequate due diligence. They failed to see that collective collateralized loans (with many low-income borrowers and many very small individual assets subject to price collapses) are far more risky than their familiar individual collateralized loans (with one robust borrower and one very large and stable asset).
They were suckered like rubes at the county fair. The gold ring turned their finger green, but they aren't willing to shoulder any blame.
INFLUENCING BEHAVIOR
This statement shows that Isaac doesn't understand financial reporting: "Accounting rules made to influence behavior are no substitute for good judgment and can interfere with appropriate business conduct."
Indeed, he's right - accounting rules should generate useful information that helps users make better decisions. They must not mislead users into bad decisions.
However, he doesn't comprehend his own point. If biased rules inhibit good judgment, then how on earth can he expect good judgments under mark-to-imaginary-much-higher-than-market accounting? Mark-to-market describes observed market values that move in tandem with real economic values, which, in turn, are shaped by the amount, timing and uncertainty of future cash flows. Whereas mark-to-market leads to transparent reporting of essential facts, Isaac wishes he could influence investors' behavior by omitting crucial facts from statements with the hope of misleading them into believing what isn't true.
THE BOTTOM LINE
Like untold millions before him, Isaac succumbed to the worst managerial temptation of thinking capital markets are driven exclusively by the contents of GAAP financial statements. Therefore, he thinks he can manage the markets if he can control accounting standards by creating a new bureaucracy to coerce FASB and the SEC into seeing the world through the cloudy lens he's looking through. This wish is nothing but misguided hubris.
Of course, if our wishes and buts were candy and nuts, there would be nothing but truth-telling bankers.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul
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