Questionable Accounting Rule Allows Banks to Record Gains Instead of Losses

Posted by Patrick O'Connor on 7/9/08 8:24 am

Believe it or not, there’s an accounting rule that allows banks to record gains when the value of their debt goes down. Sounds crazy, but it’s true—and banks are taking full advantage of the ridiculous rule. In fact, U.S. and European banks have recorded more than $8 billion in paper profits behind this method, according to FT.com.

FT.com
Banks find way to cushion losses
By Francesco Guerrera and Ben White

Banks are set to cushion the blow of more credit-related losses by using an accounting rule that enables them to record exceptional gains when their financial health deteriorates.

The method, which has allowed US and European banks to add more than $8bn in paper profits, faces increasing opposition from investors, analysts and credit rating agencies.

Under the rule, introduced in February 2007 after lobbying from banks, financial companies are allowed to use “mark to market” accounting on their own debt. As a result, if the price of their bonds and notes falls, banks can record a gain equal to the difference between the original value of the debt and its market price.

In past months, the rule has helped banks including Lehman Brothers, Citigroup, Goldman Sachs, Morgan Stanley and Merrill Lynch to boost profits.

Analysts forecast that Merrill and Citi, which report second-quarter results next week, will offset part of their expected multibillion-dollar writedowns with these gains. The impact of the accounting rule could be muted by a brief rally in debt markets in April.

Critics, such as David Einhorn, the hedge fund manager who has been shorting Lehman shares, say the rule lets banks record accounting gains when sentiment towards the companies worsens.

Mark LaMonte, a senior vice-president at Moody’s, said the credit rating agency had advised investors to strip out these gains from their analyses. “We are not big fans of the fair-value option when it is applied to a company’s own debt because the results are very counterproductive. It creates very poor quality earnings.”

Corporate governance experts say investors face difficulties in finding these paper gains as banks disclose them in different ways: sometimes in footnotes, sometimes in press releases.

“Investors should not be required to go digging deep into the regulatory filings to find out these gains,” said Lynn Turner, former chief accountant at the US Securities and Exchange Commission…Read More.

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