Accounting rule a 'hot potato' in Congress

Former GE chief Jack Welch is among those who say fair value accounting has intensified the financial crisis.

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NEW YORK (Fortune) -- Regulators should expand the toolbox banks can use to place a value on hard-to-sell assets, market participants and accounting watchdogs told a congressional panel Thursday. But some legislators said they want more sweeping action now.

The capital markets subcommittee of the House Financial Services committee held a hearing to discuss the problems with so-called fair value accounting. The rules, which oblige financial firms to carry certain securities at the price they could fetch in a sale now, are widely known as mark-to-market.

Regulators put the practice in place to give investors a fuller picture of companies' financial position. Critics, including two prominent former regulators who testified Thursday, say the fair value rules have worsened the financial crisis by forcing companies to recognize steep paper losses on bonds that in many cases are still paying interest and principal.

Questions about the role of accounting in the financial crisis have intensified as the taxpayer tab for the bank bailout has risen. The government has spent hundreds of billions of dollars supporting banks from Bank of America (BAC, Fortune 500) and Citigroup (C, Fortune 500) on down, so the notion that some of the financial sector's problems stem in part from regulatory missteps is naturally attracting attention.

"This issue has become a real hot potato," said Rep. Judy Biggert, R-Ill., as she questioned Robert Herz, the head of the nation's private-sector accounting rule maker, the Financial Standards Accounting Board.

She told Herz she expects to see the board, which operates under the aegis of the Securities and Exchange Commission, act to limit the damage to bank balance sheets sooner rather than later. Other legislators chimed in as well.

"The key is to act expeditiously - cautiously, but expeditiously," said Rep. John Campbell, R-Calif., who told Herz and two government representatives that FASB should clarify its guidelines or Congress could grow impatient and take rash legislative action.

Herz said his board stands ready to act if the SEC asks it to and added that the accounting standards as written aren't the straitjacket critics make them out to be.

Along the same lines, the view offered up by most participants in testimony before the panel supported the stated position of SEC chief Mary Schapiro. She indicated last month that she expects changes in the rules to be made only at the margins.

"Recent market events do not demonstrate that mark to market should be abandoned but rather that other measures should be used to a greater degree alongside," said Tanya Beder, a risk manager who runs the SBCC Group financial consultancy in New York, in prepared testimony for the committee.

Beder was among seven private industry panelists to speak at the hearing, which was chaired by Rep. Paul Kanjorski, D-Pa. Kanjorski said earlier this week he wanted to solve the problem of excessive writedowns while maintaining the transparency of fair value rules.

His panel doesn't have the power to set accounting rules, though he said the hearing would help policymakers to "pursue consensus solutions together to this thorny, contentious issue."

The claim that galvanizes fair value skeptics is that the rules have steepened the economic downturn by pressuring banks' balance sheets and making them less apt to lend -- constraining businesses and further feeding the downturn.

Tom Bailey, president of the Brentwood Bank in suburban Pittsburgh and chairman of the Pennsylvania Association of Community Bankers, said in testimony that his bank has lent out less money because of questionable fair value writedowns. Bailey adds that these writedowns, which total $2 million, "represent lost opportunity cost to finance $20 million in loans" -- or nearly a third of the bank's lending volume over the past nine months.

"The issues before this subcommittee today strike at the heart of how community bankers will serve their marketplaces in the months to come," Bailey said in prepared testimony.

Bailey said the accounting watchdogs at the standard-setting Financial Standards Accounting Board should allow banks to add credit analysis to their assessment of securities valuations, which currently depend on what some observers call highly conservative dealer quotes.

While Bailey and Beder are among those who believe the rules must be made more robust, the panel also heard from two prominent opponents of fair value accounting: Bob McTeer, the former president of the Federal Reserve Bank of Dallas, and Bill Isaac, the onetime head of the Federal Deposit Insurance Corp.

Isaac argues that the fair value rules have unnecessarily wiped out $500 billion of banking industry capital -- which he contends has reduced U.S. lending capacity by $5 trillion. He says immediate suspension of mark-to-market rules should be policymakers' top priority.

"I believe firmly that if the SEC and FASB had suspended this MTM rule nine months ago -- in favor of marking these assets to their true economic valued based on actual and projected cash flows -- our financial system and economy would not be in anywhere near the crisis that they are in today," he said in prepared testimony.

McTeer agreed, saying in his written testimony that "much of our recent wealth destruction has resulted from slavish adherence to an accounting dogma that never should have applied to banks and other regulated financial intermediaries in the first place."

Nonetheless, it appears unlikely regulators will seek such drastic action. The House subcommittee was scheduled to hear from a three-man panel of accounting overseers -- James Kroeker of the SEC, Herz of FASB and Kevin Bailey of the Office of the Comptroller of the Currency.

And in their prepared testimony, all three spoke of the need for further improvements to the fair value rules, while emphasizing that fair value accounting provides critical information to investors that wouldn't be available under competing accounting regimes.

That view was bolstered by comments made by private sector fair value advocates such as Jeff Mahoney of the Council of Institutional Investors and Cindy Fornelli of the Center for Audit Quality.

"Investor confidence in the reliability and transparency of financial reporting is critical to our financial system's long-term well being," said Fornelli in her testimony. "We must pursue only those proposals that do not put that confidence at risk."