[Jonathan Weil] European bank blowups hidden with shell games

The last time the world had a major banking crisis, fair-value accounting rules were near the top of the list of scapegoats most likely to be denounced by government and industry leaders. Not so this go-around.

Today many of Europe’s largest financial institutions are seemingly on the brink again, driven by fears of pent-up losses stemming from the sovereign-debt debacle. Only you don’t hear much criticism of fair-value reporting anymore. That’s probably because the accounting mandarins gutted many of their fair-value rules in response to the financial system’s near-meltdown three years ago. This hasn’t made banks safer. It has given politicians and bankers one less culprit to blame, though.

Fair-value accounting ― or the notion that financial instruments should be recorded at market value on companies’ books rather than at historical cost ― made for a popular whipping boy in 2008, both before and after the collapses of Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc. and American International Group Inc.

Companies supposedly were being forced to write down their assets to temporarily irrational prices, or so the story went. Critics said the practice exacerbated market downturns. The boards that write accounting standards for Europe and the U.S. responded by passing emergency amendments to their rules to give the world’s banks and insurance companies a break. Predictably this has only made matters worse in the long run, by hurting investor confidence in some of the numbers financial companies are reporting now.

Back in October 2008, after the European Union threatened to override its standards legislatively, the London-based International Accounting Standards Board changed its rules on balance-sheet classifications retroactively, so that companies could immediately shift many of their financial assets out of categories where fair-value accounting was required. This meant a company holding lots of dodgy mortgage bonds, for example, could delay recognizing future losses simply by changing the bonds’ balance-sheet label.

Under current IASB rules, financial assets can be classified in four ways. Those dubbed “fair value through profit or loss” must be marked to market each quarter, with changes hitting the income statement. “Available for sale” means the assets must be marked to market on the balance sheet, but changes in value typically don’t hit earnings.

The other classifications, called “held to maturity” and “loans and receivables,” allow companies to avoid using fair value on the balance sheet. In practice, these categories often let companies postpone losses until long after an asset’s market value has plunged, especially when it comes to bonds.

Take Greece’s largest lender, Athens-based National Bank of Greece SA (ETE), for example. Last month the company said it recorded an impairment charge to earnings of 1.3 billion euros ($1.8 billion) during the second quarter to write down Greek government bonds. It wasn’t as if the losses had suddenly materialized. Rather, they had been building for some time and were finally being recognized.

As of the end of 2010, about 90 percent of the bank’s 12.8 billion euros of Greek government bonds were labeled as either “held to maturity” or “loans and receivables,” in large part because of reclassifications out of the available-for-sale and fair-value categories during prior periods. There surely should be bigger losses to come, with Greek bonds now trading at levels that indicate a government default is almost certain.

Given that backdrop, there was a glaring omission in a much talked-about letter the IASB’s chairman, Hans Hoogervorst, sent last month to the European Securities and Markets Authority. Hoogervorst complained that some European companies seemed to be violating the board’s rules for financial instruments, noting the widely divergent approaches various banks used last quarter to account for losses on Greek government bonds.

Some companies, he said without naming names, weren’t writing down impaired available-for-sale bonds to fair value as they should have. And there’s no doubt he was correct.

There was a catch, though. Hoogervorst said his letter “does not address financial assets classified as held-to- maturity or loans and receivables.” In other words, he ignored the point that just maybe it was a horrible idea in 2008 for the IASB to let companies reclassify their bonds into those categories, even though that’s where much of the problem with overstated asset values resides.

There’s a simple solution here. In 2005, when the IASB and the U.S. Financial Accounting Standards Board began discussing how to overhaul the rules for financial instruments, they said one of their top three long-term objectives was this: “Require all financial instruments to be measured at fair value with realized and unrealized gains and losses recognized in the period in which they occur.”

Both boards have abandoned that path. Bowing to pressure from Congress and the banking industry, the FASB in early 2009 changed its rules to let companies keep large losses on impaired bonds out of net income. If the broad principle the boards set forth six years ago were in effect today, it wouldn’t be possible to have multiple accounting treatments for the same kind of bond on a company’s books. There would be only one.

The markets, meanwhile, know better than to believe the banking industry’s balance sheets. And so we get the present situation where most of Europe’s largest banks, including France’s BNP Paribas SA and Societe Generale SA, are trading for far less than what their books say their net assets are worth. The problem with fair-value accounting now is investors don’t get enough of it. Those banks that are destined to blow up will do so regardless. 

By Jonathan Weil

Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own. ― Ed.

(Bloomberg)