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Weakening A Market Watchdog

An Accounting Rule Change's Real Costs

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By Arthur Levitt
Thursday, March 26, 2009

Confidence, trust, and numbers that investors can believe in are the stuff that make or break the capital markets. When investors question the validity of numbers, they sell and wait, rather than buy and invest.

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Yet those charged with building confidence and trust and presenting numbers that can be believed are under sustained attack -- and they are losing. Over the past few weeks, banks and their supporters in Congress have applied significant pressure on the Financial Accounting Standards Board (FASB) to rewrite standards for valuing distressed assets on bank balance sheets.

Earlier this month, Robert Herz, chairman of the FASB, was lectured by members of the House Financial Services Committee. "Don't make us tell you what to do," said Rep. Randy Neugebauer (R-Tex.). "Just do it. Just get it done." Said Rep. Gary L. Ackerman (D-N.Y.): "If you don't act, we will."

This is like being forced to give your boss several mulligans in a round of golf. And so last week, the FASB voted to propose allowing banks to obscure -- some might say bury -- the full extent of impairments on many of the bad loans and investments they made and securitized over the past few years. These impairments have traditionally been valued at market prices (thus, the phrase "mark-to-market"), so that investors can know what the banks would stand to lose if those investments were sold today.

The FASB's proposal goes against what we know investors prefer: Stronger rules for the reporting of changes in the values of investments in income statements. Under the proposed rule, no matter how toxic the investment, whether it's a penny stock or the bonds of a government ward such as AIG, companies can choose to largely ignore the fundamental reasons behind the investments' decline. All that companies have to do is say they don't intend to sell those investments until their value rebounds.

Such a subjective judgment is bound to decrease investor confidence in reported income. And in a strange twist of fate, the FASB's proposals may create even greater opportunities for short sellers who are adept at digging into numbers that do not tell the whole story.

Yet the real scandal here is not the decision by the FASB -- with which I strongly disagree but which others might be able to defend. Rather, it is how the independence of regulators and standard-setters is being threatened. This isn't just about the income statements of banks. It's about further eroding investor confidence, precisely at a moment when investors are practically screaming for more protection.

The FASB was created to stand apart from partisanship and momentary shifts in public opinion precisely because the value of accounting standards comes in the consistency of their application over time and circumstance. Chairman Herz acquiesced, it appears, in order to keep Congress from invading FASB turf. Yet in seeking to protect its independence, the board has surrendered some of it in the bargain.

Every regulatory agency should take note: Independence from public pressure has a value, and when you give some of it away, you've lost something that takes years to rebuild. Just ask the Federal Reserve, which lost its reputation for independence from political pressure in the early 1970s and didn't regain it for a decade.

In the past, the FASB has made significant changes to its rules only after significant due process, including comment periods that often lasted for three months and a full discussion reflecting those public comments. The rule change agreed to by the FASB on Tuesday followed only one public meeting on this topic, and the board is giving investors just two weeks to comment, with a final vote the next day. This is a rush job.

The FASB should rethink its approach to these rules. The board should develop new standards providing investors with improved disclosures regarding the quality of banks' assets. More information is needed on the ratings the banks and regulators place on their loans. And above all, the Securities and Exchange Commission should take a firm stand on the side of investors and vigorously resist all political efforts to reduce the independence of financial rule-making agencies and boards.

Investors once believed that U.S. markets were sufficiently protected from political pressure and manipulation by a system of interlocking independent agencies and rule-making bodies -- some government-run, some not. That system is being dismantled, piece by piece, by political jawboning and rushed rule rewrites. Now, investors find themselves with fewer protections and weakened protectors.

The writer, a senior adviser to the Carlyle Group, was chairman of the Securities and Exchange Commission from 1993 to 2001.




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