Banking: Where It Pays to Keep Secrets

US banks posted record losses in the first quarter of this year, which was the worst quarter in history for Wall Street since The Great Depression. In one effort to stem the bleeding, big banks resorted to lobbying the Financial Accounting Standards Board (FASB) to repeal the mark-to-market accounting rule.

Simply defined, the mark-to-market rule requires companies to value their assets at the price they would receive for those assets if they tried to sell them on the market right now. Because of the collapse of the credit markets in 2008, the loans and mortgage-backed securities that banks held on their books were worth next to nothing on the market, so they had to value them accordingly. This made their balance sheets look terrible, and their stock prices plummeted. Naturally, banks wanted to declare that their loans were worth more.

So the banking industry lobbied FASB to repeal mark-to-market accounting. Big banks wanted to value their mortgage-backed securities and other loans as if the principle and interest on those loans would be paid back 100%, as if none of their customers would default on their loans.

Shockingly, FASB agreed, allowing banks to use an accounting trick to hide the terrible state of their balance sheets. Unsurprisingly, banks’ second quarter earnings vastly improved. Investors began buying bank stocks again, deeming them a good deal. Many economists declared that the tide had turned on the financial crisis.

But now, FASB is considering reinstituting mark-to-market accounting for all financial products, including loans, mortgage-backed securities, and other derivatives. This is terrible news for the banking industry.

After suffering from a double wave of defaults—first, from subprime mortgage loans given to people with bad credit, then from prime mortgages given to people with good credit who borrowed more money than they could afford—US banks are now getting hit with a third wave of defaults on commercial real estate loans. Commercial loans extended to hotels, malls, retail outlets, and office-building developers have hit a default rate of 7%, approximately double what it was last year.

Economists don’t expect the fall in the commercial loan market to hit bottom for another three years, due to lingering unemployment and lagging consumer spending. This is terrible news for mid-size regional banks, in particular, who invested heavily in loans to commercial real estate developers.

A recent example is this week’s collapse of Colonial Bancorp, the sixth largest bank default in US history. Joining 76 other banks that have defaulted so far this year, Colonial is a sign of things to come. No wonder bank lobbyists are gearing up to inundate FASB with protests against mark-to-market accounting.

Transparency is the enemy, and they make no secret of it.