Are bean counters to blame

1. Are Bean Counters to Blame?
By ANDREW ROSS SORKIN
Published: July 1, 2008
Some blame the rapacious lenders. Others point to the deadbeat borrowers. But Stephen
A. Schwarzman sees another set of culprits behind all the pain in the financial industry:
the accountants.
Shannon Stapleton/Reuters
That’s right, the bean counters.
A new accounting rule — “an accounting rule!” — partly explains why the American
financial system looks so wobbly these days, he says.
Mr. Schwarzman, the co-founder of the private equity giant Blackstone Group, has been
espousing this view for weeks over lunches and at cocktail parties around the globe. It’s a
controversial hypothesis, which others have put forward before, and it has sparked plenty
of debate within the industry. But Mr. Schwarzman is convinced that the rule — known
as FAS 157 — is forcing bookkeepers to overstate the problems at the nation’s largest
banks.
“From the C.E.O.’s I talk with,” Mr. Schwarzman said during an interview on Monday
morning, “the rule is accentuating and amplifying potential losses. It’s a significant
contributing factor.”
Some of his bigwig pals in finance believe that Wall Street is in much better shape than
the balance sheets suggest, Mr. Schwarzman said. The president of Blackstone, Hamilton
E. James, goes even further. FAS 157, he said, is not just misleading: “It’s dangerous.”
Huh? So the Citigroups and Merrill Lynches of the world are writing off billions of
dollars — but they haven’t actually lost the money?
Sort of. If Mr. Schwarzman is to be believed — and there’s some evidence he might be
right, at least partly — it all goes back to FAS 157, which went into effect Nov. 15, just
as the credit hurricane tore through Wall Street. Remember, that was about the time
Citigroup ousted Charles O. Prince III after the bank shocked investors by writing down
$5.9 billion and Merrill Lynch showed E. Stanley O’Neal the door after it was forced to
write down $8.4 billion. (The pain didn’t end there, for either of those companies or the
rest of the financial industry.)

2. FAS 157 represents the so-called fair value rule put into effect by the Federal Accounting
Standards Board, the bookkeeping rule makers. It requires that certain assets held by
financial companies, including tricky investments linked to mortgages and other kinds of
debt, be marked to market. In other words, you have to value the assets at the price you
could get for them if you sold them right now on the open market.
The idea seems noble enough. The rule forces banks to mark to market, rather to some
theoretical price calculated by a computer — a system often derided as “mark to make-
believe.” (Occasionally, for certain types of assets, the rule allows for using a model —
and yes, the potential for manipulation too.)
But here’s the problem: Sometimes, there is no market — not for toxic investments like
collateralized debt obligations, or C.D.O.’s, filled with subprime mortgages. No one will
touch this stuff. And if there is no market, FAS 157 says, a bank must mark the
investment’s value down, possibly all the way to zero.
That partly explains why big banks had to write down countless billions in C.D.O.
exposure. The losses are, at least in part, theoretical. Nonetheless, the banks, in response,
are bringing down their leverage levels and running to the desert to raise additional
capital, often at shareholders’ expense.
Mr. Schwarzman and others say FAS 157 is forcing underserved write-offs and wreaking
havoc on the financial system. There is even a campaign afoot in Washington to change
the rule.
Some analysts, even insiders, say banks like Citigroup and Lehman Brothers marked
down some of their C.D.O. exposure by more than 50 percent when the underlying
mortgages wrapped inside the C.D.O.’s may have only fallen 15 percent.
Bob Traficanti, head of accounting policy and deputy comptroller at Citigroup, said at a
conference last month that the bank had “securities with little or no credit deterioration,
and we’re being forced to mark these down to values that we think are unrealistically
low.”
As a result, Citigroup went hat in hand to Abu Dhabi, selling a significant stake and
diluting existing shareholders in the process. According to the Securities and Exchange
Commission, FAS 157 requires an institution to “to consider actual market prices, or
observable inputs, even when the market is less liquid than historical market volumes,
unless those prices are the result of a forced liquidation or distress sale.”
As a result, Christopher Hayward, finance director and head of holding company
supervision initiatives at Merrill Lynch said: “There is a bit of this pressure, a bit of this
atmosphere that says, ‘Let’s just mark it down, no one is going to question it if we mark it
down.’ ”

3. Of course, Mr. Schwarzman’s theory only holds up if the underlying assets are really
worth much more than anyone currently expects. And if they are so mispriced, why isn’t
some vulture investor — or Mr. Schwarzman — buying up C.D.O.’s en masse?
For Mr. Schwartzman’s part, he says that the banks haven’t been willing to unload the
investments at the distressed prices. Besides, the diligence required for most buyers is
almost too complicated.
It is not clear that Mr. Schwarzman’s view is correct. The folks at the University of
Chicago — those the-market-is-always-right guys — take umbrage at the mere
suggestion that marking-to-market is not always appropriate.
FAS 157 proponents say that if Mr. Schwarzman and his crowd get their way, financial
companies to might end up valuing investments based on market prices when it suits
them, and just look the other way when it doesn’t.
“He’s entitled to his view, but I don’t agree” said Daniel Alpert, managing director at the
investment bank Westwood Capital. “I don’t believe that people are taking write-downs
that forces them to dilute their shareholders.” If anything, Mr. Alpert says, “There is still
a lot of sludge out there.”
Mr. Schwarzman is suggesting that the market is somehow wrong, or wildly inefficient.
(Of course, Mr. Schwarzman is a private equity guy, so the day-to-day swings in the
market in his mind are always wrong.)
But some say Goldman Sachs proved why FAS 157 works: Goldman has been marking
its books to market for years, and as a result, its risk officers were able to hold back its
go-go traders from making bad bets when everyone else was throwing down their chips
last year into the subprime game.
Of course, the purpose of FAS 157 was to make the market more transparent and
efficient, which Mr. Schwarzman doesn’t take issue with.
“The concept of fair value accounting is correct and useful, but the application during
periods of crisis is problematic,” he said. “It’s another one of those unintended
consequences of making a rule that’s supposed to be good that turns out the other way.”