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.)

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.’ ”

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.”