Bear bailout shows Fed doesn't follow normal rules for its own books


By Jonathan Weil
Bloomberg News Service
Wednesday, June 18, 2008

The Federal Reserve is just days away from completing the financing for its bailout of Bear Stearns Cos., after which the central bank will have another big decision to make: how to account for it.

Flip through the footnotes to the Fed's latest annual report, and you'll come across an open secret. The Fed doesn't follow normal accounting rules, as promulgated by any of the major standard-setting boards. Rather, the Fed writes its own, in a document called the Financial Accounting Manual for Federal Reserve Banks.

If you ever wanted to design an accounting regime to help a bank cook its books, the Fed's would be perfect. This doesn't exactly inspire faith in the U.S. financial system, at a time when a good example might help a lot.

Imagine if there were no rules specifying when a bank must bring an Enron-style special-purpose entity onto its own balance sheet. The Fed's accounting manual has none. Now picture an accounting system where a bank never had to recognize losses on any securities it holds, as long as it continues holding them. That, too, is the Fed's policy.

Before the Fed's rescue of Bear Stearns, these practices weren't a big deal. For instance, the vast majority of the Fed's assets are U.S. government securities, the value of which the Fed can alter just by changing interest rates. So arguably it makes sense for the Fed to carry these securities at their historical cost, rather than their market value.

... Making the Rules

Now that the Fed is taking on the risk of Bear Stearns's assets, though, the game has changed. And the Fed's rules should, too, at least for these particular holdings. Indeed, the Fed's Board of Governors can change the rules anytime it wants.

Under its rescue plan, the Fed next week is scheduled to lend $29 billion to a Delaware limited-liability company that will hold a portfolio of illiquid Bear Stearns assets, which Bear Stearns valued at $30 billion on March 14. To put that in perspective, the Fed's total capital was $40.4 billion as of June 11. The portfolio consists mainly of mortgage-backed securities and other mortgage-related assets.

JPMorgan Chase & Co., which completed its purchase of Bear Stearns this month, will lend the Delaware entity $1 billion and absorb the first $1 billion of any losses. The Fed is on the hook for the rest. The central bank has hired an outside company, BlackRock Inc., to manage the sale of the assets over the next 10 years. The proceeds will go back to the Fed and then, if anything is left over, to JPMorgan after the Fed is paid.

... No Normal Bank

If the Fed were a normal bank, it probably would have to put the Delaware special-purpose entity's assets and liabilities on its own balance sheet, under the Financial Accounting Standards Board's rules. The reason is that the Fed will bear most of the risk of losses. Under the Fed's 161-page accounting manual, however, there's no such requirement. That's because the manual doesn't have any rules on the subject. The Fed hasn't said yet what it will do.

And what if the Fed brings the entity onto its balance sheet anyway? The central bank's manual requires the presentation of all securities holdings at their cost, not their fair value. Unrealized gains or losses aren't recognized. There are no exceptions, even for securities that have declined sharply in value and show no signs of rebounding.

By contrast, if the Fed followed the FASB's rules for securities being held to maturity, it would have to recognize a charge against net income whenever such a decline occurred. The Fed's manual was last updated in January, before anyone figured that the government might be bailing out a major investment bank.

... Figure It Out

"The Federal Reserve's accounting policies do not currently contemplate transactions like the planned credit extension related to the acquisition of Bear Stearns by JPMorgan Chase," Fed spokesman David Skidmore told me. "Federal Reserve staff is evaluating how to appropriately account for this transaction and will provide further information around the time the transaction closes."

The worst thing the Fed could do now is resort to accounting trickery to avoid losses. If the Fed won't be marking all the Bear Stearns assets at fair value on its balance sheet, it at least should record writedowns whenever generally accepted accounting principles would require them.

The Fed also should eliminate the secrecy around its precious accounting manual. You won't find the manual on the Fed's Web site, even though it's cited by name in the Fed's financial statements. To get my copy, after the Fed's press office initially declined to provide one, I had to file a request under the Freedom of Information Act. The Fed sent me a lightly redacted version 18 days later.

To be fair, the Fed has said it will disclose the fair value of the Bear Stearns portfolio on a quarterly basis. That promise came April 3 from Timothy Geithner, the New York Fed bank's chief executive, during testimony before the Senate Banking Committee.

While that's fine, it's not enough. Good disclosure is no cure for bad accounting. And talk about a confidence killer: The last thing our financial markets need now is the knowledge that the world's most powerful central bank is fudging its figures.

If the Fed doesn't do the right thing here, we all could be in trouble.


Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.

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