IF you think banks have trouble now, just wait until they report financial results in January.
That’s when the balance sheet will really hit the fan.
The problem involves a rule passed a couple of years ago that will put the banking industry’s outside auditors in peril if they sign off on results that they really can’t verify.
And right now there is nothing verifiable – or even understandable – about the banking industry’s exposure to derivatives.
The auditors’ dilemma was caused by a rule change that now prohibits banks from indemnifying auditors against mistakes.
All other kinds of companies can hold their auditors blameless in the event of errors that might generate investor and government lawsuits.
And sometimes that’s the only way the accountants will give a nod to the company’s books.
But a rule enacted in February 2006 by the Treasury Department, Federal Reserve and the Federal Deposit Insurance Administration now prohibit banks from doing that.
When the rule was proposed the government said it believed “that when financial institutions agree to limit their external auditors’ liability. . . such provisions may weaken the external auditors’ objectivity.”
This rule is in the spirit of the Sarbanes-Oxley era, when the government attempted to make all corporations’ numbers more transparent and hold company executives responsible for any misstatements.
Sarbanes-Oxley didn’t work out quite as planned, with many smaller companies complaining about the cost of complying.
And the 2006 changes in bank audits could create additional unforeseen problems.
Chris Whalen, who runs The Institutional Risk Analyst, says the indemnification rule was changed “during a blissfully quiet time.”
He adds that the ramifications of the new rule “wasn’t an issue because nobody saw any risk.”
Now there is risk.
As I worried about in past columns, the value of the U.S. dollar has been falling rapidly.
This is largely due to the fact that the Federal Reserve is attempting to reduce interest rates at a time when inflation isn’t tame.
But it’s also because the Chinese, already feuding with the U.S. over trade issues, are mischievously threatening to sell dollar assets.
And while the Fed won’t say so, it’s pretty clear that the rate cuts are intended to help out troubled banks.
The issue of banks indemnifying their accountants can only make the situation worse.
These days, the financial markets are seeing so much risk that it’s difficult to keep up.
Just the other day CreditSights Inc. speculated that Citigroup may have to write down another $2.7 billion worth of subprime mortgage related securities.
So far the main concern has been securities created by packaging mortgages together.
But there are securities derived from other consumer obligations – such as credit cards and corporate loans – that might cause concern in the future.
Because these derivative securities are so complex and their value so difficult to calculate, banks might have a difficult time determining if they’ve written down enough value.
And if banks are finding the calculations troublesome, then auditors aren’t likely to be any more comfortable with their task.
It’s always devastating for a company when its outside, independent auditor refuses to attest to the truthfulness of a company report.
But without any protection against lawsuits, the nation’s biggest accounting firms – having learned their lessons from Enron Corp. and other cases of corporate fraud – will likely play hardball.
At the very least, the accountants could cause a company to delay its year-end report, which in itself would scare stockholders.
But there’s also a possibility that the auditing firms will play hardball with their bank clients and force them to make provisions for more write-offs related to derivatives than is necessary.
“The auditors are going to be pressing banks to be as aggressive as possible in writing down investments,” says Whalen.
But it isn’t just banks that could be affected.
Banks often allowed clients to take part in their derivative investments.
So if nervous auditors force a bank to take a write-down on their investment in derivatives, the bank’s client may have to make a similar move.
The big fear these days – including at the Federal Reserve – is that the snowball effect of these write-downs will be difficult to stop.
So far, Citigroup’s derivative investments have gotten the most attention, especially after its Chairman Chuck Prince was forced to resign earlier this week.
But, according to the lat est figures from the Of fice of the Comptroller of the Currency, JPMorgan Chase & Co. has the most ex posure to deriva tives, with $80 tril lion outstanding. The bank has total as sets of just $1.46 trillion.
By comparison, Citigroup had “just” $34.9 trillion in derivative exposure and total assets of $2.2 trillion.
Bank of America and Wachovia Corp. were a distant second and third in derivative holdings.
Washington could, of course, step in and ask accounting firms to be gentle on their clients.
But if investors ever found out about a move like that the nervousness would just increase. john.crudele@nypost.com