June 5 (Bloomberg) -- If you can’t blind investors with brilliance, baffle them with gussied-up balance sheets. That’s the approach banks have taken to try and escape the legacy of bad lending and investing.

First, banks got bought-and-paid-for backers in Congress to ram through an easing of accounting rules that let them pretend they know better than financial markets when it comes to the value of securities they hold. Now, the banking industry is fighting a rear-guard action to keep trillions of dollars in assets hidden in vehicles that don’t show up on their books.

Investors will again be the losers if banks pull off this latest effort to fudge their true financial condition. After all, banks’ use of these so-called off-balance-sheet vehicles to churn out dodgy loans helped get the financial system into its current predicament.

The latest battle is brewing over changes to off-balance- sheet rules approved by the Financial Accounting Standards Board in May. Although these revisions have been in the works for more than a year, banks acting through the guise of a coalition of financial industry and real estate groups on June 1 wrote to Treasury Secretary Timothy Geithner to try and derail them. A similar coalition wrote to FASB the same day, also asking for a postponement of the rule changes.

Now it’s likely only a matter of time before banks get Congress back in on the act. In the debate over the use of market values, banks -- after greasing plenty of palms on Capitol Hill -- used Congress to browbeat FASB into changing these so-called mark-to-market rules, as the Wall Street Journal reported earlier this week.

Looking Weak

It’s easy to see why banks don’t want to come clean about off-balance-sheet activities. Consolidating these hidden assets will make their balance sheets look weaker than they already are.

In some cases it may even mean that banks, which in recent weeks have issued billions of dollars in common equity to shore up their capital, have to go out and raise even more money. Raising equity helps build up the cushion banks have on hand to absorb losses. New equity, though, also dilutes existing shareholders, making it painful, even if necessary, medicine.

Off-balance-sheet vehicles, along with the billions of dollars in fees they generate, are a big deal for banks. The country’s four biggest banks by assets -- Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co. -- had $5.2 trillion in assets in these vehicles at the end of 2008, according to their annual filings. That compared with about $7.2 trillion in total assets that the banks had on their books at the end of the year.

Street Time

Not all these assets would come back onto banks’ books under the accounting-rule changes. In a recent paper on the government-mandated bank stress tests, the Federal Reserve estimated that the 19 biggest banks would see about $900 billion in assets return.

The assets mainly relate to credit-card, auto and other consumer loans. They would also include mortgages that aren’t guaranteed by Fannie Mae and Freddie Mac.

What is especially galling about the latest attempt to keep the off-balance-sheet game going is that banks want the government to repeat a mistake that was a direct cause of the financial crisis.

Off-balance-sheet vehicles helped inflate the credit bubble by letting banks originate and sell loans without having to put aside much capital for them. So as lending soared, banks didn’t have an adequate buffer against losses.

Even worse, off-balance-sheet vehicles hid from investors, and in many cases regulators, the extent of lending and how much individual banks had at stake. That allowed a huge risk to build up unseen within the financial system.

Debt Guarantees

Banks claimed that they didn’t control these assets and so they shouldn’t be shown on their own books. That was a sham.

Banks in many cases guaranteed that they would roll over debts in these vehicles as they came due. When the financial crisis hit, they were often forced to take these assets onto their balance sheets.

After Enron Corp.’s implosion, FASB tried to curtail off- balance-sheet abuses. The board ended up caving in to pressure from banks and watered down the rules.

That let banks game the system, and they soon created scores of vehicles that allowed them to obscure just how much lending they were arranging.

Making a Contribution

The credit crunch exposed the charade. Citigroup, for example, had to take $25 billion of collateralized debt obligations -- a highly toxic type of debt security -- back onto its books because of its guarantee of off-balance-sheet vehicles. Those returned assets contributed to Citigroup’s $27.7 billion loss in 2008.

Banks now argue that, even with all the problems caused by off-balance-sheet vehicles, curtailing them would hurt an economic recovery. Any accounting-rule changes “must be made cautiously and seek to minimize any chilling effect on our frozen credit markets,” read the June 1 letter to Geithner.

That misses the point. Credit markets froze in large part because banks pretended these off-balance-sheet vehicles didn’t exist. As Barry Ritholtz, chief executive officer of research firm FusionIQ, recently put it when talking about banks, “You can’t drink yourself sober.”

That’s exactly what banks would like to do.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: June 5, 2009 00:01 EDT