Sunday, September 21, 2008

Fair Value Takes a Pounding

Who would have thought that an accounting standard would suddenly be front and centre in the news on the current U.S. financial crisis? That's exactly what has happened with the mark-to-market rules with the Financial Accounting Standards Board (FASB) rule on Fair Value Measurements, FAS 157.

The Wall Street Journal carried a few articles on this topic this past summer, before things blew wide open last week:
Bob McTeer at WSJ July 5, 2008, states that the most serious example of doing the right thing at the wrong time is overly strict adherence to the current mark to market rules. In his opinion, most of the write-downs of securities that are creating capital shortages in financial institutions don't result from actual losses, or even expected losses. They result from having to mark down assets, many or most of which could easily be held to maturity and redeemed at par. This includes securities issued or guaranteed by Fannie and Freddie and other investment-grade securities, especially those graded triple A. He acknowledges that this is a minority view, but claims the support of William Isaac, former chairman of the Federal Deposit Insurance Corporation, who says that mark to market is overdone and is pro-cyclical, since regulators limit the ability of banks to reserve during good times, but insist on increased reserves during bad times.

Getting Risk Right
By Tom Gurside and Andy Kuritzes, WSJ, July 31, 2008
Direct quote from their article:"Accounting can change everything. Differences in accounting treatment of individual assets create real disparities in actual and perceived levels of risk. The shift of assets from a "held to maturity" standard to a "mark to market" basis has dramatic implications for both the timing and magnitude of losses, and has contributed significantly to the volatility of earnings in the current crisis. At the same time, accounting rules contributed to the development of the shadow banking system by allowing conduits and SIVs to be kept off balance sheets. In short, accounting matters: Firms need to integrate risk with accounting and finance, just as much as they need to integrate risk with the front office."

Now that things have blown apart on Wall St., dissatisfaction in certain circles could not be more obvious than:
In Crisis, Fingers Point at Mark-to-Market Rule
by David Reilly, WSJ, September 19, 2008

Now the demise of Wall St. firms is rekindling debate over whether so-called mark-to-market accounting has fanned the flames of the credit crisis. Before tumbling into bankruptcy, Lehmans Brothers proposed hiving off hard-hit commercial-mortgage assets so that the investment bank no longer would have to use battered market prices to value the holdings.
American International Group (AIG) contended in August that the use of market values was forcing it to recognize greater losses than it would ultimately realize on derivatives insuring complex financial instruments backed by mortgages.

Now, a major flurry of articles in the WSJ on this topic, concurrent with the $700 billion plan to save the financial markets.

Loosen Deposit Insurance Rules To Prevent a Bank Run
By Lawrence B Lindsey, WSJ, September 17, 2008
"Following Sarbanes-Oxley we gave accountants the power to use overly precise and inflexible values for assets, and compensated by allowing firms to use highly flexible and history-driven models to apply those values to test for capital adequacy.This gets it exactly wrong. Many assets are highly illiquid and the institutions that hold them, such as banks, are in the business of providing liquidity to the economy and holding such assets as collateral. Making those assets "mark to market" meant that reserves were drawn down and converted into ever more loans during the upswing, and now must be built back up at a time when asset prices are plummeting and capital is scarce. Instead, a more stable capital adequacy rule -- such as a leverage ratio that was based on the original asset values -- would limit this pro-cyclical behavior. The complex approach ...for international capital rules need(s) to be scrapped, and the process restarted."

Maybe the Banks Are Just Counting Wrong
By John Berlau, WSJ, September 20, 2008
Financial Accounting Standard 157, which U.S. regulatory agencies put into effect last November, requires accountants o look at market "inputs" from sales of similar financial assets even if there isn't an active trading market. That means that less-leveraged banks holding mortgages that haven't been impaired often have to adjust their books based on another bank's sale -- even if they plan to hold their loans to maturity. Yale finance Prof. Gary Gorton wrote in a paper presented last month at the Federal Reserve's summer symposium: "With no liquidity and no market prices, the accounting practice of 'marking-to-market' became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates."These write-downs, based on accounting standards, can jeopardize balance sheets and solvency -- much like a spreading contagion. In effect, a single bank's fire sale can decrease the "regulatory capital" (or the total dollar value of assets that government regulations require banks and other financial institutions to keep as a reserve to immediately make good on their obligations to depositors and other creditors) of others. So "partly as a result of GAAP capital declines, banks are selling . . . billions of dollars of assets -- to 'clean up their balance sheets,'" notes Mr. Gorton, creating a "downward spiral of prices, marking down -- selling -- marking down again."

Other sources have contributed to the debate.
According to Todd Sullivan at Valueplays:

This is the problem with "mark to market" accounting when the market is so dislocated. It is a bit like the bank coming to you because the price of your home fell and telling you to sell your car to raise capital. If you are not selling your home and have a conforming mortgage, its current valuation is meaningless. JP Morgan does not need to sell the securities to raise capital. Now, if troubled firms desperate for cash need to dump additional assets to save themselves, the value of all assets may drop further, causing additional write-down and then the need may arise to restore ratios. What is being ignored here is the cash flows from the assets. Not all of them are impaired and now are trading at prices below the streams of income they produce.
Just because your neighbor gets himself in a jam, it should not force you to liquidate or materially markdown your assets. Mart-to-market is exacerbating the current banks problem because it is forcing actions that without it in the extremity of the current market, would not be necessary.

If you read just one article on this topic, it should be this:
All’s fair--the crisis and fair-value accounting
From The Economist print edition, Sep 18th 2008

SO CONTROVERSIAL has accounting become that even John McCain, a man not known for his interest in balance sheets, has an opinion. The Republican candidate for the American presidency thinks that "fair value" rules may be "exacerbating the credit crunch". Some fear that accounting dogma has caused a cycle of falling asset prices and forced sales that endangers financial stability. The fate of Lehman Brothers and American International Group will have strengthened their conviction.

In response America’s Financial Accounting Standards Board (FASB), and the London-based International Accounting Standards Board (IASB) have not budged an inch. So, for example, banks will have to mark their securities to the prices Lehman receives as it is liquidated. The two accounting bodies already act cheek by jowl, and America will probably soon adopt international rules. Are they guilty of obstinately pursuing an abstract goal that is causing mayhem in financial markets?

And for an in depth look at the fair value concept and rules:
Fair-Value Revolution
Historical cost accounting is fading as Corporate America marches into a new era. Davis M. Katz - CFO Magazine, September 1, 2008

The above is a really good article.

The following two well known investment pundits have weighed in:
Jeff Miller, and Jim Cramer, at state that the rules should be dumped.

And from a former Fed staffer:
In this article,
Vincent R. Reinhart, former director of the Federal Reserve's monetary affairs division, states that:
While the reverse auctions could help banks set a clearing price for mortgage-related assets, Reinhart said, that "price doesn't mean that every financial firm will be solvent" after those assets are sold. Another risk is that if the auctions set too low a price for mortgage-related assets, other institutions with bad debt may be forced to take the distressed valuation onto their books under mark-to-market accounting rules, Reinhart said. Mark-to-market rules involve adjusting the price of an asset to reflect its current market value. "If the auctions don't go well, it will drag down everybody's balance sheet who marks to market," Reinhart said.

And finally, accounting bodies, as expected, are not about to give in:
Tweedie: Don't Blame Fair Value for the Crisis
Accounting did not exacerbate the credit crisis, says the IASB chairman
., September 17, 2008
Tweedie noted that "accounting is not the cause of the credit crisis, but it is important that market participants should have confidence in the information presented within financial statements."

At its meeting today, IASB will consider a comprehensive package of proposed amendments to IFRS 7, Financial Instruments: Disclosures, as part of a post-implementation review of the standard. In its discussion, IASB is expected to consider papers on disclosures related to off-balance sheet risk, fair value measurement, and financial instrument risk, including disclosures related to liquidity risk. Later this year, the board will published proposed amendments to the disclosure provisions of IFRS 7.

In addition, IASB has started work on replacing IAS 39, Financial Instruments: Recognition and Measurement. The standard is generally considered complex and difficult to understand, according to IASB. Further, it contains several alternative ways of measuring financial instruments, which can lead to reduced levels of comparability among similar companies. Up for discussion — at least until Friday (Sept. 19), when the public comment period ends — is whether IASB can reduce the number of ways of measuring the instruments.

IASB's target date for converging accounting standards with FASB, as described in the joint memorandum of understanding, has been expedited and now is set for 2011.

No comments: