Warning: Tough Accounting and More Writedowns Coming

The recent excesses of the financial services industry seem to be coming home to roost at the same time. Just when the arcane paper that sold like hotcakes a mere few months ago is now languishing in dealer inventories, so to is coming accounting treatment that gives the firms far less latitude in how they value it.

Readers may have already heard of Level 1, 2, and 3 accounting, which was set forth in FASB 157 and defines various methods that can be used to value financial assets. Today’s Financial Times gives a layperson’s explanation:

Levels One, Two and Three may sound as if they belong in a computer game, but ac countants, investors and auditors are finding them anything but fun.

They are the “buckets” into which financial statement preparers must classify financial assets under FAS 157, a new US accounting standard for financial years beginning in November.

Similar to the international accounting standards followed in Europe and elsewhere, it is aimed at simplifying and standardising “fair value” accounting, where assets and liabilities are booked at market price. Some companies, notably banks, took advantage of the option to introduce FAS 157 a year ago, including Goldman Sachs, Lehman Brothers, Citigroup, Merrill Lynch and JPMorgan.

At the top of the bucket hierarchy is Level One, involving assets with prices quoted in active markets, such as mainstream stocks. Level Two contains less-traded securities and uses prices for assets very like the one being valued.

At the bottom lurks Level Three, assets with “un observable inputs”, meaning their value is calculated via a series of assumptions. Most collateralised debt obligations end up here.

While these categories may be familiar to many readers, what is not as widely know is that another rule, FASB 159, pushes institutions to put positions into the lowest bucket possible. Thus, no phony-baloney Level 3 valuation if there is a way to come up with a gridded or extrapolated Level 2 value.

And in addition to the strict new standards is a new toughmindedness within the accounting profession. They can smell an incipient Enron a mile away, and aren’t about the be the fall guys again.

Nouriel Roubini gave some fire and brimstone on this topic in his latest post:

The amount of losses that financial institutions have already recognized – $20 billion – is just the very tip of the iceberg of much larger losses that will end up in the hundreds of billions of dollars. At stake – in subprime alone – is about a trillion of sub-prime related RMBS and hundreds of billions of mortgage related CDOs. But calling this crisis a sub-prime meltdown is ludicrous…. it is spreading to every corner of the securitized financial system….the losses that banks and investment banks will experience in the next few quarters will erode their Tier 1 capital ratio; the ABCP and related SIV sectors are near dead and unraveling; and since the Super-conduit will flop the only options are those of bringing those SIV assets on balance sheet (with significant capital and liquidity effects) or sell them at a large loss; similar problems and crunches are emerging in the CLO, CMO and CMBS markets; junk bonds spreads are widening and corporate default rates will soon start to rise. Every corner of the securitization world is now under severe stress, including so called highly rated and “safe” (AAA and AA) securities.

The reality is that most financial institutions – banks, commercial banks, pension funds, hedge funds – have barely started to recognize the lower “fair value” of their impaired securities. Valuation of illiquid assets is a most complex issue; but starting with the November 15th adoption of FASB 157 the leeway that financial institutions have used so far for creative accounting will be much more limited… As suggested by a commentator (Bernard) of my recent blog many Wall Street firms are still playing the game of putting too many assets in the “level 3” bucket of mark-to-model to models that don’t make much sense…..

As explained in three recent white papers by the Center for Audit Quality (CAQ) using the excuse of “illiquidity” to put assets in the model driven valuation bucket is highly inappropriate:

The white paper notes that it is important to distinguish between (1) an imbalance between supply and demand (e.g., fewer buyers than sellers, thereby forcing prices down) and (2) a “forced” or “distressed” transaction. Because persuasive evidence is required in establishing that an observable transaction is forced or distressed, it is not appropriate to assume that all transactions in a relatively illiquid market are forced or distressed.

The SEC, in a 2004 accounting and auditing enforcement release, determined that using a definition of fair value that assumed supply and demand were in reasonable balance was a violation of GAAP and that the registrant should have considered the current market environment, such as imbalances of supply and demand, in the determination of the then-current market value. Further, the SEC objected to the practice of taking a long-term view of the market while ignoring prices quoted by external sources.

Other key points from the draft white paper include the following:

· A decline in a market’s transaction volume does not necessarily mean that the market is not active. A market is still considered active if transactions are occurring frequently enough on an ongoing basis to obtain reliable pricing information. When an active market exists, a quoted price provides the best evidence of fair value (Level 1 per Statement 157).

· In the absence of an active market for the identical asset, entities often use valuation models. Entities may not ignore available market information or market participant assumptions that are reasonably available without undue cost and effort. Valuation models that use historical default data, or an entity’s own default assumptions, rather than assumptions that marketplace participants would use, are not appropriately using current market participants’ assumptions, even if the default assumptions are “stressed.”

· Statement 157 contains disclosure requirements regarding fair value measurements that apply to entities that have adopted Statement 157. Entities that have not yet adopted Statement 157 should consider disclosures required by existing pronouncements (for example, AICPA Statement of Position No. 94-6, Disclosure of Certain Significant Risks and Uncertainties) in situations in which fair value measurements have a significant effect on the financial statements. When an entity that has not adopted Statement 157 measures fair value using significant unobservable inputs, the white paper suggests that the entity may wish to consider disclosures similar to those found in Statement 157.

The message from FASB 157 and the CAQ white papers is clear: using dubious models and accounting tricks to avoid using market prices or proxies for market prices to value illiquid asset is extremely inappropriate. And appropriate disclosure of the methods used to estimate the “fair value” of assets is now a requirement. Note that the proposed Super-conduit is another one of these scheme aimed at parking securities and avoiding having to recognize their true market value. So, the process of recognizing hundreds of billions of losses, not just in sub-prime related assets but across the board of trillions of dollars of securitized assets has barely begun. Thus, you can expect that the ongoing credit crunch will get much worse in the year ahead and its fallout spread from the US to Europe and throughout Asia and the globe. Trillions of dollars of securitized assets that were sliced and diced in the long food chain of securitization are now at some risk. The first crisis of financial globalization and securitization is thus only at its beginning stage.