The US is acting more and more like a banana republic with every passing day. One of the characteristics of a banana republic is that it puts out flattering-to-the-point-of-being-unreliable data about its economy and important institutions.
Alert reader James Bianco pinged us about a new SEC release today and Floyd Norris of the New York Times’ commentary on it, “If Market Prices Are Too Low, Ignore Them,” Norris, who is usually pretty understated, disapproved of one of the items in the SEC letter, as do we.
Most readers probably know that accounting rule FAS 157 became effective as of January 1 of this year. It requires companies, subject to certain restrictions, to classify financial assets as Level 1 (easily valued by reference to market prices), Level 2 (doesn’t trade actively, but similar enough to actively traded assets that can be valued in relationship) and Level 3 (known in the trade as “mark to model” or “mark to make believe”). Some financial firms opted to comply with FAS 157 early, which led to quite a few investment banks revealing that the value of their Level 3 assets exceeded their net worth.
In the last couple of months, there has been increased worry that mark-to-market accounting leads to the operation of a destructive “financial accelerator.” As prevailing values go down, banks have to lower the value of their holdings. This leads to a direct hit to their net worth, which will lead them to contract their balance sheets, either by withholding credit or selling assets. More sales in a weak market lead to further declines in the prices of financial instruments, leading to more writedowns and sales of inventory.
Funny how no one had a problem with mark-to-market when asset prices were rising. The process in reverse leads to mark-to-market gains, higher net worths fueling balance sheet growth and credit expansion, which led to more demand for financial assets. That gives you higher securities prices which least to more mark-to-market gains. Sounds like a bubble, doesn’t it?
The SEC’s solution for the contractionary version of this dynamic is simple: ignore those market prices if they are too ugly. From the release:
Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).
Quite a few observers had argued that the windups of SIVs and the failure of hedge funds, and even Bear Stearns, would be a good thing because they would force price discovery of assets that are normally illiquid and/or hard to value. That in turn would resolve a great deal of uncertainty of what bank and hedge fund positions were really worth.
But now the SEC has given banks and brokers a huge out. No matter how small or easily absorbed by the market a forced sale might be (think of a hedge fund hit by a margin call), a financial institution can ignore the price realized. In fact, they get to determine what trades constitute a forced sale. As Norris dryly notes:
Some people on Wall Street think that nearly every sale today is a forced sale. There are entire categories of collateralized debt obligations where most, if not all, of the trades, occur because a holder has received, or expects, a margin call.
Moreover, we’ve seen plenty of unintended consequences, or worse, backfires, as regulators intervene trying to alleviate the credit crisis. Banks have been reluctant to extend credit to each other precisely because they don’t trust their creditworthiness. That’s tantamount to saying they already don’t trust their public financial statements, since according to their public filings, virtually all major financial institutions have more than the required statutory capital.
So this move, to stem the balance-sheet-shrinking impact of mark-to-market accounting in a falling price environment, may further undermine liquidity. Companies will less able to judge whether their published financials are telling the whole story, And where the numbers are in doubt, rumors are taken more seriously.
Now in fairness, the entire letter wasn’t a gimmie to the securities industry. Entities that report Level 3 exposures have to talk about them at great length:
To paraphrase Winston Churchill, it has been said that mark to market accounting is the worst form of financial accounting except for all the others that have been tried. But it looks like we are going to try them anyhow.
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Death of a salesman…Life is stranger than fiction
Today marked a seminal event in capital markets. For the first time as far as I am aware we got an upgrade of an American icon, the investment bank, on grounds there can be no liquidity issue as they have the full faith and credit of the government. This is no quasi governement agency either. This is the almight Lehman Brothers. Forget the good old days of burying it in the middle of the report; instead we get a front page bullet. A few days ago Dick Bove, relic turned CNBC darling, laid the foundation for this timely rating schange saying that Lehman has the best management in the industry. Wait what? First off that is an oxymoron to begin with, no? Bove soundly reasons that Lehman’s will simply find growth somewhere else. Oh, ok. No mention of the $80 billion in mortgages on the book, or the ballooning balance sheet.
As a postscript to the story we actually had a break in call by Lehman IR yesterday midday when the stock was under pressure which followed the tried and true tactic being employed in the UK so successfully, namely demonizing the hated locust of capitalism: the SHORT SELLER.
Is it me or is there something sureal about this entire espisode. A bankrupt bank led by former head of Treasury who helped engineer the destructive policies that took us down this road (an arbitrage guy himself, how ironic) – an now being touted as boy genius by Hillary Clinton – upgrades an insolvent investment bank based on an implicit government guarantee. Then we have the rough and tumble Fuld, sounding more and more like Willy these days, who showed such bold leadership going hat in hand to the Fed window, sending out his PR squad to attack short sellers. I wonder if that applies to their hedging subprime bonds or their internal prop desks?
I say bring on the investigation; perhaps through the process of discovery we might get to examine the internal logs and trade blotters. Could be a seminal event in the quest for a market clearing mechanism.
The bank with the sharp elbows has been reduced to publicly wimpering to regulators – who have responded vigoriously in a pavolvian fashion with an “investigation” into the bear raiders.
If not the government than at least Lehman has a fiduciary responsibility to Lenin to lower the green flag and ceremoniously raise the hammer and sickle. Fitting that it would fly over Time Square the epicenter of American consumerism. Red really has become America’s color.
The rule sets keeps changing and not just in the financial markets. The Harari inquiry has a new lead (Canadian) and he has conculded after something like 10 reports that scream incontrovertably Syria — that it was now a rogue criminal element. Exact same strategy here. Drag it out as long as possible; public loses intertest and the WHAMO bait and switch. Truly shocking what is going on
Forget about Dick Bove. I don’t know what happened to that guy. He is shredding his credibility. He also just sent out the “all clear” that the financial crisis is over. No kidding? With another 20% plunge in nationwide home prices still to come?
I would go with Meredith Whitney. She is a genuine sharp-shooter with integrity (which is in scarce supply nowadays).
She was made a point on CNBC lately about the banks just dragging this writedown process out forever, because they refuse to mark-to-market on their holdings. If you don’t like the price, just make something up.
The worst part is that since they stubbornly insist on holding onto the assets no matter what, they will incur more and more losses, and eventually may end up selling the assets way down the line at severely marked down prices.
This giant loophole that the SEC just granted them (no need for “forced liquidation” prices) will only further encourage them to hold onto these “dead” assets and incur massive losses upon sale later on.
Honestly, I just don’t see how ALL of these investment banks don’t end up being nationalized when it’s all said and done (maybe that’s the plan?). They are way too highly leveraged to be able to absorb much losses on their balance sheet. Hence the need to dance around mark-to-market.
And this whole notion about having hedged the toxic assets on their balance sheet (i.e. Goldman and Lehman).
Who sold them the insurance? Monolines? Hedge funds? Hahaha.
If the assets are still on the balance sheet, you’re dead—hedge or no hedge.
So what are you going to do about it, tough guy? Ha, ha, ha…
Let me make an observation regarding level 3 assets.
One of the reasons that they can ONLY be sold on a
forced liquidation basis is because they are so nearly
impervious to analysis. They were designed that way-
made to be SOLD, but not to be BOUGHT. To use a simple analogy, take an ounce of gold, a ton of copper and a few grams of plutonium. The gold is worth $935, the copper $3800 and the plutonium has no value except to make a dirty bomb. Put them in a crucible and melt. Now what are they worth? Some processes are non reversible, like cooking a fish. Level 3 assets fall into this category. You just have to wait until maturity-or eternity, which ever come first.
Level 3 assets fall into this category. You just have to wait until maturity-or eternity, which ever come first
March 29, 2008 6:50 AM
rk – so what happens when the company or particular line of business faces going concern problems, wouldn’t the logical assumption be that assets are evaluated now at a present value of maturity value?
Yves- another dumb question from me: if historical prices are used, but the buyer pays eg 1% of the valuation and it’s a forced sale, wouldn’t that mean an immediate recognisable loss of 99%?
foesskewered:
I was only addressing the “salability” of the asset, which flows from its original construction. You are
of course correct with regard to the accounting treatment at present value. That leaves open the question of what the present value of a virtually
unsalable asset is.
“So what are you going to do about it, tough guy? Ha, ha, ha…”
Move my capital out of the US you idiot
Re Foes: “wouldn’t the logical assumption be that assets are evaluated now at a present value of maturity value?”
I think the question then is just exactly how much of the asset (assuming its a bundle of whatever) would not default before maturity. Then you are right back in the same box as now–what’s good, what’s not.
Yves,
In addition to encouraging EVEN LESS transparency at investment and commercial banks, I’m certain that FAS 157 will continue to permit financial institutions to realize gains on liabilities whose values have gone down as a result of increased credit risk and subsequent widening of credit spreads. This looks to me as if regulators are actually encouraging financial institutions to avoid discovering appropriate market clearing prices for illiquid assets AND they’re going so far as to ‘reward’ these same institutions for their significant credit risk by flowing gains through to earnings. Is the SEC the next disaster waiting to happen and are bank balance sheets so bad that even the SEC is kneeling to markets? I guess earnings driven by deterioration in your own credit quality works, but I’d say that’s quite an interesting interpretation of the concept of ‘fair value’.
(btw, i dont believe i’ve posted a comment before, but Yves I’m the guy who recently emailed you with a link to information on bank holding companies)
I think this whole situation can be simplified. The SEC should simply state that all Level 3 assets should be valued at 0, their true worth.
I think both you and Norris are being unfair to the regulators. SFAS 157 has always included an exception for forced sales (as indeed it must, if you think about it). The AICPA has already made it clear that just because markets are illiquid that does not mean that firms can claim that all sales are forced. It was precisely on October 3, when the accountants made it clear that firms would not be allowed to abuse clauses like the “forced sales” clause that dramatic plans to rescue the banking sector began to be concocted. Here is October’s White Paper on fair value rules.
Blame the regulators, including FASB? Hell, yes. They’ve been waving this garbage onto the books for years and enabled the current crisis. Why do they not require a qualified audit opinion if level 3 assets exceed a percentage of total assets or equity, and why are these things not required to be carried on a cash recovery basis? Want to find the market clearing price for this crap? Require 100% of executive bonuses to be paid as interests in the firm’s level 3 assets.
I agree with comments above, but will add, we have organizations in place to look at accounting, fraud, crimes, misinformation, etc, but what we lack, are people that understand what they are doing, and then working for tax payers, versus looking the other way as if they are part of a netwrof of collusion.
We have laws which are broken by people. Corporations are in general, not accountable enties, but the people, like CEOs, CFOs are the people that should be fined and or placed in jail for fraud. For some reason, we have a network of public servants who refuse to comply with the law, then they look away at a network of crooks that walk away with massive bonuses for stealing. These are people breaking laws, hiding behind corporations that are backed by the governments un-willingness to act against crimes!
An example of a bogus organization, like FASB is the following:
The Public Company Accounting Oversight Board (or PCAOB) (sometimes called “Peekaboo”) is a private-sector, non-profit corporation created by the Sarbanes-Oxley Act, a 2002 United States federal law, to oversee the auditors of public companies. Its stated purpose is to ‘protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports’. Although a private entity, the PCAOB has many government-like regulatory functions, making it in some ways similar to the private Self Regulatory Organizations (SROs) that regulate stock markets and other aspects of the financial markets in the United States.
100% bogus! They audit public accounting firms on wall street that fail audits year after year, and it doesnt matter, because there is zero accountability in this mafia-like collusion ring!
Anon:
Yes SFAS has always had the forced sales expemption. Until now, it has been ignored. Reason, the auditors fear their professional lives.
If the auditors used thr forced sales exemption on, say Bear or Thornburg, they would be handed the death penalty a-la Anderson in the Enron debacle. Look at the teeth hashing over New Century changed of accounting procedures.
Friday’s SEC letter is being looked at as a “get out opf jail free” card to the auditors. Should be invoke this rule on a firm that subsequently blows up, they will live to see another day.
Anon March 29, 2008 10:21 AM
Actually, it doesn’t really matter what is good or not, when the forced sale comes through, it’s just a matter of whether a buyer emerges and what kind of price they are willing to pay.
RK
know what u mean, but frankly, as long as a buyer emerges, there will be a price; of course it’s instructive when no buyer emerges. Perhaps, the FED can resolve this, letthe FED put a buyer of last resort price to the unsaleable items, obviously that puts them in the unenviable position of possibly having to take up thoise assets on a permanent basis. (think wicked glint in the eye type of humour!)
Worthless securities being hidden in plain sight on the balance sheets of major US financial institutions for the purpose of defrauding investors with the backing of the SEC, Fed, Treasury, etc.
The legal system was the first to be corrupted so the Supreme Court will rubber stamp whatever criminal enterprise the government wants to propose.
If I didn’t see it happening, I would never have believed it. Pretty much corrupts the whole system.
I’d like to echo the comments above about this not being a change as such. Here is what SFAS 157 itself says:
“A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).”
It seems that nobody is reading the offending paragraph carefully.
The sentence is addressing “observable inputs,” which are COMPARABLE MARKET TRANSACTIONS that you are using to value your holding.
It is NOT addressing the holding that you are valuing. Big difference!
If one of the COMPS that you have selected is a liquidation transaction, YOU DON’T USE IT to value your holding.
It is NOT saying that if your holding is in foreclosure that you can simply ignore or fudge the valuation.
Read the actual words!