Wednesday, October 01, 2008

On your marks ,,,

At the root of the credit mess we're in is the slippery idea of valuation. Just exactly how valuable are the assets (and liabilities) of the things that financial companies own?

Do you accept the valuation marked by the companies' own valuation model or the valuation marked by the independent market?

The recent revolt of the Republicans who torpedoed the stabilization bill is based on the demand that the companies be allowed to mark the assets to their models rather than mark the assets to market.

(The revolting Dems chose to demand more CEO heads on stakes and more chickens in the pot for mortgagors, but that's a different issue and, while both sides revolted, they had no common interest in their respective agendas.)

Enron got around the problem of hiding losses by moving them off the books, hidden away in special purpose vehicles. Until, that is, the SPVs bit them on the butt, and then the valuation of the company, as portrayed by its management, disingenuously, tanked, taking down millions of investors with it.

While SarbOx supposedly dealt with that in some small ways (but big enough ways for Wall Street to rail against it to get back to the Enron slather), somehow the financial institutions were able to develop their own version of the SPVs. In the financial world the spivs became the seives, as in leaking like a SIV, etc.

But the real damage done to the credit markets has come in hiding losses and other bad investment notions in instruments whose values are questionable, in more than one sense of the word. Putting the spin and best light on it, the valuation is supposedly ambiguous because there is no ready, deep market for the instruments from which you can extrapolate a disinterested price.

But accounting rules require companies to place sound valuations on the assets of the companies. Companies cannot just make up a valuation and go with it, for their own purposes. Well, that's the idea, anyway.

There are various ways that accounting rules allow valuations to be recorded, such as original cost, but far and away the most relevant and preferred valuation is the market price at the time of the effective date of the accounting period.

But, financial firms argue, the CDO, CPDO, swaps and other financial instruments on their balance sheets (and off), which they created to be intricate and opaque, are so arcane and precious that they are simply incapable of being priced in any relevant current market.

What the financial firms are saying is that because the instruments are non-valuable, that they can write them up as invaluable.

They want to concoct any model they consider reasonable,
even if any one assumption in the model is false, and put that valuation on the asset, regardless of the bigger picture the markets more broadly are painting.

To prevent this sort of monkey business, the Financial Accounting Standards Board adopted Rule 157. While not entirely easy to understand, if you take just a few moments to wade through the basic explanation they give it, you can understand its purpose to shift emphasis away from subjective valuations by the companies themselves to a more objective market analysis.

Barry Ritholtz described the rule on the day it went into effect way back last year (long after this crisis had its genesis), November 15, 2007:
What that accounting change requires is that all of the crappy paper on the balance sheets of various funds, banks and brokers -- RMBS, CDOs, CDS, etc. -- must be "carried at fair value on a recurring basis in financial statements."

In other words, no more mark-to-model or other accounting fantasy.

Before you applaud FASB for requiring fair and transparent disclosure of holdings by Financial institutions -- something that most reasonable folks would describe as a no-brainer -- allow me to point out that a total deferral for a full year nearly passed. After various lobbying efforts by groups like Financial Executives International, the seven-member FASB rejected such a proposal by a four-to-three vote.

That is a reminder of exactly how pathetic and shareholder unfriendly the corporate infrastructure remains.
Guambat believes that the Rule 157 mark to market rule did not create this crisis and that removing it would not ameliorate it.

Guambat feels that the accounting rules should be consistent in looking to objective third party valuations, appreciating full well the gray areas of the process.

Guambat feels that Wall Street needs to accept the pain of the market pricing mechanisms if they are going to insist on taking as much gain from it as they have.



But not so they Republican "libertarian" right wing.

Newt Gingrich comments in Forbes: Suspend Mark-To-Market Now!
[W]hen a company in financial distress begins fire sales of its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This has begun a downward death spiral for financial companies large and small.

The criminal liabilities imposed under Sarbanes-Oxley have driven accountants to stricter and stricter accounting evaluations and interpretations and have prevented leading executives from resisting them.
FIRE SALE VALUATIONS. That's the cry of the financial firms. But Guambat has heard that before in a different context.

When the big financial houses lend to market participants in margin-financed lending, and there is a momentary air pocket in the markets causing a temporary drop, the financial firms don't just shrug their shoulders and go, "oh, well". Hell no. They say "we closed out your position because you didn't meet your margin call based on the fire sale valuation caused by that air pocket". (And don't get Guambat started on how those same firms mop up on all the forced sales of those margin accounts.)

When a small business is having a tough cash crunch and needs an extension from the bank, does the bank ignore or rely on fire sale valuations to put the small business into bankruptcy or otherwise out of misery?

The financial firms are quick to put the fire under others, but when they find themselves in the frying pan, they want to eliminate the fire sale rules as to their own particular assets.

And worse. They want to eliminate the mark to model rule so that in good times they can plump up their balance sheets to give them inflated values, which allows them to leverage up even more, so they can get back to the halcyon days of last year. They're taking advantage of this tight spot to recreate the easy non-accountability rules that facilitated their excesses.

And that's why they're holding the stabilization bill hostage. It's a cynical move to politically leverage their financial leverage.

Michigan Rep. Miller demands that certain accounting practices be curtailed
U.S. Rep. Candice Miller is calling for the elimination or suspension of some current accounting practices as a way to improve the situation on Wall Street.

“There are common sense solutions to this problem that will have far less impact on the American taxpayer,” she said.

One of those, she said, is the elimination or suspension of so-called mark-to-market accounting practices in relation to mortgage-backed securities.

That is pressuring financial institutions which have to keep certain level of assets on hand and are having a hard time finding lenders as those securities continue to lose value. Suspending mark-to-market could allow those institutions to re-value those assets, improving their books and potentially giving other lenders confidence to loan those institutions more money.

Yep, that's what Guambat is talking about.

How Mark-To-Market Accounting is Killing the Financial Markets
One of the levers in the financial crisis is the concept of mark-to-market, a regulation that forces banks to devalue their own assets.... With assets marked down, banks' working capital is reduced and they find themselves in the liquidity crisis they are in right now.
Yes, and how is that different from the investor with a margin call or a small business suffering a temporary cashflow problem?

The WSJ does note that there are many responsible persons, even accountants for god's sake, who remain confident in the Rule 157 mark to market valuations.
Auditors Resist Effort To Change Mark-to-Market

U.S. accounting firms, which had been silent on the $700 billion financial-rescue package rejected by the U.S. House of Representatives on Monday, are opposing congressional efforts to scrap mark-to-market accounting rules.

Accounting firms hadn't weighed in on the rescue plan, but are gearing up to lobby against an alternative that would rescind mark-to-market accounting rules.

Congress is mulling the idea as regulators from the Securities and Exchange Commission and standard-setters at the Connecticut-based Financial Accounting Standards Board are considering issuing additional guidance on using mark-to-market accounting, according to individuals familiar with the matter.

"It's just bad for investors," said Beth Brooke, global vice chair at Ernst & Young LLP, in Washington, D.C. "Suspending mark-to-market accounting, in essence, suspends reality."

"It's absolute idiocy," said Barbara Roper, director of investor protection for the Consumer Federation of America. "Allowing companies to lie to investors and lie to themselves is not the solution to the problem, it is the problem."

Ms. Roper said lawmakers need to understand "that the alternative to mark-to-market accounting is mark-to-myth" and could give banks and other financial companies the freedom to value assets at inflated amounts.

Mark-to-market accounting isn't new and companies have always been required to mark down the value of impaired assets, Mr. Ciesielski noted. He said lawmakers who seek to suspend the requirement would be siding with banks and their trade group at the expense of investors, and "may be sowing the seeds for another round of financial reporting devastation down the road."
Barry Ritholtz has kept up to date on this issue since the early days, and provides a great deal of worthwhile reading on the subject.


FOOTNOTE:

One suggestion made, to avoid the mark to market rule, is to allow the financial assets to be valued "at maturity", which ignores current market conditions and prices implicit in those conditions. This attempts to put a sophisticated gloss on the "fire sale" argument, but is really no different, merely ignoring the fire and waiting for the fire crew to put it out and clean up the mess. For instance:
How Mark-To-Market Accounting is Killing the Financial Markets
As a Chartered Accountant, I welcomed the new mark-to-market rules and worked with many companies to implement them. Unfortunately, the mark-to-market rule has had the opposite effect on corporate financial statements.

Financial instruments represent assets that derive their value from other assets. For example, mortgage-backed securities are "bundles" of mortgages sold as investments to banks and other financial institutions. The mortgage-backed securities derive their value from the mortgages that support them. If the mortgages have no value (i.e. no one is paying their mortgage), then the mortgage-backed securities do not have any value.

Many of these financial instruments are not going to be sold in the short term, so the short term value is less meaningful than the value of the financial instrument on the date of maturity.

How the mark-to-market rules have precipitated a crisis is that many of the banks' financial instruments, especially the mortgage-backed securities, do not currently have a market.
Implicit in the author's argument is that the investment security assets, though derived from the underlying mortgages, should be valued independently from those underlying mortgages.

Guambat pellets!

Guambat reckons, if you're going to live by the derivatives, you die by the derivatives.



FOLLOW THROUGH:

The SEC is now giving financial firms a lot of wiggle room to undo the effects of Rule 157, according to its latest release. The firms can now use their own judgment to determine how "temporary" an "impairment" is, use their own internal cashflows to offset lack of evidence from "an active market" and disregard broker quotes in same, etc.

As Guambat noted above, there are obvious gray areas in this valuation process, and Guambat actually has no objection to using methods and models other than as required by a strict application of market prices in every instance. Guambat would require, however, in that instance, at least a footnoted reference to the prices indicated by such approach to contrast it to the modeled valuation.

The new SEC "clarification" doesn't go quite that far but does require
because fair value measurements and the assessment of impairment may require significant judgments, clear and transparent disclosures are critical to providing investors with an understanding of the judgments made by management. In addition to the disclosures required under existing U.S. GAAP, including Statement 157, the SEC's Division of Corporation Finance recently issued letters in March and September that are available on the SEC's Web site to provide real-time guidance for issuers to consider in enhancing the transparency of fair value measurements to investors.

2 Comments:

Anonymous Anonymous said...

Not long after reading this, I sat through a class during which the professor professed his beliefs to the marked contrary.

Apparently, the joy of holding illiquid assets, which are quite different beasts compared to their more liquid counterparts, is unfairly hampered during flights to liquidity. The idea is that a flight to liquidity sees market participants sell down the only assets they can - the liquid ones - thereby artificially deflating the liquid indexes (indices?) beyond a 'fair' level, were participants also able to proportionately sell down their illiquid assets.

The whinging then starts when the banks are forced to MTM the illiquid assets to their oversold liquid brethren.

I chose to keep my mouth shut during this particular class. I think that constitutes 'consensus provision risk'...

7 October 2008 at 9:10:00 am GMT+10  
Blogger Guambat Stew said...

Notice that Guambat, too, fudged that difficult judgment by advising using one mark (consistently) in the books, but footnoting full disclosure of the value/effect of the other mark.

7 October 2008 at 1:50:00 pm GMT+10  

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