Banks set to “play make believe” with the valuation of their assets

Money and Markets reports that the banking industry's problems are solved.

(emphasis mine) [my comment]

Eureka! The Banking Industry's Problems Are Solved!
by Mike Larson 03-13-09

Who knew it would be so easy? Who knew we could solve the banking industry's collapse by simply changing how we account for assets. Eureka! Problem solved!

That seems to be the conclusion Wall Street came to earlier this week, judging by the reaction to Fed Chairman Ben Bernanke's comments at the Council on Foreign Relations on Tuesday. During that speech, Bernanke weighed in on "mark to market" accounting, saying the following:

"The ongoing move by those who set accounting standards toward requirements for improved disclosure and greater transparency is a positive development that deserves full support. However, determining appropriate valuation methods for illiquid or idiosyncratic [worthless] assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle.

"As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is underway on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers."

What Bernanke did is shift ever so slightly toward the position of the banking industry's apologists. These lobbyists, assorted policymakers, and pundits (including folks like Steve Forbes, who wrote an Op-Ed in the Wall Street Journal the other day), are arguing — once you cut to the chase — the following ...

The problem with the banks isn't all the crappy securities and loans they're loaded up with.

It's not that they took on too much excessive risk, lending against assets whose value is plunging.

It's not that they funded asinine private equity deals, stupid commercial construction deals, and dumb home purchases.

It's that they have to mark their book of securities made up of these bundled loans to market. And they argue that the prices they could get for those securities in the markets are "artificially" low — or in some cases, that there is NO market for them [The reason there is no market for radioactive waste is because no one want to own it].

If only they could avoid marking those assets to market, or use their super- duper net present value and cash flow MODELS — which, surprise, surprise, say the "real" value of those securities is higher — then the banking system would be fine. We could all go back to the wonderful world of yesteryear.

The Financial Times reports that IASB to consider changes to fair value rule.

IASB to consider changes to fair value rule
By Jennifer Hughes in London and Joanna Chung in New York
Published: March 18 2009

US proposals to ease controversial fair value accounting rules could alter practices around the world after the international accounting standard setter said it would also discuss the changes.

The US Financial Accounting Standards Board was poised on Tuesday to publish two staff papers that would allow banks and other companies more freedom in how they value financial assets
[Yay! US banks can now pretend they are solvent!]. More securities would be valued by computer models [ie: Mark-to-myth] rather than current market prices [ie: Mark-to-market] and many are expected to go up in value. A rule change could come into effect as early as next month.

The International Accounting Standards Board agreed on Tuesday to put out the papers for comment by those who follow its rules — a list of more than 100 countries.
[Remember how Europeans are pushing for more transparency in the international financial system? I wonder how they are going to like this.]

Both the IASB and its US counterpart have resisted changes to the rules in ways that could make accounts less transparent for investors
[until today]. But political pressure in the US has led to these latest changes, while the IASB was forced to soften its own rules last autumn by the European Commission.

Fair value accounting requires companies to report most financial holdings at current market prices. Critics have complained that the plunging prices have slashed banks' profits and undermined their capital reserves.

The impending rule change has attracted criticism and praise.

"I've been wondering for about two years why they haven't done it already ... to me it seems to be the simplest, fastest, cheapest way to deal with the heart of the problem which is the negative feedback loop between the economy and marking asset values in illiquid markets," said Ed Yardeni of Yardeni Research.

"Mark to market implies that there is a market that provides accurate information, but that assumption clearly fell apart even in early 2007
[Yes, exactly! (very heavy sarcasm) It isn't the terrible lending decisions made by bankers which caused this crisis! Everything is the fault of accountants and their mark to market "assumptions"]."

But Shyam Sunder, an accounting professor at Yale and critic of fair value, said the move was ill-judged. "It is fundamentally a bad idea to switch accounting methods in response to what is happening in the markets.
[Agreed] When you look at the market and decide the rules, it amounts to having no rules at all," he said.

Lynn Turner, former Securities and Exchange Commission chief accountant, said: "They are taking accounting standard-setting back four decades." He added: "The reality is that with this proposal, FASB is really suspending fair value accounting. The bottom line is that these type of things never gets reversed."

Jonathan Weil on Bloomberg says don't blame mark-to-market for banks' problems.

Don't Blame Mark-to-Market for Banks' Problems
Commentary by Jonathan Weil

March 17 (Bloomberg) -- If only we didn't know how badly off the banks are, then maybe we could save the financial system as we used to know it.

That is the growing mantra from financial executives and their water carriers in Washington. The major problem isn't that banks made poor decisions and lost credibility with investors, in their view. The problem is that mark-to-market accounting is dragging down financial institutions and the U.S. economy, as House Financial Services Committee Chairman Barney Frank said last week.

They couldn't be more wrong [Agreed]. And there's so much misinformation floating around the markets on this subject that it's time, once again, to debunk the myths.

Myth No. 1: The rules known as Financial Accounting Standard No. 157 are to blame.

The latest iteration on this tired saw comes from Christopher Whalen, a managing director at Institutional Risk Analytics, who gave an interview on the subject Friday. Among his recommendations:

``Rescind FAS 157 so if you have a real quoted price for an asset, fine, use it. Otherwise you allow companies to use historic cost. You had a transaction, you know what you paid for it, it's a fact. All this other stuff is speculation. We are literally creating the impression of losses.''

The Awful Truth

The truth: FAS 157 doesn't expand the use of fair-value accounting. Rather, it requires companies to divulge more information about the reliability of their reported fair values.

Most companies won't even adopt FAS 157 until this quarter. All the standard does is require companies to disclose how much of their assets and liabilities are valued using quoted market prices, how much are measured using valuation models, and how much come from models using inputs that aren't observable in the market. That's it.
[In other words, FAS 157 would let investors see just how unrealistic the valuations used by banks are, which would in turn reveal just how insolvent the US financial system is.]

Myth No. 2: Mark-to-market accounting is new.

Companies have been ``marking to model'' for decades, and few people complained when banks and others were recording large gains as a result. The difference now, thanks to FAS 157, is that outsiders can see the extent to which companies' fair-value results are based on estimates, at least at companies that adopted the rules early.

Financial statements always have been piles of estimates heaped upon a bunch of guesswork. Look through the footnotes to any company's financial statements, and you'll see that estimates are used for everything from loan-loss reserves, to income-tax and stock-option costs, even revenue.

Solves Nothing

Moving everything to historical-cost accounting wouldn't solve anything. For assets that aren't marked-to-market each quarter, such as goodwill and inventory, they still must be written down to fair value whenever their values have declined sharply and show no sign of bouncing back. The accountants call this an ``other-than-temporary impairment.''

So even if we had historical-cost accounting today for all the mortgage-related holdings that have plummeted in value and for which there is no liquid market, companies still would have to estimate the assets' fair values and write them down accordingly. That's because the values probably won't come back anytime soon, if ever.

Myth No. 3: Companies aren't allowed to explain their mark- to-market values.

This is a fairly new one. Last week, the Securities and Exchange Commission said it is drafting a letter to let companies tell investors when they think the market values of their plunging assets don't reflect the holdings' actual worth. Companies also would be allowed to disclose ranges showing what their models say the assets might fetch in the marketplace.

Guess what? Companies are allowed to do these things already in the discussion-and-analysis sections of their SEC reports each qu arter. They also can make such disclosures in their financial-statement footnotes. What they can't do is print ranges on their balance sheets or income statements, any more than taxpayers can put down ranges on their Internal Revenue Service returns.

Myth No. 4: Eliminating mark-to-market accounting will prevent margin calls.

If you're a banker for, say, Thornburg Mortgage Inc. or Carlyle Capital Corp., do you think for a minute that you would hesitate to call in one of these companies' loans just because they started using historical cost to account for hard-to-value financial instruments? No way. The moment lenders decide the collateral isn't worth enough to support the loans, they'll demand more collateral or pull the plug, no matter what the financial statements say.

Myth No. 5: The public would be better off without mark-to-market accounting.

Investors are fully capable of understanding that unrealized losses on hard-to-value assets are estimates. They're also smart enough to know that values change over time. And in the case of things such as credit-default swaps that eventually might reach some settlement date, the fair-value changes include vital forward-looking information about what the future economic costs of these derivatives may be.

What most investors can't tolerate is being kept in the dark, when companies in their portfolios are sliding toward insolvency and whistling along the way that all is well.

We've got a meltdown, folks. Deal with it.
[Agreed]

Finally, here is a quick extract from Slate.com which reports on the mark-to-market melee.

The language is technical, but the arguments here are simple and really quite silly—especially coming from folks who value market indicators over all else. These folks are saying that when markets are volatile and irrationally pessimistic, it's just not fair to force people to act as if the market prices are real.

But you'll notice that they never made that argument back when markets were irrationally optimistic, as they were from 2003-2006. No hedge fund manager ever told a bank that it should lend him less money because the value of the collateral he was putting up was clearly a product of unwarranted optimism [Nicely put] or that he shouldn't collect management fees based on the assets under management because their value was clearly inflated. Nobody ever complains about the market's ruthlessness and inefficiency when it's making them money.

My reaction: Basically, banks really want to pretend that they are solvent. They are arguing that if we let them "play make believe" with the value of their assets, everything will be OK.

1) The US Financial Accounting Standards Board was poised on Tuesday to publish two staff papers that would allow banks and other companies more freedom in how they value financial assets.

2) With FASB's new rule changes, toxic bank securities will be valued at the prices bankers wish they could sell them rather than the prices at which they could actually be sold.

3) Since the imaginary prices are a lot higher than the real prices, most of these assets will go up in value.

4) Banks will be able to use these imaginary prices as soon as next month.


Conclusion:
Expect more banks like Citigroup to start posting profits as accounting rules are "tweaked". When these bank "profits" do start showing up, remember that they are as real as the Easter bunny.

-----------------------------

In the spirit of Wall Street make-believe, I dug up an appropriate story from last year. Below, the WSJ's Marketbeat blog reports that Lehman to be acquired by tooth fairy.

Breaking News: Lehman To Be Acquired by Tooth Fairy

The market responded with enthusiasm to reports that the Tooth Fairy has agreed to acquire Lehman. The purchase price has not yet been determined and will be set by Dick Fuld wishing upon a star, clicking his heels three times, and being transported back to that magical place where Lehman still sells for over $70 per share.

In related news, Lehman has agreed to sell all of its level III capital, including CDOs, ABSs, pet rocks, baseball cards, slightly used condoms, and credit default swaps written by MBIA and Ambac. Lehman's level III capital will be acquired for 150% of its face value by Tinkerbell, who will carry it off to Neverland to be fed to a crocodile. Lehman is financing 90% of the acquisition at an interest rate that has not been announced; Tinkerbell's up-front payment consists of a handful of pixie dust, three crickets, and a bullfrog. Analyst Dick Bove estimates that the bullfrog could eventually be transformed into three princes and a pumpkin coach. The deal gives Lehman no recourse to any of Tinkerbell's assets other than the Level III capital. If Tinkerbell defaults, Lehman's successor entity will stick its hand down the crocodile's throat and attempt to get it to regurgitate. The firm's historical value-at-risk analysis shows that sticking your hand down a crocodile's throat is completely safe.

Treasury Secretary Hank Paulson issued a statement: "I am delighted that SWFs (Sovereign Wealth Fairies) continue to express confidence in the terrific values represented by American financial institutions. As I have been saying since August of 2007, this shows that the crisis is now over."

Meanwhile, the SEC has announced an investigation of mean, evil, bad short-seller David Einhorn. While out for a beer with a friend, Einhorn reportedly suggested that the Tooth Fairy does not exist and that wishing upon a star is not a wholly reliable price discovery mechanism. Christopher Cox, chairman of the SEC, said, "Vicious rumors attacking the Tooth Fairy will not be tolerated. Our entire financial system and indeed the American way of life depend on the Tooth Fairy and wishing upon a star. How e lse could one value level III capital appropriately?" The SEC is reportedly planning to set up re-education camps for short-sellers.

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5 Responses to Banks set to “play make believe” with the valuation of their assets

  1. Martijn says:

    Just as Mr. Yardeni said: this is by far the easiest way to "solve" the current problems. By simply changing the accounting method, Bernanke's printing press can perhaps get some rest.

    And it doesn't really change that much after all. The system is based on trust right now, and when the accounting rules change trust will still be its only foundation.

    Banks are structurally insolvent due to fractional reserve banking, and no accounting standard can change that. A different valuation of assets will only change the perceived (not the real) solvability of banks and hence can increase the trust the main public has in the system.

    Changing valuation right now will convince quite some people that many problems are solved and restore some trust. So this move will most likely buy the current system some time, and for that time might be bearish(!) for gold.

  2. Anonymous says:

    I'm simply curious - what's going to happen to the markets, values, the future if banks play 'the pretend game'? What's the downside? Excuse me, I'm a novice.

  3. Martijn says:

    Well, obviously the products that are now allowed to get fairy tail prices in reality remain worthless. As long as they just sit still on the balance sheet they will not cause any trouble. However, these products are basically amounts of money loaned, and at the time those loans were made they were expected to be repaid. That is however not likely to happen anymore -the reason why those products are now worthless in the first place- and by the time they mature their owners will still get in trouble. However, the new rules will buy some extra time before that happens.

  4. Anonymous says:

    This is crazy! The problem of todays economy is foremost the lack of confidence, how will these new rules help confindence?
    The FED is pumping "money" into the system and all rules are off.

    These events are truly a sign that the people in power have no sence off reality and they are draging the west towards the abyss.

  5. Martijn says:

    No, the problem is that the reality is bad, not that those people have no sense of reality.
    The ship has been built rather badly, however, that is not a reason to sink it and let everybody on board drown. Keeping it afloat is a rather natural reaction, although perhaps not optimal. Optimal would be building a new, better ship on board of the old, but that is hard to do.

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