Wednesday, October 29, 2008

Asymmetrical accounting

There are no accounting issues, no trading issues, no reserve issues, no previously unknown problem issues.

- Kenneth Lay

(FT Alphaville) Another day, another ex post facto colloquy-come-regulatory power-snatch:

The Emergency Economic Stabilization Act of Act 2008, enacted and signed by the President on October 3, 2008, among other things requires the Commission to conduct a study of “mark-to-market” accounting applicable to financial institutions, including depositary institutions, and submit a report to Congress with the findings and determinations within 90 days.

The SEC hosts its first roundtable on Mark-to-Market financial accounting today. You can take a peek at the exciting agenda here.

The allegations are fairly straightforward: mark-to-market accounting, as defined under FAS rule 157, has exacerbated - in some cases grossly - the current crisis, by forcing banks to make unrealistic, severely under-priced marks on illiquid assets and has thus impaired balance sheets.


First, a quick recap. FAS 157 was issued in September 2006, with effectiveness from November 2007. It’s not applicable to all assets, but is typically used on those held for trading purposes or those available for sale (it’s also applied to all derivatives). Under FAS 157, assets must be priced using rules set under three categories: level 1, level 2 and level 3. Assets classified as “Level 1″ are priced according to prices readily available in liquid and active markets. Assets classified as “Level 2″ are less liquid, and are priced according to observations taken from other transactions: in active, non-active or non-public markets. Finally, “Level 3″ assets are illiquid. Pricing is derived from models, with detailed disclosures of underlying assumptions, inputs and risk exposures.

There are quibbles over a lot of FAS 157, but the major bone of contention is in the pricing of level-3 assets.

FAS 157 detractors argue, in a nutshell, that the rules are in many cases requiring them to take hits on illiquid securities - either under level 2 or level 3 classfication - because of read-across from “firesale” prices in the market.

The banks - for it is mostly they - are being slightly disingenuous here, however. Not wanting to mark assets at firesale prices is perfectly legitimate. As Ann Rutledge at Credit Spectrum points out:

The concept of fair market value is as old as the 1587 edition of Blacks Law Dictionary. It is exactly the same in the Merriam-Webster dictionary (1901):

“…A price at which buyers and sellers with a reasonable knowledge of pertinent facts and not acting under any compulsion are willing to do business.”

But who said today’s prices are forced by compulsion? Banks are lobbying to have FAS 157 suspended on the basis of firesales which may not actually be firesales. As the FASB notes in its recent clarification of rules:

… in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales.

Anyone who thinks subprime CDOs are really worth holding onto because their fundamentals reflect a high value on the dollar is patently wrong. Consider the number of defaults and liquidations, for example.

Can detractors complain about straightforward sales causing mark-to-market hits under FAS 157? Apparently.

If by common consensus we are seeing the deflating of a bubble, then what we are seeing is the repricing of formerly overpriced assets. The mistakes in accounting are not being made now, but were being made earlier. Why?

Or as Rutledge phrases it:

…willing and informed are not the same. Symmetry of information between buyers and sellers, a crucially important part of the original definition, has been left out of the discussion. Why?

As the original 1587 definition of fair value says, the participants in a transaction need a “reasonable knowledge of the pertinent facts”. Those facts, in the case of structured finance products, having been wrong or else, willfully suborned to the use of stochastic modelling.

Perhaps it is because the truth up-ends much of what is held sacred about capitalism: genius-priests, all-knowing institutions, liturgies of heat transfer equations, etc.

But we digress.

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