Friday, January 23, 2009

Does Fair Value Accounting + Credit Default Swaps = Global Deflation?

From the Institutional Risk Analyst:

Today we want to return to the issue of fair value accounting and whether this last remnant of bubble-think is not driving us into the proverbial Thresher (SSN-593) scenario, straight down into the deepest trench of an economic correction that is well-beyond crush depth. Over the past several months, we have come to the conclusion that we must make a correction in the FVA rule. We see two issues:

First, FVA relies on efficient market theory, namely that short term price = value and that consequently income, assets and liabilities should be adjusted in real time to reflect same. (This is the same problem with CDS pricing, BTW, as we discussed in our last comment, ("To Stabilize Global Banks, First Tame Credit Default Swaps," Janury 21, 2009.) We think that the collapse of all of the other market efficiency based constructs, from structured assets to hedge funds, ends the discussion of derivative notions such as FVA. < /P >

Second, FVA fails to recognize the historical role of depositories, pensions and insurance companies as repositories for long-term value and consequently as havens from swings in short-term market pricing and economic trends. The whole point of capital adequacy regulation, with the notable exception of broker dealers, is to give such institutions the freedom to take the long view. FVA makes the long view impossible and basically turns what are supposed to be low-beta, low risk, highly solvent hold-to-maturity vehicles into mark-to-market liquidations every day via the CDS markets.

Just as you cannot buy bad assets from an insolvent bank at "fair value" without worsening the insolvency, likewise when you mark down assets you are reducing the ability of the entire financial system to support leverage. When you combine the zero effective collateral and margin operating in the CDS market with the quarterly idiocy of marking down performing securities and loans to satisfy the advocates of FVA, it would be difficult to imagine the enemies of the United States constructing a more perfect weapon to bring about our collective demise.

That said, we are not against disclosing the short-term fair value of assets. In fact, we want to see expanded disclosure of swings in FVA for all public companies, financials and otherwise. And as we have written, the regulatory is moving, painfully, slowly, to expand disclosure for banks and BHCs via efforts such as the expansion of the Shared National Credits reporting matrix, Basel II and a monthly reporting series on credit cards, a vast task that could require the collection of half a trillion records containing your personal credit and financial information, some 100 data elements per discreet record.

IRA is actively competing as a subject matter expert and system design architects for some of these new data collection tasks before the OCC, SEC, FDIC, etc, and we shall keep you in the loop to the extent we are allowed under the very tight confidentiality that is required. But suffice to say that we believe that there will be vast amounts of new data available on assets and liabilities as the restoration of prudential limits on finance proceeds apace.

We agree with those who believe that a compromise must be struck between the utopian goals of complete and total market efficiency and transparency and the real world of human action and inefficiency. The fact is, normal people are simply not able to react to and understand the torrent of short-term swings in assets prices, thus the net effect of FVA is not greater understanding, but instead fear, panic and systemic instability.

Believe us when we say that we have seen the wild eyed, "don't you get it" look from the proponents of FVA in our colleagues in the XBRL community. We love their idealism and their vision, and we share same. But we at IRA also live in the real world of operating and delivering decision support systems for investors and fiduciaries. These systems must operate in the objective and very arbitrary rules of scientific method, because as Graham and Dodd taught us 80 years ago, the more speculative, the more unstable the data inputs, the less the analysis matters.

The subjective, speculative perspective that is the essence of FVA, when applied to illiquid assets has, we believe, the net effect of increasing the instability in the global economy. We'd like to ask the economists who read The IRA to answer the following question: Is FVA accelerating the slowdown in the velocity of money? Because if the answer is yes, than nothing the Fed or Treasury try to do in nominal terms will be effective in stabilizing prices or GDP because FVA, imposed just as the great bubble was imploding, is now driving the global economy to a fire sale liquidation.

Disclose swings in market value of assets, you can even put aside reserves against the weaker credits, but so long as the asset is money good, it should not be charged against reserves. We might even construct some type of averaging rule for FVA swings in assets, affecting income and even reserves once the swing in value if confirmed over time, but the notion of instantaneous and immediate price discovery, disclosure and financial adjustment is a childishly idealized notion that must be gently restrained.

Below we republish an article which appeared in The American Spectator last month by our friend Alex Pollock from American Enterprise Institute appropriately entitled "Not Fair." Don't forget that we'll be appearing next Wednesday, January 28, 2009, with Alex, Josh Rosner, Barry Ritholtz, Walker Todd and Tim Bitsberger at the next AEI/PRMIA joint-effort, "Bust, Bankruptcy, Bailouts: What Should We Do Now?"

"No Fair"
The American Spectator
December 22, 2008
By Alex J. Pollock

Many of us argued against Financial Accounting Standard (FAS) 133, a big step on the downhill path of "fair value" accounting ten years ago, finding it not only wildly convoluted and expensive, but conceptually wrong. The more criticism the Financial Accounting Standards Board (FASB) got, the more they dug in. At the time, this led me to develop a two-part plan for the FASB. Part one: tar. Part two: feathers.

Unfortunately, this plan was not implemented. FASB was able to continue on its metaphysical quest for "fair value" accounting up through FAS 157 (so far), enabling it to be an important factor in making the financial panic of 2007-08 worse--"a major cause of the world-wide financial crisis," as Bill Isaac recently observed.

What is accounting truth? It is never and never can be simply "the facts."

A FASB defense against this indictment claims that "Fair value reflects losses that have been incurred, it does not cause losses." But in a downward spiral of panic and illiquidity, this is manifestly untrue. Accounting has real world effects on funding markets, including heightening international uncertainty and triggering defaults on debt covenants, customer behavior, and the actions of regulators. All this creates further uncertainty, which further depresses prices.

The perverse effects of fair value accounting in a market panic are why almost all financial institution regulators oppose it. It is too easy for them to think of distressed situations which the banking system survived, but would not have survived if it had had to "mark to market" at the time. The 1980s and 1974-75 are good examples.

Apologists for FASB and fair value accounting also say they are only insisting on "the facts" of market prices, although of course admitting that in many cases there is no active market or no market at all, and that panicked markets can reach fire sale prices that will be judged by later observers as irrational. Nonetheless, they say, we must not hide from "the truth."

But what is accounting truth? It is never and never can be simply "the facts." It is facts treated according to some theory, which also generates the projections, estimates and guesses needed to calculate what the theory defines as its results--for example, the defined concepts of "profit" and "capital." As the Institute of Chartered Accountants of England and Wales so rightly observe: "Financial reporting attempts to measure inherently abstract and debatable concepts such as income and net assets, and it has particular features that make it to some extent inevitably subjective."

Debatable indeed: accounting theories are debated over years and decades without one side or the other being demonstrated as correct.

So what kind of a theory is fair value accounting when applied to debt instruments? It is okay in a stable period when prices are equilibrium-seeking. But in a period of dynamic disequilibrium and discontinuity, like a panic, it adds to the disequilibrium and makes the problems worse.

An essential distinction is that debt instruments, unlike equities (or houses), have a principal to be repaid at maturity, and contracted-for interest payments until then. Suppose all interest and principal are going to be paid exactly as agreed. What is the right accounting representation? This is the same question as asking what discount rate should be applied to the cash flows of interest and principal and how that should affect the defined concepts of profits and capital. To discount the cash flows by the exaggerated illiquidity premiums of a panicked market, then by doing so to produce losses and erase capital, is to feed the panic. Many right-minded observers therefore say we should "suspend" fair value accounting. This seems to me to give it too much credit, to merely ask for a mulligan. I say it should not be suspended, but fixed.

Here's how. Produce pre-"fair value" balance sheets and income statements as before. Then add as a new principal financial statement a completely "marked to market" balance sheet, showing the "truth" according to fair value theory, using whatever market prices there are or are estimated to be. This would give the proponents of fair value accounting all the information they desire. It would not be "buried" in the notes, a typical complaint, but added to the set of key financial statements, which would become:

Balance Sheet
Statement of Income
Statement of Shareholders' Equity
Statement of Cash Flows
Marked to Market Balance Sheet

Thus we would have multiple perspectives on asset values, just as cash flows and accrual accounting are multiple perspectives on operations. But we wouldn't have accounting feeding the downward spiral of a panic (or for that matter, helping inflate a bubble). Faced with the current effects of its fair value theory and consequent criticisms, the FASB has redoubled its commitment to the theory and announced it wants to take it even further. Thoughtful government policy makers are unlikely to share the view that "I must follow my accounting theory, though the heavens fall." Somebody needs to simply overrule FASB. If the SEC won't do it, then who? Well, FASB is a government-sponsored entity, which ultimately works for and has its funding mandated by Congress.

Alex J. Pollock is a resident fellow at AEI

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