Friday, April 3, 2009

The international FAS 157-e

The US accounting standards board - the FASB - voted to change mark-to-market rules yesterday, in a widely-expected move.

The analysts - and pundits - have had plenty of time to formulate their opinions on the subject; here’s a selection.

First, Morgan Stanley sees a potential boost for banks — albeit a small one, and nowhere near the 20 per cent profit increase being heralded by others.

Impact on our views: We view the new FASB rules as a small positive to LC bank stocks for two reasons: 1) they could reduce volatility of future earnings, and 2) they could reduce potential declines in regulatory capital. However, we do not anticipate banks moving assets from Level 2 to Level 3 and realizing mark-to-market write-ups.

Who’s Best Positioned to Benefit: We believe STT and BK will be the biggest beneficiaries, followed by C, BAC, JPM and NTRS, based on higher securities as % of earning assets relative to peer group, composition of securities book and legacy mark to market exposure.

Analysts at Dresdner, meanwhile, are rather less sanguine.

On the positive side, the new accounting methodology could mean higher asset valuations and short term relief of capital pressures, and could subsequently have a positive effect on 2Q 2009 earnings.

However, we think a number of negatives outweigh the positives! First of all, giving banks’ greater flexibility to use their own valuation methodologies likely implies a mark-up of prices and could in our view endanger the effectiveness of the Geithner plan. So far, investors have been unwilling to buy these toxic assets at market prices, and at likely higher prices under internal model valuations, there is even less incentive for investors to buy these assets. Also, the incentive for banks to participate in the plan and to shed their toxic asset exposures could be reduced.

We have repeatedly argued that an important prerequisite for ending a banking crisis is that banks have to come clean and start recognising their losses. We don’t think this plan contributes to that. A reduced incentive for banks to sell toxic assets, and lower visibility in the quality of the balance sheet, if internal valuation models are allowed to be used, could distract much needed outside investors, and could also make 2Q 2009 earnings harder to read.

Although the markets may react positively on the short term benefits of the change in accounting methodology, we think the negatives of a possibly less effective Geithner plan and reduced incentive for banks to crystallise their losses outweigh these positives and could drag out the length of the banking crisis.

And Cazenove is looking at the read-through for non-US banks.

US accounting change less dramatic than expected

FASB voted through changes on FAS 157, though as detailed below the changes were less than expected. Specifically it declined the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise.

Implications for banks

Compared to earlier expectations there is less scope for US banks to produce substantial profits in Q1 figures (starting 14 April with Goldman) from revaluing assets away from Level 2 to Level 3. After the announcement, US bank share prices gave back much of their earlier gains.

In our view, the key point is that the Board removed its original proposal that all transactions within a market are distressed unless proven otherwise; the Board believes an unintended consequence of the original proposal is that relevant price inputs could have been too easily ignored for asset valuations. While there remains the option to reclassify assets to Level 3, the Board is to provide guidance on what constitutes a distressed market (and conversely an “orderly” transaction) and the accounting rules will still require firms to seek out the best pricing inputs to meet the fair value objective.

While the market may enjoy higher reported earnings, the critical question is whether the FASB ruling would act as a deterrent to PPIP. If a bank could value assets on what it believed was fair value and ignore the market, the bank would be reluctant to sell those assets under the PPIP. On the basis of the press release, our initial interpretation is that the proposals are less of a deterrent than anticipated.

The rally in UK banks has been less on specific hopes for a change in US accounting feeding through to a copycat move in IFRS than a reaction to a series of relatively positive economic data points which has seen the sector rally internationally.


FT Alphaville’s own thoughts on the matter are located here.

We mentioned yesterday that the proposed changes were unlikely to have a massive effect on banks’ balance sheets. The vast majority of banks’ financial assets and liabilities are in the form of loans, which are carried at historical cost and won’t be helped by FAS 157-e. Further to that, current accounting rules are already wide and varied — not everything is being marked-to-market. There are variations in the form of Level 1, Level 2 and Level 3 asset-classifications. FAS 157-e is essentially a license to increase the amount of Level 3 assets on banks’ balance sheets but it hasn’t created an entirely new asset-category.

Given that this was an expected decision by the FASB, of interest now will be whether the International Accounting Standards Board, the IASB, follows suit. While Cazenove might see the move as unlikely, there is precedence for copycat decision-making from the IASB.

Since October 2008 international accounting standards already have a similar system to the FASB rules recounted above. Assets under IFRS can be reclassified from “held for sale” to “held to maturity”. The reclassification eliminates the need to record the assets at market prices unless there’s a permanent impairment — similar to Level 3 assets under the FASB. So could the IASB follow suit on the FAS 157-e issue as well?

The board itself, says it’s pressing forward with a “full, faster review of how it accounts for financial instruments” instead of rushing a single FAS 157-e-type change. But, as far as we can tell, it certainly hasn’t ruled out the change.

Economist Willem Buiter, for one, still thinks there’s a strong possibility the IASB will follow the FASB’s suit.

The IASB (International Accounting Standards Board) promptly followed the lead of the FASB when the FASB permitted the re-classification of securities between the three categories. Banks throughout the US and Europe immediately shifted securities out of the “held for trading” category and into the “available for sale” and “held to maturity” categories. It was a major exercise in shareholder deception and deception of the wider public. I expect the IASB to stand to attention and salute once more now that the FASB has run up the further-emasculation-of-fair-value-accounting-flag.

No doubt the IASB will wimp under also, and promulgate a new ukase permitting European banks also to substitute managerial judgment/wishful thinking for market valuation. Our accounting standard setters are making terrible and very costly choices. Paraphrasing Churchill: mark-to-market accounting is the worst accounting principle in the world, except for the others.

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