Affordable Housing Institute : US

[Continued from yesterday’s Part 1]

 

Yesterday’s post highlighted the first of two new planks in a slowly emerging post-crunch global regulatory framework and platform, restoration of the uptick rule (as reported in the New York Times and as we recommended last December).  Today we look at another overdue change as part of the necessary improvements in regulatory structures after the financial catastrophe. 

 

Time to rethink the structure

 

2. Easing the mark-to-market rules

 

Over the last few years, the FASB had moved to require periodic revaluation of assets under a mark-to-market rule based on trading prices – a fine idea for securities that have a thick market with many similar items for sale and prices that rise and fall smoothly.  But, as I wrote in State of the Market 1 (September, 2007) and State of the Market 7: Banking on Value (April, 2008) that system collapses when the securities in question are thinly traded because they are unique, and when only some of the traders have to mark-to-market:

 

Enabling the revolution: FAS 157 and mark down, not up

Display or financial reporting only

 

Once upon a time, assets went on the balance sheet at cost, got depreciated, and lay inert until sold, whereupon the company got a book gain or loss. Overvalued assets were left undisturbed because selling them would mean writedowns, leading (among other slow tragedies) to the 1990s’ Japanese deflation, where banks would not touch their loans lest the balance-sheet bubbles pop. Undervalued assets slumbered happily at depreciated book values well below market. Either way, CFO’s needing a late-in-the-quarter kick up or down on earnings could conjure them via financial transactions on previously dormant assets.

 

Over the first years of this decade, the FASB and regulatory bodies pressured public entities to report changes in asset values – particularly down – when they occurred, rather than when they were ‘recognized,’ via a series of rules requiring writedowns if assets were permanently impaired. Later that was extended in an issuance, Financial Accounting Statement 157, requiring all assets to be ‘marked to market,’ with risk Levels 1 (best) to 3 (worst) based on the defensibility of their valuation method. FAS 157 sounded abstract, and until August everyone thought it would remain so; its market consequences were anything but.

 

Not what Paulson was hoping

 

Widening the information asymmetry

The capital markets have an intrinsic information asymmetry – private companies (not listed on stock exchanges) need not report their earnings, whereas public companies (whose shares trade on exchanges) are required to fess up quarterly.  This mattered less when the public companies were dominant, but private equity grew into giga-funds by exploiting the public markets’ unforgiving punishment of underperforming publics. When spreads exploded last August, the trading values of complex assets plummeted, and just as the bankers returning from vacation were coming to grips with this, FAS 157 took effect in October.

 

Now, nearly a year later, as Bloomberg repots, the FASB is catching up with the problem:

 

April 2 (Bloomberg) — The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value accounting rules that Citigroup Inc. and Wells Fargo & Co. say don’t work when markets are inactive.

 

Changes to fair-value, or mark-to-market accounting, approved by FASB today allow companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ writedowns and boost net income. Firms could apply the changes to first-quarter results.

 

As long as the judgment is transparent, and the evaluations can be audited, this should improve market dynamics, as we continue to evolve toward the Bank of Glass.

 

Are transparent financial structures more fragile?

 

“Good decision,” Citigroup Chairman Richard Parsons said of FASB’s move. The market for mortgages and other assets was not working, so something had to change, Parsons said in a New York interview today. Citigroup later said in a statement the decision will have “no impact” on its financial statements.

 

The Judgment of Parsons?  Our judgment is no change in assets

 

Right; as I put it in Bailout or bonanza:

 

The Paulson premises.  Beyond the Paulson doctrines, the TARP proposed by Secretary Paulson is predicated on several premises:

 

* These assets have an ‘intrinsic value’ – say, what a good evaluator would come up with provided there was plenty of rational money in the market.  (That is, they’re probably real paintings – if not Vermeers, then Jan Steens.)

* They have an ‘immediate trading price’ – what you’d get if you sold them tomorrow – which is grossly below intrinsic value, because the market’s acting irrationally.

 

That view was later ratified by events:

 

William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985, has called fair value “a major cause” of the credit crisis. Robert Rubin, the former Citigroup senior counselor and Treasury secretary, said Jan. 27 the rule has done “a great deal of damage.”

 

The reason is simple:

 

Kessler again:

 

There is a saying on Wall Street that goes, “The market can stay irrational longer than you can stay solvent.”

 

Actually, he’s quoting John Maynard Keynes.

 

The young Keynes, by Duncan Grant

 

If Paulson’s premises are right, then Treasury can buy the assets for more than ‘fair market value’ and less than ‘intrinsic value.’

 

Fair market value, fair value, or some other value?  Most definitions of ‘fair market value’ use ‘immediate trading price’ as their measure, except for ‘distressed sales,’ which mean situations where the seller has a financial gun to his or her head.  The problem is the entire country is a distressed seller, which screws up the market, so it’s entirely possible to have immediate trading price (the usual best evidence for ‘fair market value’) much, much less than intrinsic value (which is what people use for ‘fair value’).

 

Selling goods for less than intrinsic unimpaired value?

 

The move back to some valuation other than the fire-sale price, albeit overdue, is welcome:

 

Financial shares rose after the FASB move. Citigroup rose 2.2% to $2.74 at 4:15 p.m. in New York Stock Exchange composite trading. Bank of America Corp. added 2.7% to $7.24. The KBW Bank Index earlier rose as much as 6.1%.

 

Responding to investor complaints about its March proposal, FASB today [April 2, 2009 – Ed.] increased the amount of information companies must give on how they value assets. In a related measure, the board voted to allow more flexibility in valuing so-called impaired securities. FASB decided to apply that proposal only for debt securities.

 

People liked it:

 

“You really, really like it!”

 

 “I think we’ll see significant write-ups as a result of this,” boosting bank earnings, said Brian Wesbury, chief economist at First Trust Advisors LP in Lisle, Illinois. “It will put the banks back to where they would have been if the rule hadn’t been in place.”

 

What’s that phrase about locking the barn?

 

The biggest remaining question is “whether auditors will agree with the judgment of the bank management,” Wesbury said in an interview.

 

Accounting always involves judgment.  As the old joke goes, what’s the difference between the accountant and the controller?  The accountant knows; the controller doesn’t.

 

FASB’s staff conceded the March 17 proposal led to a “presumption” that all security sales are “distressed” unless evidence proves otherwise.  Such an interpretation might have let financial firms ignore transactions in valuing assets.

 

Which would be too much latitude, wouldn’t it?

 

Ignoring you and your transactions

 

FASB staff said banks should only disregard transactions that aren’t “orderly,” including situations in which the “seller is near bankruptcy” or needed to sell the asset to comply with regulatory requirements.

 

Over when it’s being overwhelmed by a bear raid.

 

The staff said in a report today it was not FASB’s intent “to change the objective of a fair-value measurement.”

 

Fair-value “provides the kind of transparency essential to restoring public confidence in U.S. markets,” former Securities and Exchange Commission Chairman Arthur Levitt said in an interview yesterday.

 

Levitt is co-chairman, along with former SEC head William Donaldson, of the Investors’ Working Group, a non-partisan panel formed to recommend improvements to financial regulation.

 

“The group is deeply concerned about the apparent FASB succumbing to political pressures,” he said. Levitt is a senior adviser at buyout firm Carlyle Group and a board member at Bloomberg LP, the parent of Bloomberg News.

 

Mr. Levitt, honorable though he be, is not without self-interest in this matter.  Private-equity buyout firms like Carlyle flourished in the asymmetric-information era of the mark-to-market rule.  And the FASB has not gone into cahoots with the banks:

 

We are not conspiring with the FASB!

 

FASB rejected requests from banks to let them apply the fair-value change to their year-end financial statements for 2008. While the new standard takes effect for earnings reports filed at the end of June, FASB said companies could apply it to their first-quarter financial statements.

 

Dual tracking for a while is probably wise as well.

 

When building a new structure, start with dual tracks

 

 “The changes themselves are not quite as robust I think as the market had hoped,” said Gary Townsend, a former bank analyst who is president of Hill-Townsend Capital LLC in Chevy Chase, Maryland. “The outlook for the financials is turning out to be not as bleak as some in the market had suggested. Overall there is reason is see some optimism with respect to the direction of bank stocks.”

The likelihood of the nationalization of the banks seems to be close to zero.”

 

Thank heaven for small favors.

 

 

 

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