Mark-to-Market Accounting: More Rules

With less than a week to go for 2008, the Financial Accounting Standards Board (FASB) has a proposal, which it has thrown into the arena to address the problem of fair value.

Mark-to-market accounting has stirred up a very ugly debate between its adversaries and its proponents. Mark Sunshine, in a Seeking Alpha post some months ago noted that:

Mark-to-market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse.

Other prominent naysayers as far as the current accounting rules for mark-to-market include Steve Forbes and noted fund manager, Ron Muhlenkamp. Here is a recent interview where they discuss mark-to-market accounting, and Forbes does not mince his words:

Henry Paulson is the worst treasury secretary in living memory. But even though he's miserably mishandled this financial crisis there's still time for him to turn things around. He can--somewhat--repair his reputation. He simply needs to back away from the disastrous policies and practices that have defined his tenure.

His first mistake was to support the weak-dollar policy that sparked and fed the crisis. Then he continued to enforce mark-to-market accounting rules. Mark to market destroyed bank balance sheets. Now insurance firms are faltering under its weight. But there's still time for common sense...And while mark to market is fine for publicly traded stocks, it makes no sense when you don't have a market, as with packages of subprime loans. And it also makes no sense for long-term insurance reserves. Paulson and the SEC can suspend this inane rule in a heartbeat, yet they refuse. Adhering to one position without regard to consequences and expecting a different result is the definition of insanity. It's time for Paulson to follow the path of reason.

Proponents of mark-to-market generally perceive greater transparency with its usage. For example, here is a part of a letter to FASB by Rebecca McEnally of the Investors Technical Advisory Committee (IATC):

The ITAC believes that it is especially critical that fair value information be available to capital providers and other users of financial statements in periods of market turmoil accompanied by liquidity crunches such as we're now experiencing. In the absence of timely fair value information, uncertainty increases, further exacerbating market instability and causing investors to withhold investable funds or demand a hefty uncertainty premium. A cornerstone of the restoration of investor confidence must be to provide the information investors need to make risk-based decisions.

Regulators recognize that fair value measurement is an essential tool in their oversight and monitoring of the risk management practices and risk profiles of financial institutions, and ensuring that the institutions' capital provisions are adequate to support the risks embedded in the financial instruments and other assets the institutions hold and the financing used to support those assets. Given this widely-recognized critical importance of providing relevant, high-quality financial information to the markets, the ITAC has been dismayed to learn that a few managers of major financial institutions, along with representatives of industry organizations representing some financial institutions, are now calling for a suspension of fair value reporting for financial instruments. They argue, in effect, for a return to the old financial reporting model for financial instruments in effect decades ago with its out- of-date historical cost reporting and lack of transparency, particularly for embedded financial risks.

The proponents credit the transparency they believe that mark-to-market has brought to capital markets with the market's improved understanding of the risks and consequent selling off of many financial services stocks.

Recently, some have attempted to shift the blame for the current crisis from the poor business and investment decision-making, including the flawed underwriting, securitization, risk management, and disclosure practices in which they engaged, to fair value financial reporting, a "shoot the messenger" argument. This reasoning is both perplexing and misleading. In fact, the current requirement to report financial instruments at fair values was instrumental in the uncovering of the deep and widespread problems in the markets. The long-term solution to the problems relies heavily on the retention of the requirement to provide fair value information to investors and regulators: the higher the quality of fair value information that is provided, the faster will be the necessary market adjustments to the problems.

What those making the argument fail to recognize is that these are not abnormal features of the measurements, per se, but rather characteristics of the normal functioning of markets as investors reassess risks and rewards and liquidity disappears for poor quality securities and investments with little transparency. Some downward price revisions will inevitably result in the triggering of covenants that the original purchasers of securities or lenders demanded as a condition of investing in the securities and agreeing to the terms upon which the capital was provided to issuers. Again, these triggers are a normal part of the contracting process and designed to protect the investors, including lenders. The fact that the triggers were activated is not an indictment of the measurement system but rather is a direct function of the poor or deteriorating quality of the investments. Arguing that by not recognizing the poor or deteriorating quality of the investments we will somehow solve the problem is not only inappropriate but is a variant of the "shoot the messenger" argument: Pull the covers over the problems and maybe they will just go away.

I certainly recognize that under most normal circumstances, there is great transparency in fair value as opposed to other methodologies. However, it is also very clear to me that a myopic and complete focus on fair value can in effect be liquidation or bankruptcy value in times of severe systemic stress. I would agree with Forbes that the triggering of covenants that has resulted from large and probably unnecessary write-downs has caused more panic than elucidation as far as asset values. As he said very colorfully:

Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline.

A compromise of sorts appears to be coming. The FASB would like firms to include in their financial statements a table, which provides a comparison of three different reporting measurements:

1. The reported carrying value
2. Fair Value
3. Incurred Loss Amount

These changes would allow managements to highlight future cash flows of securities that will be held to maturity and are available for sale. Though the near term "fair value" or "market value" in a very constrained and illiquid market may look dreadful, the majority of many of these assets will likely pay off over their long-term maturity. Hence, the "incurred loss" category when it demonstrates that few losses have actually been incurred may create some substantiation of long-term value that is more realistic in my opinion than what we have now.

This proposal, labeled proposal FAS 107-a, if approved, would go into immediate effect for reporting periods after December 15, 2008! That puts more than a little uncertainty into forecasts of fourth quarter financial services profit forecasts. But at least the uncertainty may be somewhat positively skewed in favor of less write-down in the recognition of "fair value."

Part of the backbone of accounting is what's known as the conceptual framework, which describes the function and purpose of accounting. As the FASB and the global body, the IASC consider a new conceptual framework, they propose (italics are mine):

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Capital providers are the primary users of financial reporting. To accomplish the objective, financial reports should communicate information about an entity’s economic resources, claims to those resources, and the transactions and other events and circumstances that change them. The degree to, which that financial information is useful will depend on its qualitative characteristics.

Financial reporting information is a faithful representation if it depicts the substance of an economic phenomenon completely, neutrally, and without material error. It must also be relevant.

In my view, the substance of financial reporting should focus on the long-term substance of the transaction rather than the strains of the current capital market. Perhaps the new proposal begins to address the situation. Perhaps what is sacrificed in terms of timeliness and verifiability is offset by improvements in comparability and relevance.

Unfortunately, forecasting results will become even more difficult as accounting rules may be modified at the worst possible time, the year-end for most companies. However, if implemented, these rules may finally provide a bit of sunshine and upside to a sector that has been wrapped in uncertainty and fear, if not deprived of common sense for some time.

Comments

[user 327894:]

Rick,

I would love to see your evidence that the write-downs have been "large and probably unnecessary." The weight of the evidence is that the write downs have, in many cases, not been large enough. With respect to whether the write-downs are necessary, please read about what happened in Japan in the 1990's when their financial institutions failed to report their losses in a timely and credible manner.

2008 Dec 30 07:24 AM

[Rick Konrad:]

Hi 327894

Thank you for your comment.

Write-downs of credit instruments that reflect credit defaults are completely warranted and represent relevant and "honest" accounting. Hence, I agree with the notion that an asset whose value is impaired should be "tested" for impairment, and written down to the appropriate valuation.

However, what has taken place in the last year has been a write-down of many assets to current "market" prices due to erratic, sporadic, and in many cases,forced selling.

Such exaggerated markdowns and write-offs have forced what I view as unnecessary capital and regulatory consequences.

I do not advocate a whistling past the grave approach and maintaining book value of assets through thick and thin when defaults are coming fast and furious.

Fair value measures require (a) applying market prices regardless of how
erratic the market may be, or (b) referring to prices of similar securities. When neither of those alternatives exists, companies employ models to determine fair value. As of yet, there is little accounting guidance as to how these models are to be constructed and what factors should be considered.Valuing what at present are fairly illiquid assets is a subjective job filled with conflicts and some fearing sanctions and/or litigation under Sarbanes Oxley may simply write down these assets even if they are not impaired! In a stressed market, unanticipated and unprecedented discrepancy between price and value have exacerbated problems with valuing assets "properly."

Here is an interesting article from American Banker on the topic:
www.onwallstreet.com/a...

There is an excellent review on this debate from the Virginia Society of CPA's:
www.vscpa.com/For_Memb...

It would have been more correct for me to state that the amount of write-downs has been excessive rather than unnecessary. Clearly, the evidence for credit related defaults continues to develop. However, the underlying performance of many credit pools remains quite satisfactory and is subject to a growing pool of distressed asset buyers. Perhaps that is the only evidence that the marketplace may have driven these values down to too low a level.

2008 Dec 30 10:21 AM

[user 327894:]

Rick,

The following white paper does an excellent job of explaining why your views on the appropriate measurement attribute for accounting for financial instruments are inconsistent with the views of most investors and many accountants, including why your views, if adopted, would be bad public policy.

www.cii.org/UserFiles/...

On Dec 30 10:21 AM Rick Konrad wrote:

> Hi 327894
>
> Thank you for your comment.
>
> Write-downs of credit instruments that reflect credit defaults are
> completely warranted and represent relevant and "honest" accounting.
> Hence, I agree with the notion that an asset whose value is impaired
> should be "tested" for impairment, and written down to the appropriate
> valuation.
>
> However, what has taken place in the last year has been a write-down
> of many assets to current "market" prices due to erratic, sporadic,
> and in many cases,forced selling.
>
> Such exaggerated markdowns and write-offs have forced what I view
> as unnecessary capital and regulatory consequences.
>
> I do not advocate a whistling past the grave approach and maintaining
> book value of assets through thick and thin when defaults are coming
> fast and furious.
>
> Fair value measures require (a) applying market prices regardless
> of how
> erratic the market may be, or (b) referring to prices of similar
> securities. When neither of those alternatives exists, companies
> employ models to determine fair value. As of yet, there is little
> accounting guidance as to how these models are to be constructed
> and what factors should be considered.Valuing what at present are
> fairly illiquid assets is a subjective job filled with conflicts
> and some fearing sanctions and/or litigation under Sarbanes Oxley
> may simply write down these assets even if they are not impaired!
> In a stressed market, unanticipated and unprecedented discrepancy
> between price and value have exacerbated problems with valuing assets
> "properly."
>
> Here is an interesting article from American Banker on the topic:
>
> www.onwallstreet.com/a...
>
>
> There is an excellent review on this debate from the Virginia Society
> of CPA's:
> www.vscpa.com/For_Memb...
>
> It would have been more correct for me to state that the amount of
> write-downs has been excessive rather than unnecessary. Clearly,
> the evidence for credit related defaults continues to develop. However,
> the underlying performance of many credit pools remains quite satisfactory
> and is subject to a growing pool of distressed asset buyers. Perhaps
> that is the only evidence that the marketplace may have driven these
> values down to too low a level.
>

2008 Dec 30 02:47 PM

[Gtarras:]

i have been a critic of the FASB rules (specifically 157), since i deal with them on the daily basis while calculating MTM for CDO positions. Trash in (skewed index panicky values), trash out (writedowns)... In CDO cases the trash is squared and cubed... Which means a CDO tranche, if hold-to-maturity (Bernanke laughed at definition), should be 100 cents, but its current value is 10 cents.. GREAT, IS NOT IT? So a bank (Citi, JP etc), take a billion dollar hit on MTM basis on a single CDO... Does ANYBODY care? NOT REALLY! Bernanke is STUPID!

maybe, just maybe, some of you, smart bloggers, should listen to practitioners?? at the end, we all have to deal with the destroyed trust in financial system, and a huge hole in the economy... but hey, if it makes you look SMART, and Bernanke STUPID than.. all power to ya...

2008 Dec 30 07:18 PM

[Gtarras:]

"It would have been more correct for me to state that the amount of write-downs has been excessive rather than unnecessary. Clearly, the evidence for credit related defaults continues to develop. However, the underlying performance of many credit pools remains quite satisfactory and is subject to a growing pool of distressed asset buyers. Perhaps that is the only evidence that the marketplace may have driven these values down to too low a level."

Rick, specifically, lets take super senior CDO positions on investment grade corporate portfolios. For example, the ones that have subordination so substantial, that it would take 30-40 IG defaults over period of 5 years for them to take a hit (impossible). They should be marked at 100 cents, however, FASB forces people to report them at 60-70 cents. Multiply "lost" 30-40 cents by $1 billion on a single CDO and you get the huge write-downs that subsequently scare the hell out of investment public.

2008 Dec 30 07:28 PM

[user 327894:]

Gtarras,

You and Rick need to reread Statement 157 and the subsequently issued interpretative eguidance. There is nothing in the Statement or the guidance that, in your example, "forces people to report them at 60-70."

On Dec 30 07:28 PM Gtarras wrote:

> "It would have been more correct for me to state that the amount
> of write-downs has been excessive rather than unnecessary. Clearly,
> the evidence for credit related defaults continues to develop. However,
> the underlying performance of many credit pools remains quite satisfactory
> and is subject to a growing pool of distressed asset buyers. Perhaps
> that is the only evidence that the marketplace may have driven these
> values down to too low a level."
>
> Rick, specifically, lets take super senior CDO positions on investment
> grade corporate portfolios. For example, the ones that have subordination
> so substantial, that it would take 30-40 IG defaults over period
> of 5 years for them to take a hit (impossible). They should be marked
> at 100 cents, however, FASB forces people to report them at 60-70
> cents. Multiply "lost" 30-40 cents by $1 billion on a single CDO
> and you get the huge write-downs that subsequently scare the hell
> out of investment public.

2008 Dec 31 08:33 AM

[Rick Konrad:]

Gtarras and user, I do appreciate your comments. User, I respectfully submit that you should re-read my original comment.

Rather than question my interpretation of FAS 157 or that of Gtarras, it is very clear that the FASB itself has stepped back to have another look at the entire reporting schema going back to fair value under FAX 107. Perhaps you should read the intro to the FASB staff position paper FAS 107(a)which asks the following questions:

1. Do you believe that requiring disclosure of different reporting measurement attributes (that is, as reported in the statement of financial position, at fair value, and at the incurred loss amount) for certain financial assets within the scope of this proposed FSP would (a) improve the quality of information provided to users of financial statements and (b) increase the comparability of financial statements under U.S. generally accepted accounting principles (GAAP) and IFRS? Why or why not?

2. Do you agree that the proposed disclosures should not include financial assets measured at fair value in the statement of financial position with changes in fair value recognized through earnings? If not, would you propose including such financial assets within the scope of this proposed FSP? Should financial assets measured at the lower of cost or fair value (such as mortgage loans) be included within the scope of this proposed FSP? Why or why not?

3. Do you believe that requiring disclosures of the pro forma income from
continuing operations (before taxes) for financial assets within the scope of this proposed FSP as if those financial assets were carried (a) at fair value with changes in fair value recognized through earnings and (b) at the incurred loss amount with changes recognized through earnings would improve financial reporting? Why or why not? Should the disclosure requirements described in the preceding sentence also be required for net income and shareholders’ equity? Why or why not?

4. Would including separate reconciliations of reported income from continuing operations (before taxes) to the proposed pro forma adjusted income from continuing operations (before taxes) under both a fair value basis and an incurred loss basis for financial assets within the scope of this proposed FSP be useful? Why or why not?

Obviously, though as you claim "most investors and many accountants" favor fair value accounting, the FASB staff is continuing to refine just how to define fair value, hence this call for commentary. Although there is little disagreement about the fair value of an asset or liability in an active market with orderly transactions, the challenge begins when those same markets are no longer active or transactions are complex or disorderly. Management would then use a valuation model designed to provide the best evidence of fair value. Since this model relies on management’s assessment of various factors, different companies may determine different values for substantially identical assets and liabilities. This leads to concern that management may use financial engineering to produce desired results or that the goals of Fair Value Measurements are compromised.

The SEC just yesterday delivered a report to Congress upholding mark-to-market accounting with a few provisos...exactly what I am Gtarras have described as important considerations:

While the report does not recommend suspending existing fair value standards, it makes eight recommendations to improve their application, including:

1. Development of additional guidance and other tools for determining fair value when relevant market information is not available in illiquid or inactive markets, including consideration of the need for guidance to assist companies and auditors in addressing:
o How to determine when markets become inactive and whether a transaction or group of transactions are forced or distressed
o How the impact of a change in credit risk on the value of an asset or liability should be estimated
o When should observable market information be supplemented with and/or reliance placed on unobservable information in the form of management estimates
o How to confirm that assumptions utilized are those that would be used by market participants and not just a specific entity


2. Enhancement of existing disclosure and presentation requirements related to the effect of fair value in the financial statements.

3. Educational efforts, including those to reinforce the need for management judgment in the determination of fair value estimates.


4. Examination by the FASB of the impact of liquidity in the measurement of fair value, including whether additional application and/or disclosure guidance is warranted.

5. Assessment by the FASB of whether the incorporation of credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided currently in practice.

The report also recommends that FASB reassess current impairment accounting models for financial instruments, including consideration of narrowing the number of models under U.S. GAAP. The report finds that under existing accounting requirements, information about impairments is calculated, recognized and reported on basis that often differs by asset type. The report recommends improvements, including: reducing the number of models utilized for determining and reporting impairments, considering whether the utility of information available to investors would be improved by providing additional information about whether current declines in value are consistent with management expectations of the underlying credit quality, and reconsidering current restrictions on the ability to record increases in value (when market prices recover).

As is obvious from this string of comments, the debate continues among many market participants. The SEC has urged consideration of the impact of liquidity on market price, essentially questioning the validity of the measure in times of erratic and thin markets. The SEC has urged that fair value measures have some comparability (i.e. assumptions utilized are those that would be used by market participants and not just a specific entity.) Finally, FASB staff is bringing in a new concept of incurred loss to supplement fair value disclosure which would bring clarity to Gtarras example.

2008 Dec 31 01:40 PM

[user 327894:]

Rick,

You stopped one recommendation short in your reading of the SEC fair value study. Recommendation #6 states: "Accounting standards should continue to be established to meet the needs of investors." The second bullet under that recommendation states: "Most appear to agree that fair value measurements provide useful information to investors, meeting their information needs. Finally, the last bullet states: "General-purpose financial reporting should not be revised to meet the needs of other parties if doing so would compromise the needs of investors." What troubles me most about your initial blog and your continuing comments is that you are repeating the bank lobbyist mantra that that there is a significant problem with fair values causing financial assets to be understated because of illiquidity in the markets. That may have occurred in some limited circumstances, but there is simply no evidence that the occurrence is a common one. The SEC study makes that clear. As one example, the study states that "over 90% of investments marked-to-market are valued based on observable inputs, such as market quotes obtained from active markets." If you dig into this lobbyist orchestrated controversy a little more, you will find that the great weight of evidence indicates that many banks and insurance companies are holding significant amounts of financial assets that are overstated in value (not understated as you suggest) and the lobbyists for those industries are working hard trying to obtain changes to accounting standards that will help the industry avoid having to report that economic truth to market participants. If they win; investors, the capital markets, and the economy, lose.

Jan 01 05:18 PM

[Gtarras:]

User
FASB 157 forces me to mark-to-market bespoke (ie customized) CDO tranche positions.. Since the best proxy to tie the customized portfolio is index, my auditors insist that I map my positions using index. For CDO of ABS it is ABX index, for corporates it is either IG or HY indecies... as simple as that... I do believe that the indicies are skewed due to panic already. Then the indicies input is further skewed due to levered nature of a CDO tranche.. Thus the output is skewed (and doubly so) to the downside..

Jan 01 06:14 PM

[user 327894:]

Gtarras,

Again, Statement 157 does not require that your CDO's be reported at fair value, that is the result of other GAAP requirements that have been in existence for many years. Second, Statement 157 does not require that a specific index be used in valuing your CDO's. If you believe the index that the auditors are "forcing" you to use results in a value that understates the fair value of the CDO's and that some other valuation approach would provide a more accurate fair value amount you need to make that case with your auditor and if necessary with the audit committee. Remember that it is management that has the responsibility for the appropriate application of financial accounting and reporting standards--not the auditors. Good luck.

Jan 02 09:55 PM

[Gtarras:]

User
sorry to say that, but it is pretty clear you have never dealt with it in the real world..

Jan 12 09:54 AM