FAS 157 and Other Regulatory Actions: Good Intentions, Unintended Consequences

Not long ago, financial regulators told Congress that the year-old accounting rule known as FAS 157 had little to do with last year’s string of high-profile bank failures. This blanket exoneration, however, is not supported by the evidence.

While I don’t think FAS 157 is the only reason for the problems encountered by banks, brokerages and other financial firms, it seems that this rule and other regulatory actions may have played an unintended yet significant role by exaggerating the risks associated with the banks’ heavily leveraged balance sheets.

It’s important that these potential cause-and-effect relationships be explored because the Obama administration and Congress have made it clear that enacting more market regulations will be one of their top priorities. But this is a delicate time in our financial markets—the layering of complex new rules over complex old rules without fully understanding how they will fit together could cause more harm than good.

FAS 157 changed how companies establish the value of securities when there is little or no active trading in those securities. As a result of this rule change, many financial companies have written off untold billions of dollars worth of securities on their balance sheets, even if these securities continued to produce income.

The above chart tracks the relationship between quarterly operating EPS for the S&P 500 (solid line) and the net EPS, which includes writedowns and other special one-time items. As you can see, for most of the past 20 years, the two lines have moved together. But look at the far right side—the operating profits were down, but net earnings were down much more.

I believe a strong case could be made that the sharp falloff in net earnings is largely due to FAS 157-related writedowns by financial companies, which were the largest sector of the S&P 500.

We all want the financial sector to be healthy again, but as Forbes accurately pointed out last week, FAS 157 takes away the time these institutions need to heal. A lack of healing time in the 1930s, when rules similar to FAS 157 were in place, deepened and prolonged the Great Depression.

Concerning the current financial meltdown, Wall Street, Main Street and government agencies were all excessively leveraged, and a rule change for short-selling that eliminated the uptick rule set off a feeding frenzy by predatory short sellers. Banks and brokerages sought to raise capital to rebuild their balance sheets, but short-selling mercilessly drove down the value of their shares and impaired their ability to raise enough new money.

Lacking capital, the banks had to cut back on new loans, which hurt manufacturers and others that need access to short-term working capital to run their businesses. Products didn’t get made, workers didn’t get paid and before long the economy ground to a halt.

The banks also made margin calls against existing loans, including those to highly leveraged hedge funds. To get their hands on cash, the hedge funds sold liquid assets, among them natural resources and emerging markets equities that had been performing so well.

click to enlarge

The chart above plots the performance of the S&P 500 Financial Index alongside the VIX, which measures market volatility, for 2007 and 2008. The general trends are clear to see: the financials declined more than 60 percent over the period, while market volatility dramatically increased.

Key events during the two years are marked with red circles.

Event 1—In July 2007, the SEC removed the uptick rule that required any short sale of a stock be done following an uptick in the price of that stock. The S&P financials essentially traded sideways prior to the removal of the uptick requirement, but they fell more than 12 percent in the first month after the rule change and at the same time the VIX nearly doubled.

Event 2—Volatility leaped in mid-November 2007, at the same time that FAS 157 was implemented. The S&P financials continued trending down. Citigroup CEO Charles Prince retired under pressure and Merrill Lynch CEO Stanley O’Neal was ousted around this time.

Event 3—In mid-March 2008, Bear Stearns collapsed under the weight of its exposure to mortgage-related derivatives, creating another volatility spike.

Event 4—In mid-July, the SEC restricted short sales of the 19 largest financial companies. This included shares of Fannie Mae and Freddie Mac, both of which had huge exposure to mortgage securities. The beleaguered S&P financials bounced up on the news, while volatility declined.

Event 5—In mid-September, just a few days after the collapse of Lehman Brothers, the SEC temporarily banned short selling of about 1,000 financial stocks. Many of these companies had reported many billions of dollars in FAS 157-related write-offs. Initially, the S&P financials popped up but the longer-term downward trend quickly resumed. Volatility shot up to record levels.

That these market events occurred in tandem with significant regulatory actions was likely not a coincidence.

I have no doubt that the elimination of the uptick rule and the implementation of FAS 157 were intended to benefit investors, just as Sarbanes-Oxley was when it was enacted several years ago. And under different circumstances, the impact of these rules may have been less onerous on the financial companies. But with so much balance-sheet leverage for these companies, it turned out to be a recipe for disaster.

It reminds me of 1986, when markets were hammered by the combination of the Reagan administration’s tax reforms, a rapid falloff in oil prices and the high degree of leverage being carried by savings-and-loans. Any one of these challenges would not have been a big problem—putting them all together led to the failure of hundreds of financial institutions and destabilization of the nation’s banking system.

Like in 1986, the fundamental problem in 2008 was dangerous levels of debt carried by Wall Street banks and brokerages (along with Fannie Mae and Freddie Mac) and Main Street homeowners.

There may have been a way to address the current overleveraging in an orderly fashion if the rules were different, but as the chart above supports, a case could be made that the convergence of FAS 157, highly leveraged balance sheets and the loss of the uptick rule were the trigger that set off the financial meltdown.

Comments

[mplaut]

A good article that raises important points. It seems, however, a little uncertain about what its main thesis actually is.

"the fundamental problem in 2008 was dangerous levels of debt carried by Wall Street banks and brokerages (along with Fannie Mae and Freddie Mac) and Main Street homeowners."

Yes, and FAS 157 and the repeal of the uptick rule were catalysts that triggered the meltdown, but not true causes. FAS 157 seems to be a fundamentally good policy but bad timing in its implementation. If it had been in place for several years, it may have helped avoid many of the problems.

I cannot see how the repeal of the uptick rule helps anyone but the shorts, and it helps them go beyond their basic contribution of providing liquidity and a check on excesses and thereby damages many others.

2009 Mar 03 05:16 AM

[Paul Wilkinson]

"Good policy, bad timing" is one of the better explanations for FAS 157 that I've heard. Perhaps bad execution was also part of the problem. Just as turning on a floodlight in the middle of the night can help improve vision, flipping the switch can also blind people. Giving investors more time to understand how to evaluate the new information would have eased the transition.

One tactic that would have helped was suggested in the SEC staff report on FMV published in December. The explanation is the second point here: paulwilkinson.com/2009.../. There's also a link to the staff report.

What the staff means by "the complete integration of interactive data as a tool to bridge the gap between historical cost measures and fair value" is using XBRL to give investors choice in how to evaluate asset value, as described elsewhere on paulwilkinson.com. Different views as to value make markets. More useful information to evaluate investments would certainly help improve credit markets, just as more useful information helped make U.S. equity markets the world's strongest.

2009 Mar 03 11:34 AM

[Jack Walker]

Frank,

Nice job documenting and explaining what many of us knew was a significant contributing factor to the banking problem. There are good arguments on both sides of this issue, but why is there no solution to the problem? Are the politicians and bankers unable to resolve this issue or don’t they get it?

Jack

2009 Mar 03 12:36 PM

[Paul Wilkinson]

Jack,

I think part of the reason there is not yet a solution stems from a complex cultural stalemate among lawyers, accountants, investors, and regulators. Lawyers like documents, accountants like numbers, investors like numbers in context, and regulators don't know how to proceed. Politicians simply throw up their hands and take the "easy" way out -- earmark more of "other people's money" to prevent what they are warned would otherwise be "catastrophic."

I can't understand why the President, who has spoken eloquently on the power of markets, doesn't command a market solution. Perhaps today's WSJ story on creating public-private investment funds is another trial balloon about a bureaucratic attempt to address these "complex" issues without frightening too many people into the realization that what they hold is worth either what a buyer will pay for it or the net present value of future cash flows to them -- but no more. (See paulwilkinson.com/2009.../.)

Politicians hate giving bad news to their constituencies. Bankers won't take sub-optimal prices as long as there's a reasonable chance that waiting for government money is a better option. We've yet to see the leadership -- the guts -- required to restore a functioning market. Someone, some time, will step up to lead. Until enough economic actors know who and when, the economy, which most of all depends on information that can be used by market participants to make decisions, will continue to suffer.
Paul

2009 Mar 03 01:19 PM

[Tas1974]

Question for the group:

I agree that the uptick rule should've never been repealed. Now that it's gone the question is "can it be brought back"? Nothing like this has ever been tested especially with the new double-short and triple-short ETFs. My thought is simple, if the SEC decides to bring back the uptick rule would that not create a short squeeze the likes that has never been seen before? Would the market be able to handle the monster move that would follow. Remember the short-squeeze that hit Volkswagen last year? Seriously, if the uptick rule was still in place does anyone really believe we would be trading under 7000? That being the case, if you bring the rule back the shorts would KNOW that there is no way of keeping the market here so they would be forced to cover at the same time people would be dumping the double and triple levered short ETFs before getting wiped out. The squeeze would be incredible. Probably more than the market could handle.

Something to think about.....

2009 Mar 03 09:47 PM

[sonearsofar]

User367426: The market survived the initial implementation of the uptick rule in the Great Depression, so there's no reason it wouldn't this time. The way to bring it back is to make it effective after a reasonable adjustment time, such as 3 or 6 months after the announcement, to allow the short ETFs and hedge funds to unwind in an orderly manner. If necessary, they could be directed to unwind in increments.

2009 Mar 03 11:18 PM

[chordbender]

An update of the 2nd chart with "Event 6 - FAS 157 Rules Eased" would amplify the message that FAS 157's implementation & easing correlate incredibly well with the recent turmoil.

2009 Dec 11 11:08 AM