Blame the Accountants: A Lynch Mob Forms

Someone's got to take the fall the market's falling out of bed and the economic turmoil. No managers of financial institutions have been brave enough to step forward and acknowledge that it was their fault. No regulators have been bold enough to say, well, they weren't bold enough as regulators.

So there's only one thing left to do: blame the accountants. There's an angry mob forming, and it looks like they brought a rope. They're converging at the Rayburn House Office Building in Washington, DC on Thursday, March 12, when Congressman Paul Kanjorski holds a hearing to "address problems facing mark-to-market accounting."

The press is having a field day with this: it's been a long time since an accounting standard was in the news so much. Ben Stein threw a tantrum in the Sunday New York Times, calling for someone, anyone, to "immediately end the near-universal applicability of the accounting rule formally known as FAS 157." Ben: get a grip. Statement 157 is universal, alright - it applies to any balance sheet account that had been given fair value treatment before the issuance of Statement 157. The most pervasive and confidence-destroying myth about Statement 157 is that it's somehow requiring fair value reporting for the first time in places where it hadn't ever been used before.

If folks like Ben would maybe just READ Statement 157, they'd understand that. If they'd really stretch and read the SEC's Congress-mandated study on fair value accounting, they'd know that at the banks where all the alleged fair value damage has been wrought, only about 31% of total assets are given the fair value treatment - hardly "near-universal." The biggest assets on banks' balance sheets are their loans - and they do not receive fair value treatment. Their greatest amount of assets were unaffected by the implementation of Statement 157. It's easier to deflect blame on an accounting rule than face culpability for bad loans made, however.

The conventional wisdom (hard to call it that) that Statement 157 is creating fair value reporting where it had not been applied before. It's simply misinformation: Statement 157 put one definition of fair value into the accounting rules and added more disclosures for users - including the widely-used Level 1, 2 and 3 fair value hierarchy disclosures.Skeptical? You could read Statement 157 - or just the following excerpt from the SEC's report:


Statement 157 wasn't in effect in 2006; it was required to be employed in the first quarter of 2008. The percentage of assets using fair value in 1Q08 was 4% higher than in 2006, and it wasn't because of the standard. While the percentage jumped at broker-dealers, over half of it was due to voluntary application of fair value principles - these firms took the fair value option available to them in Statement 159. Again, there was nothing in Statement 157 that made B-Ds apply more fair value reporting where they hadn't applied it before. Credit institutions' percentage of assets on fair value reporting were nearly flat and the insurance companies' proportions were exactly the same. The now-crippled GSEs actually showed a decline in the proportion of fair valued assets to total assets, as they tried to put the brakes on their securitization activities.

So - where is the "near-universal" reach of the new and nuclear Statement 157? The standard didn't spread the reach of fair value accounting. And the empirical facts don't support the claims of the fair value Cassandras.

Another critic, Steve Forbes, threw an even bigger, louder tantrum in his op-ed piece in Saturday's Wall Street Journal. Forbes' record on finding the right side of an accounting issue is not too good: he was an ardent critic of treating stock options as compensation earlier in the decade. On Statement 157, he has this to say:

Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market -- which was in force before the Great Depression -- is why FDR suspended it in 1938. It was unnecessarily destroying banks.

But bad ideas never die. Mark-to-market was resurrected by the Financial Accounting Standards Board and became effective in the fall of 2007 (FASB rule 157) to the approval of the Bush administration, its Treasury Department, and the Securities and Exchange Commission.

Mark-to-market accounting is the principal reason why our financial system is in a meltdown? A preposterous statement on many levels. First, the foolish lending by financial institutions led to the meltdown, and the lending was lubricated by all-too-opaque securitization accounting. If Mr. Forbes would like to foam over accounting rules leading to meltdowns, I'd suggest he spend some time reading Statement 140. That standard made it too easy for bad loans to disappear from lenders' balance sheets through securitizations - and we all know how well that process diversified away risk around the world, right?

Another false assertion: FDR somehow saved the banks in 1938 by suspending mark-to-market accounting. He did no such thing in the realm of financial reporting, which lets investors know how corporate managers are doing for their shareholders. What happened was a loosening of the credit standards for regulatory accounting principles - in effect, regulators look the other way when market values are telling a story about the creditworthiness and solvency of a financial institution. If there's a beef with the way regulators have been setting capital limits, take it up with the regulators, Steve. Don't try to change capital limits by blinding shareholders.

Mark-to-market "resurrected" by the FASB in 2007? Another case of disrespect for facts. Mark-to-market has been around in varying strengths for decades. Until the early 1990s, firms couldn't mark securities beyond their cost basis if they had to first mark them down to market values. When Statement 115 became effective in 1992, firms choosing to do so (as a policy decision, not on a one-by-one basis) could recognize gains beyond any writedown. Firms could also elect (as a policy choice, again) to hold investments to maturity, without fair value fluctuations. The rules prohibit gains-timing by switching from one classification to another, but Statement 115 hardly created "unfairly represented" balance sheets. (If anything, it showed that more fair value reporting could eliminate a lot of complexity; save that for another post.)

Critics tend to forget that what's different in this credit crisis is that there are far more instruments being fair-valued than ever before - and they're not the best financial assets on the planet, making them tough to value. According to Federal Reserve statistics, there were $2.2 trillion of asset-backed liabilities outstanding at the end of 2003 - and $4.2 trillion of them at the end of the third quarter of 2008. We know they're not all worth 100 cents on the dollar.

What's new is trying to develop fair values for the volume of these kinds of instruments when there are no liquid markets. If Statement 157 had never existed, they would still have to be reported at what they're worth. The fair values for those things have plummeted or there are no markets for them at all. And if there are no markets for them at all because nobody wants them - what's their value? You can make a strong argument that if nobody wants something offered for sale, it hasn't got any value. Statement 157 isn't even that draconian - it permits estimates of fair value when markets aren't working.

But, hey, it's more fun to have a lynching than accept facts. Thursday's hearing is being greeted as some kind of market event, with reports of trades being positioned for the expected "suspension of mark-to-market" outcome. We'll see: it's only a hearing and not an act of Congress. Will it lead to one? That will take a lot longer to find out.

Comments

[Tradememe:]

I don't see how the desire to change mark-to-market should be considered to be an attack on the accounting profession.

Mar 11 09:39 AM

[Dave Wrixon:]

If anything more regulation and more transparent accounting standards are called for, not relaxatio of the modest progress that has been achieved to date. The credibility of the entire financial services industry is on the line here. There is no time to start to fudge the numbers to attempt to influence market sentiment.

Mar 11 10:04 AM

[Larrysyr:]

The problem in the mark-to-market debate is that the lynch mob is going after the news-bearers, not the wrong-doers.

We could suspend the accounting rules, but the underlying realities - bad loans made to uncreditworthy borrowers, off-balance sheet assets producing real losses, and an oversized CDS market where couterparties cannot cover their bets - would remain. The housing bubble, in particular, would still be bursting and still be taking down the financial world with it.

Mortgage-backed securities went down in value because their cash flows turned out to be far less reliable than originally thought. The market has now priced in that risk, resulting in steep declines in value. We can second-guess the market's assessment, but what would be a more reliable basis?

Mar 11 10:10 AM

[Steve in Gr...:]

Great article. Somebody should send it to Steve Forbes, who has damaged his reputation by his wrongheaded cheerleading against SFAS 157 and 159.

This issue and the reinstatement of the uptick rule are unhelpful responses to the current problems.

Mar 11 10:28 AM

[The Simple ...:]

Warren Buffet has, correctly in my opinion, drawn a distinction between mark to market for regulatory purposes and for disclosure purposes. See here:

online.wsj.com/article...

Steve Forbes is not alone, and quite rightly points out that companies with positive cash flows are being called insolvent. Also see John Mauldin's fine analysis on the worst case default scenarios being considerably less devastating than is often supposed.

If we can avoid panic reactions, over time we may very well be able to work our way out of this.

Mar 11 02:50 PM

[samwise:]

lynch mobs do exist--thought Bernie Madoff would be a target myself. As prices in energy and food start to soar (or certain physical items cease to exist--like whole milk) you'll start to see it. I highly doubt accountants will be in the crosshairs once the Senate tries to get to the bottom of what happened to the 1 trillion in bail-out money. If I were an elected official I'd take the South Park route and "blame Canada."

Mar 11 05:19 PM

[Aristophanes:]

On Mar 11 02:50 PM The Simple Accountant wrote:

> Steve Forbes is not alone, and quite rightly points out that companies
> with positive cash flows are being called insolvent. Also see John
> Mauldin's fine analysis on the worst case default scenarios being
> considerably less devastating than is often supposed.

Many of these "positive cash flows" are because of government safety nets. Because of that intervention and a lack of transparency, no one knows how to differentiate the patient with a broken leg from the one with a boo-boo. They're both sitting in the same waiting room waiting for a stress test.

> If we can avoid panic reactions, over time we may very well be able
> to work our way out of this.

AIG will take many, many years.

Fannie & Freddy will be wards of the state for 100+ years given the estimated rate of return they are projected to pay back to the taxpayer. This is a permanent change in the housing finance market of the nation, and one that has certainly not been factored into the long term profiles of many financial companies.

Sharpen those pencils. We need to stab some new spreadsheets.

Mar 11 10:49 PM

[THofler:]

The Simple Accountant above has it correct. Blame the regs layered on top of the accounting, not the accounting.

But, we now have a financial system that is built for instability. Why, because regulators have no clue about the types of feedback effects that can cause stability or instability. Mark-to-market & the current regs. that go with it are insanely procyclical and are hugely to blame.

Also, Business Development Corp. have been decimated by the weird way FAS 159 and FAS 157 were implemented. The window allowing the selection of FAS 159 closed in Jan. 2008 before the FAS 157 was required of everyone in March 2008. Apparently it wasn't clear that the downside of 157 could be mitigated with 159. By the time this was discovered, it was too late and 159 couldn't be adopted.

Mar 12 02:55 AM

[PainfullyAware:]

Complexity Favors The Sinister.

We need some serious simplification of things and a mandate of - NO OFF ACCOUNTING BOOK ASSETS.

Nothing will change for the better if the system still has two sets of books contributing to the bottom line - Those regulated and those that are not.

Mar 12 01:34 PM

[Mike Razar:]

Contrary to what anybody says, accounting rules have no effect on the true value of a company, unless there are hidden facts (I think that's usually referred to as fraud, but I'm no expert.). Who cares what an accountant says an asset is worth? If I'm thinking of loaning money against that asset, I will use the brand new, innovative method called due diligence. As to regulatory capital, do you want banks to be able to loan money based on regulatory capitsal that no one will loan money against. Ummm,,where will they get the money to loan?I can't believe how many supposed experts have embarrassed themselves over this. Even such famous non-experts like Newt Gingrich and Barney Frank suffer from mtm-phobia. What does that tell you? Maybe the people who pass the laws should understand what they are trying to regulate.

Mar 20 12:56 AM