FAS 157: Let the Tweaking Begin

Well, someone was listening.

In recent Congressional testimony, Ben Bernanke, Sheila Bair, Tim Geithner, Mary Schapiro, and other regulators have all taken reasonably constructive positions on reforming FAS 157 and Fair Value accounting, also known as Mark-to-Market. While they all say they see great conceptual value in mark-to-market accounting (for its “transparency” and “clarity”) and wouldn’t support a rescission or suspension of FAS 157 per se, they support “tweaking” it, or changing to reduce its “pro-cyclicality,” or allowing greater management judgment in determining marks and preparing associated disclosures. And we now know that the Financial Accounting Standards Board plans to issue a new disclosure draft for public comment on proposed changes within weeks.

Can anyone spare a fig leaf?

The truth is that any one of these “tweaks” implies fundamental changes to FAS 157--changes that will leave the rule largely unrecognizable.

To be clear, Fair Value accounting must be reformed, in my opinion. It is fundamentally flawed and at war with FASB’s own conceptual framework for financial reporting. But in the interest of “transparency and clarity,” the FASB would do the public a great favor if, when it issues its new rule, it also provides its own full disclosure and explains what an utter and miserable failure FAS 157 has been. Here are some proposed topics it might touch on (and I invite readers to add to my list):

• The importance of professional judgment to the valuation process. FAS 157 took judgment to the vanishing point. The new rule should explain why professional judgment is essential to the valuation process.

• The deficiencies of the “Fair Value.” FAS 157 eliminated “market” from the definition of “fair value”. It’s time to put “market” back in. But FASB should also discuss the conceptual deficiencies of the “fair value” definition. Interested readers can find my critique here.
  
• When are mark-to-market disclosures misleading? If the objective of FASB’s conceptual framework is to provide information to help “assess the amounts, timing, and uncertainty” of cash flows, users of financial statements may be misled if losses are recorded based on the market’s perception (or misperception) of an asset’s value. Here’s the real-life experience of Bank of New York Mellon when it disclosed the “fair market” value of its Alt-A mortgage portfolio along with the portfolio’s estimated cash-flow value. The difference? Only $1 billion.

The new definition of Fair Value accounting must look first to the purpose of the assets or liabilities being valued, rather than their value in liquidation. One of the great ironies of FAS 157 was that it has undercut the public’s confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles. For instance, banks typically mark only a small proportion of their assets and liabilities to market for purposes of their financial statement presentation. However, all are required to disclose in footnotes the “fair value” of their financial assets and liabilities. Though MTM results can bear little relevance to the intrinsic value of a loan or security that the holder plans to hold to maturity, the disclosures became the perceived reality. The math is easy. Many banks that are well-capitalized and solvent in accordance with GAAP are simultaneously insolvent when GAAP results are adjusted to “fair value”. Here’s what happened to Capital One: the company’s tangible book value per share of $28.24 according to GAAP became minus-$1.21 after adjusted for disclosed FV marks. Such absurd contradictions are extremely harmful to public confidence.

Washington, D.C. hasn’t done much to boost investor confidence lately. That needs to change. It’s time that the SEC, FASB, Treasury, and bank regulators embark on a full-court public relations press to affirm GAAP financial results, while detailing the conceptual problems and doubtful accuracy of “fair value” in such a highly stressed and illiquid economy as the current one.

Comments

[jeandit75:]

M2M rules are a non sense for the real economy. We need a compromise between fair value accounting and real business conditions. The current business conditions will not remain the way the are forever. We are in a severe recession. Recessions are ALWAYS followed by up cycles. Why then should we markt asset prices to 0 just because they are illiqs. These assets that are so-called toxic assets or non-performing loans will see a some liquidity back wen normal business conditions come back. So for that simple reason we should assign them a value that is somewhere below acquisition cost but certainly not 0. Now, we are all cirticizing banks because they are not lending to the small corporations in America. The corporations that would normally survive the crisis if they only could get a temporary load. Well, its the same for the banks! Stopping M2M is like providing them a loan. It will have them stop marking down assets so they can start to lend money to the needing ones again.

Mar 15 04:19 AM

[John Petersen:]

FAS 157 was issued in September 2006 and effective for fiscal years beginning after November 15, 2007. As soon as the rule took effect, the Dow started its decline. As a one time practitioner of the dark arts, I believe FAS 157 is wholly inconsistent with the "going concern principle." If we are going to abandon the basic principals that give periodic financial statements value, why not turn the entire process over to qualified appraisers and be done with it? Seriously, what good is a consistent application of generally accepted accounting principles if the core valuation of assets changes from quarter to quarter?

Mar 15 04:26 AM

[cranyinnyc:]

This is incredible. So many people who know nothing about accounting are leaping to the conclusion that all these problems banks are experiencing are either the result of or exacerbated by mark to market. Nonsense!
First, only assets (and liabilities) designated by the bank itself as TRADING assets are subject to mark-to-market accounting with the gains or losses impact earnings and consequently regulatory capital. Let me repeat the banks acquired the assets and THEY decided they wanted to use mark-to-market accounting because they INTENDED to trade the assets not hold them to maturity! Nobody 'forced' the banks to do this.

Second, when there no longer is a functioning market for a trading asset the banks can use Level 2 or Level 3 methods to value the assets (Level 1 is to use available quotes). Level 2 method looks to functioning markets of similar assets to derive key inputs such duration, discount rates etc. that the bank will use to value the assets based on its cash flows (so called marked-to-model). Level 3 can be best described as mark-to-myth. Assets valued this way have nothing to do with any quotes. The bank forecasts cash flows and durations then values these cash flows using discount rates they believe appropriate.

So assets that were once so liquid that the banks bought them to trade (i.e. never had the intention to hold them to maturity) but now there is a wide gap between what the bank thinks they are worth and the bids they are getting (if any) are now valued by the banks at values they think they are worth and not at the bid price.

Assets the banks designated as available for sale are subject to the same mark-to-market rules as the trading assets but the resultant gain or losses do not effect income (the gains or losses net of taxes are booked directly to equity through accumulated other comprehensive income or AOCI) nor do they have any impact on regulatory capital (AOCI is excluded from tier1 or core capital).

Third, the overwhelming majority of the banks’ assets (and more importantly the banks credit exposure and source of future losses) are valued at amortized historical cost.

Mark-to-market has neither forced banks to sell assets at prices they consider too low nor has it forced them to raise capital or sell other liquid assets to meet capital demands.

So why is mark-to-market ‘pro cyclical’ and why will its removal help?

Mar 15 07:21 AM

[BlueOkie:]

MTM is a smoke screen for banks buying assets they didn't understand. The assets are more than zero but less than what originally paid. I'm far more concerned about those assets/liabilities that were Off Balance Sheet (OBS). I've decided banks are far too complex and cloudy for my investment dollars.

Mar 15 08:23 AM

[bruggs:]

The issues on mark-to-market are numerous. The biggest issue that has hurt banks in the past year is related to Other Than Temporary Impairment charges. This is where fair value accounting is absolutely broken. If a bank estimates that they will incur a loss in the future on an investment due to credit issues, it must mark that investment to market through earnings immediately (which hits capital).

For example, many banks as well as the Federal Home Loan banks have securities which were originally Aaa that now have estimated losses. These estimated losses occur over 20 or 30 years and might be 2 or 3% of the balance. With market liquidity so strained, these securities are trading at 40 to 50% unrealized losses. So banks write off 50% of the bonds through earnings when they expect to receive 97% of the principal back.

This accounting is non-sense. Allow the banks to mark the investment down by the estimated losses and not the fair value (when little or no bonds are trading). There are other OTTI examples like this. OTTI accounting needs to be reformed now.

If loans were accounted for in this same manner, the entire banking industry would be undercapitalized. Banks are entities which raise deposits to fund illiquid assets. They earn net interest income cash flow from these assets and liabilities. Most banks (excluding the larger banks with broker dealers) do not actively trade assets. Why account for these activities using trading levels? It makes no sense.

Let the banks get back to serving their purpose. Regulators need to restrict trading activities in the future to make sure the larger banks that were trading do not hurt the rest of the industry. Accountants need to reform the accounting policies to properly report the activities and cash flows of the banks (especially the banks which take deposits and lend without trading).

Mar 15 08:43 AM

[Shorts Are ...:]

Investor confidence will not return completely until the extremely flawed and destructive M2M is fixed and the Uptick Rule is reinstated. Hopefully that will be soon.

Mar 15 09:04 AM

[cranyinnyc:]

Another misinformed attempt to blame the problem on accounting rules rather than high leverage and weaken underwriting.

Other than temporary impairments in not new nor was it a product of FASB’s move toward more reliance on of fair market values. It existed in the S&L crisis.

Other than temporary impairments are only taken on assets that are designated by the banks as held to maturity and as a result the assets were valued at amortized historical cost. Such impairments are not automatic when the fair value is below amortized historical cost. In fact management has wide latitude and only has to book OTI charges when it is clear that even if they held the security to maturity they would not realize the amortized cost. Such OTI hits have been very modest thus far. They are not why banks face capital pressures.

By the loans are accounted on an analogous manner. When the banks expect they will not be repaid the full loan balance they are required to make provisions for loan loss reserves.

Stop trying to blame accounting you are only enabling zombie banks.



On Mar 15 08:43 AM bruggs wrote:

> The issues on mark-to-market are numerous. The biggest issue that
> has hurt banks in the past year is related to Other Than Temporary
> Impairment charges. This is where fair value accounting is absolutely
> broken. If a bank estimates that they will incur a loss in the future
> on an investment due to credit issues, it must mark that investment
> to market through earnings immediately (which hits capital).
>
> For example, many banks as well as the Federal Home Loan banks have
> securities which were originally Aaa that now have estimated losses.
> These estimated losses occur over 20 or 30 years and might be 2 or
> 3% of the balance. With market liquidity so strained, these securities
> are trading at 40 to 50% unrealized losses. So banks write off 50%
> of the bonds through earnings when they expect to receive 97% of
> the principal back.
>
> This accounting is non-sense. Allow the banks to mark the investment
> down by the estimated losses and not the fair value (when little
> or no bonds are trading). There are other OTTI examples like this.
> OTTI accounting needs to be reformed now.
>
> If loans were accounted for in this same manner, the entire banking
> industry would be undercapitalized. Banks are entities which raise
> deposits to fund illiquid assets. They earn net interest income cash
> flow from these assets and liabilities. Most banks (excluding the
> larger banks with broker dealers) do not actively trade assets. Why
> account for these activities using trading levels? It makes no sense.
>
>
> Let the banks get back to serving their purpose. Regulators need
> to restrict trading activities in the future to make sure the larger
> banks that were trading do not hurt the rest of the industry. Accountants
> need to reform the accounting policies to properly report the activities
> and cash flows of the banks (especially the banks which take deposits
> and lend without trading).

Mar 15 09:16 AM

[cranyinnyc:]

Another misinformed attempt to blame the problem on accounting rules rather than high leverage and weaken underwriting.

Other than temporary impairments in not new nor was it a product of FASB’s move toward more reliance on of fair market values. It existed in the S&L crisis.

Other than temporary impairments are only taken on assets that are designated by the banks as held to maturity and as a result the assets were valued at amortized historical cost. Such impairments are not automatic when the fair value is below amortized historical cost. In fact management has wide latitude and only has to book OTI charges when it is clear that even if they held the security to maturity they would not realize the amortized cost. Such OTI hits have been very modest thus far. They are not why banks face capital pressures.

By the loans are accounted on an analogous manner. When the banks expect they will not be repaid the full loan balance they are required to make provisions for loan loss reserves.

Stop trying to blame accounting you are only enabling zombie banks.



On Mar 15 08:43 AM bruggs wrote:

> The issues on mark-to-market are numerous. The biggest issue that
> has hurt banks in the past year is related to Other Than Temporary
> Impairment charges. This is where fair value accounting is absolutely
> broken. If a bank estimates that they will incur a loss in the future
> on an investment due to credit issues, it must mark that investment
> to market through earnings immediately (which hits capital).
>
> For example, many banks as well as the Federal Home Loan banks have
> securities which were originally Aaa that now have estimated losses.
> These estimated losses occur over 20 or 30 years and might be 2 or
> 3% of the balance. With market liquidity so strained, these securities
> are trading at 40 to 50% unrealized losses. So banks write off 50%
> of the bonds through earnings when they expect to receive 97% of
> the principal back.
>
> This accounting is non-sense. Allow the banks to mark the investment
> down by the estimated losses and not the fair value (when little
> or no bonds are trading). There are other OTTI examples like this.
> OTTI accounting needs to be reformed now.
>
> If loans were accounted for in this same manner, the entire banking
> industry would be undercapitalized. Banks are entities which raise
> deposits to fund illiquid assets. They earn net interest income cash
> flow from these assets and liabilities. Most banks (excluding the
> larger banks with broker dealers) do not actively trade assets. Why
> account for these activities using trading levels? It makes no sense.
>
>
> Let the banks get back to serving their purpose. Regulators need
> to restrict trading activities in the future to make sure the larger
> banks that were trading do not hurt the rest of the industry. Accountants
> need to reform the accounting policies to properly report the activities
> and cash flows of the banks (especially the banks which take deposits
> and lend without trading).

Mar 15 09:16 AM

[fdsa:]

Appraisers never liked FAS 157 either, as it provided little room for judgment, let alone professtional judgment.


On Mar 15 04:26 AM John Petersen wrote:

> FAS 157 was issued in September 2006 and effective for fiscal years
> beginning after November 15, 2007. As soon as the rule took effect,
> the Dow started its decline. As a one time practitioner of the dark
> arts, I believe FAS 157 is wholly inconsistent with the "going concern
> principle." If we are going to abandon the basic principals that
> give periodic financial statements value, why not turn the entire
> process over to qualified appraisers and be done with it? Seriously,
> what good is a consistent application of generally accepted accounting
> principles if the core valuation of assets changes from quarter to
> quarter?

Mar 15 03:18 PM

[31October:]

crankyinnyc is CORRECT. The rule was instated for reasons.

And what idiot trusts professional judgement? Bear Stearns CEO James Cayne is a good example of what happens when professionals arre allowed to judge the value of their assets.

With MTM, assets had to be valued based on their intent. We are headed back to saying things are worth whatever they need to be to get my @#^%$ bonus.

The reason the MTM rule is being changed is because the Treasury cannot print money fast enough to support the Fed to support the banks.

Google the "scariest chart ever" to see why banks want to cover ["tweak"] what they have done - as assisted by the Fed, as mandated by Congress.

Mar 17 04:51 PM