Next Round of Bank-Based Appeasement

On Tuesday the FASB released two exposure drafts that tinker with the edges of fair value reporting. While the Board had planned several fair value improvements projects that encompassed one of them (guidance on determining whether a market for a security is active), the timing of these two projects is in direct response to the Congressional pressure brought to bear on the FASB last week when Congressman Kanjorski held an investigative hearing into mark-to-market accounting.

Talk about misplaced investigations: what needs to be investigated is why Congress listens so well to bankers and their lobby. Consider the bill sponsored by Representative Ed Perlmutter of Colorado - the "Federal Accounting Oversight Board Act of 2009." It fairly bristles with the kind of rewards the banking industry would love: better than bonuses, it could give them the kind of regulation they want. The bill would transfer the SEC's oversight of the FASB to the new "Federal Accounting Oversight Board." Look at its mission - it's a banker's dream come true:

(1) APPROVAL OF ACCOUNTING POLICY- The FAOB shall approve and oversee accounting principles and standards for purposes of the Federal financial regulatory agencies and reporting requirements required by such agencies. In approving and overseeing such accounting principles and standards, the FAOB shall consider--

(A) the extent to which accounting principles and standards create systemic risk exposure for--

(i) the United States public;

(ii) the United States financial markets; and

(iii) global financial markets;

(B) the extent to which various accounting principles and standards resolve questions concerning liquid and illiquid instruments;

(C) whether certain accounting principles and standards should apply to distressed markets differently than well-functioning markets;

(D) the balance between investors' need to know a value of a company or financial institution's balance sheet at any given time versus financial regulators' responsibility to examine a company or financial institution's capital and value on both a liquidation and going concern basis;

(E) the accuracy and transparency of financial statements;

(F) the ability of investors and regulators to accurately judge the current and long term financial condition of companies and financial institutions from their financial statements;

(G) the need for accounting principles and standards to take into account the need for financial institutions to maintain adequate reserves to cover expected losses from assets held by such institution

(H) the extent to which accounting principles and standards can improve the usefulness of financial reporting by focusing on the characteristics of relevance and reliability and on the qualities of comparability and consistency;

(I) the extent to which such principles and standards can be kept current to reflect changes in methods of doing business and changes in the economic environment; and

(J) any other factors that the FAOB considers appropriate.

It's downright Orwellian: to protect the public, this "oversight body" would blind them from the mistakes made by financial institutions by making accounting less transparent. The body has right to determine "the balance between investors' need to know a value of a company's balance sheet ... versus regulators responsibility to examine capital?" Doesn't that mean that the actual owners of an institution take a back seat to the regulators' decision to keep them in the dark about its true condition?

Truly incredible stuff. This bill wouldn't just turn the asylum over to the inmates; it would arm them with pistols and napalm, too. The banking lobby deserves to be proud of itself for making lemons out of lemonade: though financial institutions have covered themselves with muck through incredibly bad underwriting, they've managed to convince some folks that bad underwriting can be cured by bad accounting.

Speaking of curing bad underwriting with bad accounting, let's move on to the two exposure drafts.

Both have a 15-day comment period ending April 1. (Which is incredibly ironic.) Both will be effective on a prospective basis for interim and annual periods ending after March 15.

First up: FSP FAS 157-e, "Determining Whether a Market Is Not Active and a Transaction Is Not Distressed," which is intended to help preparers and auditors determine when a financial asset's trading price is affected by illiquid markets or a distressed transaction. It provides a list of indicators of illiquid markets; upon reviewing, if the preparer judges the securities in question to be trading in an illiquid market, it must take a second step.

That second step is a presumption that the price is associated with a distressed transaction; it's a presumption that can only be overcome by evidence that sufficient, usual and normal marketing activities occurred for the asset before measurement date, and that multiple bidders existed for the asset. If those conditions aren't met, then the asset must be valued using a valuation technique other than one that uses the quoted price without significant adjustment.

Bottom line, this will grease the skids for the expansion of "Level 3" valuations.

Next: FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, "Recognition and Presentation of Other-Than-Temporary Impairments." This tweak will create a broad class of new long-term corporate investors in both debt and equity securities. Why? Because a firm will not recognize an other-than-temporary [OTT] impairment charge through earnings if it does not intend to sell an impaired security, and it is more likely than not that the firm will not have to sell it before the recovery of its cost basis. Therefore, we will likely witness an outbreak of "patient capital."

If those two criteria are not met (for either debt or equity securities, by the way), then only the part of the impairment charge attributable to credit losses is to be recognized in earnings. The remainder is to be recognized in a new bucket in other comprehensive income. For debt securities, the non-credit loss charges are to be pulled out of accumulated other comprehensive income and recognized in earnings over the remaining life of the debt securities in a prospective manner based on the amount and timing of future estimated cash flows.

Net result: if OTT impairments ever do occur, the hit to earnings will be less than they are now, all else equal. Accumulated other comprehensive income will take a blow for the non-credit loss charges - but financial institutions won't mind because it won't affect regulatory capital. Charges through the income statement definitely affect regulatory capital, and they'll decrease. And earnings will be so smooth, they'll make a baby's bottom look like 20 grit sandpaper.

Nothing in these two proposals betters the lot of investors, except for the ones in "the sky is falling, we gotta save the market from accountants" crowd. It'll at least make them feel like they've been heard.

The link between financial accounting and regulatory accounting needs to broken for good. Because regulatory capital is in part driven by GAAP, firms apply pressure to the FASB - who is essentially friendless in Washington, so pressure can be applied to it with favorable results. Bonus: if GAAP looks good, so do GAAP-based compensation targets. Would the financial institutions lobby their regulators so hard if there were no connection to GAAP? It would certainly be open to more scrutiny in the public eye if they did - and it might be harder for them to have their way.

Comments

[monday1929:]

I must admit I stopped reading about half-way through, but why is anyone suprised when Criminals commit Crimes?
All fiduciaries have been and are here again, in this public forum, being warned that investing any client money into these opaque Banks is negligent and will expose you to damage awards.

Mar 19 11:48 AM