Mark-to-Market Accounting: FASB Responsive, But Not Independent

On Wednesday, acting Chief Accountant Jim Kroeker testified before the House Committee on Financial Services with regard to the progress being made by the FASB on "fixing" mark-to-market accounting. Some of the points he made are troubling in that they illustrate just how far - and how fast - the political interference in independent standard setting has gone. For example:

"... the FASB has acted diligently and responsively to use their expertise as an independent standard-setter and expose amendments to the measurement of securities in inactive markets and the recognition of "other-than-temporary" security impairments. Following the FASB due process procedures, the proposed amendments were deliberated fully at an open public meeting of the full Board, were approved by a majority vote, and are now subject to public comment."

They've acted responsively, for sure. But as an independent standard-setter? Hardly. Kroeker emphasized the following of due process in this escapade, but it can only be termed perfunctory at best. They'll have one day to consider the comment letters they receive. How many other proposals have they floated with that kind of deliberation? I can't think of any. Would "an independent standard-setter" conduct its affairs in such a fashion, in the face of a Congressional inquisition? I don't think so.

This affair is beginning to look like the IASB's cave-in last fall. In fact, there's practically a template being hammered out: in the last month of a quarter so bad it demands accounting cosmetics, financial institutions get politicians to bully the standard setters into making a running change in the standards in time for the reporting season. The big difference between the IASB and the FASB in these two episodes is that at least the FASB went through the motions of a due process - just like they did with the January OTTI amendment.

Kroeker emphasized the need to have the amendments in place for the first quarter reporting season - and noted the OCA is seeking support wherever they can find it:

"This has been and remains my number one priority. We have been proactively reaching out to investor groups, the accounting profession, fellow regulators, and representatives from those industries that would be most affected by the FASB's proposed amendments. And of course we are, as we always are, in constant contact with the FASB, and we understand that they have likewise engaged in active dialogue with capital market participants."

They wouldn't have to "reach out" so hard to find support if an adequate comment period was in place. These are big honking changes to the accounting standards, more so than in the usual FSPs, and it seems unseemly to have to go out to garner support just to be able to have the Board vote on them the day after the comment period ends.

One particularly disturbing claim by Mr. Kroeker:

"The FASB proposal would seek to provide additional information to the investor by reporting the minor loss of expected cash flow in earnings with other changes in value recognized in equity (i.e., OCI) until a decision to sell the security, and realize the loss, was made. That is, such a model would appear to help bridge the gap between the current fair value and the value expected from holding investment positions until markets return to normal liquidity levels."

I wonder which investors to whom they "reached out" thought that additional information was provided by putting losses in other comprehensive income - where it's practically buried at earnings release time - instead of in earnings, where it's visible? "Bridge the gap between current fair value and value expected from holding investment positions?" Let's see what people would think of professional investors if they applied that kind of reporting to their own portfolio performances.

* * * * * * * * * * *

There's a silver lining to this, and yes, it is a stretch. If there will be more junk dumped into other comprehensive income, investors will have to pay more attention to it, if only to UNDO it. The FASB/IASB joint project on financial statement presentation proposes far more description of what goes in on those parts of the balance sheet. So, the FASB's negative investor actions in this regard elevates the importance of what they develop on the financial statement presentation project. That will be the subject of an Accounting Observer report sometime in early April. Stay tuned.

Comments

[BxCapricorn:]

I've tossed the idea of Mark-to-Market (FAS 157) reform or suspension around in my mind, ever since it was set on fire and waved overhead by the same Congress that deplores institutional deceit, unless said deceit is Congressionally condoned. Anyone else find this mindboggling?

Will having less transparency help or hurt the banking sector? Congress wants less tranparency, and FAS 157 to disappear, for now, while at the same time demanding more oversight (SEC and Madoff come immediately to mind) but the root cause of the falling financial dominos should be ignored to allow us to re-lubricate the system with freshly released capital reserves.

I was hoping this piece would help me decide, but now I am as confused as ever. As a 'trade', a bank stock like C or BAC should go up with FAS 157 suspended, but long term, in walks deceit and a long term investor winces at the idea that every quarter, the balance sheet is nothing more than columns of financial shenanigans, fully condoned by both Congress and the FASB. Ideas?

Mar 28 04:45 AM

[optionsgirl:]

FAS157 was instituted in order to "bring greater transparency" after the Enron fraud was perpetrated on the public. So was Sarbanes Oxley. Both have been disasters. What will they cook up next?

Mar 28 09:41 AM

[whisperonth...:]

To assume that FAS157 was all good would be foolish. To assume that it is all bad is also foolish. To assume that all mortgage debt is bad, that all investment debt has little or no value, is just as foolish. I don't even consider myself to be very knowledgeable in accounting or banking standards or rules, but "all or nothing" would be the wrong way to go. Modification, even if only gradual, would be an improvement and perhaps more honest. If an asset has not proven itself to be bad, then perhaps it is not bad and should not be labeled and valued as bad. If an asset has shown to be a poor investment, then it should be dumped into that new program and removed from the books. Removing bad assets would improve the picture. All banks aren't bad, all assets aren't bad, and all FASB rules aren't bad, but we would be insane to believe they were all good. Some middle ground, somewhere, will prove to be the right path to take.

Mar 28 11:03 AM

[dcb:]

This is stupid. It is like saying that the Madoff funds were great investments until the SEC caught on and that the problem with them is that the SEC caught on. You are saying that anything that doesn't allow you to hide your BS is a mistake, not the BS in the first place.


On Mar 28 09:41 AM optionsgirl wrote:

> FAS157 was instituted in order to "bring greater transparency" after
> the Enron fraud was perpetrated on the public. So was Sarbanes Oxley.
> Both have been disasters. What will they cook up next?

Mar 28 12:16 PM

[dixie:]

Wellsaid "whisperonthewind."

FASB 157 does not insure transparency. In fact, in a disorderly market, it may be doing the opposite.

Mar 28 02:46 PM

[Robert Mcdo...:]

Fair value accounting presumes there are fair value markets, but only if you abandon the idea that fair value is a price between willing sellers and willing buyers. Fair value quality of markets requires a balance of plenty of buyers and sellers in the markets. Legal firms are collecting class action groups of shareholders to sue banks over misrepresenting their balance sheets. Why don't they or the investment banks or the Fed or FDIC or fannie Mae and Freddy Mac collect large groups of distressed mortgagees and let them into the market for buying the banks' impaired RMBS instead of the hedge funds (who are seeking minimum 17% returns on the Geithner Plan). Remortgage money should buy the sub-prime and Alt-A RMBS at substantial discounts and use that to cut the mortgage debts of borrowers and thereby also cut their negative equity overhangs. That way Main Street wins something in place of the Wall Street hedgers who made plenty shorting the banks and shouldn't be further rewarded by Fed loan subsidies plus exit clauses to profit from banks' fire-sale deals.

Mar 28 03:51 PM

[partnerj:]

It appears that most MTM supporters are looking back at the assets that the financial institutions currently hold. If Alt-A or Jumbo or student loan portfolios are trading at a 25% discount to face, then the MTM supporters want all financial institutions to mark their Alt-A, Jumbo and student loan portfolios down 25%. This means that the banks cannot afford to ever make another loan, until the “Market prices” recover.

In my opinion, some of the basic flaws in the MTM accounting measures are:

1. Currently bankers make loans based on projected cash flow. The banker and the borrower negotiate the terms including interest payments, principal payments and maturity. It would seem that the completed negotiation is the market for the loan.

Now, consider the MTM alternative. The banker prepares for the loan negotiation by collecting trade price data for similar assets. This might be from the Merrill sale of mortgages at 22% of face or sales by the Lehman bankruptcy Trustee or from FDIC sales of assets to PennyMac. The banker would then use the trade data to determine the terms of the loan. Or the banker writes the loan and immediately writes it down to market.

2. MTM destroys predictability. The financial companies cannot mark-to-market until they have figures for the trade prices. (Level 1 and Level 2 under SFAS 157) This means huge surprises when the companies report their earnings. They can predict their cash flow, but not the end-of-quarter trade prices and resulting MTM valuation changes.

3. SFAS 157 wants all assets and liabilities to be marked-to-market. This means that a TARP contribution creates a phantom loss and reduces equity. (The TARP contribution improves the credit-worthiness, which increases the market value of the Company’s liabilities. Under SFAS 157 this translates to a loss, since the Company would have to pay more to buy-back their own liabilities. The loss reduces the equity.) This is counter-intuitive.

The SEC and the FASB have introduced and actively defended SFAS 157 and 159. The Statements themselves, the amendments and the SEC’s 12-30-08 letter to Congress total over 400 pages. It appears that they had good intentions, but the volume of amendments and explanations indicate that there were unintended consequences.

The MTM that the banks want to suspend is SFAS 157, which was introduced in 2006 with an effective date for financial statements after 11-15-07. The FASB & SEC encountered objections and delayed the enforcement until 11-15-08. Before SFAS 157, assets that were held for trading were marked-to-market. SFAS 157 wants all assets and liabilities to be marked-to-market.

Part of what helped gain support for SFAS 157 is a clever use of the English language. If the FASB and the SEC had called it “Value Based on Trade Prices Measures” and the subset “marked-to-trades-in-a... no one would have taken it seriously. Instead SFAS 157 and 159 use the phrase “Fair Value” over 1,400 times to assure us that this method is fair and they tell us the new rules will help provide transparency.

Please remember that the FDR administration suspended a similar Mark-to-Market system in 1938. The SEC provided details on the 1938 suspension on page 44 of their 12-30-08 report to Congress in their “Study on Mark-to-Market Accounting”. The report is at www.sec.gov/news/studi...

An interesting side question is who benefited from this recent accounting change?

1. Some of the regulators are hiring while the banks are laying workers off. Think about the FDIC as one example. We are witnessing major employment shifts and major power shifts in our country at this time.

2. Articles have mentioned short sellers benefiting. (In addition to regular short-sellers and naked-short-sellers, also think about SKF, SRS and similar issues on the NYSE.)

3. Public firms are getting seriously hurt and some private and foreign firms are benefiting. (Think of the Lehman assets that were sold at distressed prices to Barclays and the Japanese securities company and the Merrill mortgage assets sold to a private TX hedge fund and the recent private offer for IndyMac assets, or the Nevada bank assets that went from the FDIC to PennyMac or the recent purchases by Wilber Ross etc.) Private Hedge Funds and foreign firms are benefiting from the U.S. public companies’ MTM challenges. Many of the private firms do not have capital requirements or MTM requirements. In talking about profits, a PennyMac executive was recently quoted as commenting on his firm’s recent experience buying assets from the government. He said, “In fact, it’s off-the-charts-good.” (See page 5A of the 3-4-09 Sarasota Herald Tribune.)

4. Maybe our Government will print another trillion to have the Hedge Funds start making loans. After all, this most recent non-recourse money for the Hedge Funds is supposed to get assets out from the threat of MTM and capital requirements at the banks and into private hands.

Who comes up with these programs? Who did the hedge funds support in the last election? It is pretty transparent.

“Those who do not learn from history are destined to repeat it.”

Recent MTM References:
Public comments on MTM in the latest SEC study are here www.sec.gov/comments/4...

Some of the writers presented real-life examples of their current holdings and the effect of MTM. These include:

Richard A. Dorfman, President & CEO of FHLBank Atlanta at www.sec.gov/comments/4...

Norman Smith, Corporate VP, MassMutual Financial Group
www.sec.gov/comments/4...

K Brick, SVP & CFO, U.S. Central Federal Credit Union
www.sec.gov/comments/4...

Mar 28 04:32 PM

[Albert Meyer:]

Brilliant... as is dixie 69's comment "FASB 157 does not insure transparency... see above.

FASB is clueless, but talking about M-T-M, why not mark stock options to market? Why use a flawed model to estimate the cost and then not true up the numbers once an employee exercises the option? Because FASB dances to the piper's tune. Stock options allow insiders to steal from shareholders and FASB won't stand up to its financial backers on this one. Besides, for 15 years FASB held firm that stock option compensation was not an expense. You can't make it up. When companies use operating cash flow to repurchase stock issued to employees it incontrovertibly becomes an operating expense, not a financing activity. FASB can't even figure something as basic as this.

The people at FASB had no clue what damage M-T-M would cause, because they never understood the financial machinations of Wall Street. Bring back cash accounting and accrue only for operating revenues and expenses. Disclose and discuss any significant differences between cash flow and earnings in plain English. Countrywide would not have survived one year on this basis. Instead, it lasted long enough for insiders to extract $500 million in stock option gains. GAAP is flawed, only the Conceptual Framework (CP) has validity, but CP is not part of GAAP - go figure. The accounting profession has failed in its mission.


On Mar 28 04:32 PM partnerj wrote:

> It appears that most MTM supporters are looking back at the assets... etc.... see above

Mar 30 11:15 AM

[Mike Razar:]

Is this accountiing or religion? At least mtm makes some sense. You want to price by expected (discounted) cash flows? So how do you estimate the probability that a subprime jumbo loan will perform two years from now? What discount rate will you use? It seems like zero now but if inflation strikes it might be double digits. What would a savvy investor pay for such a loan? Would he lend more than that value?
The oft cited problem of "no bids" is about as self-serving as most whines.Why are there no bids? Maybe it's because the smart buyers HAVE estimated the probability of default. Pout, pout! It's not our fault that these securities are illiquid. Not that the pouters themselves are prepared to field a bid. That is for other people's money. Part of the risk of any investment is uncertain liquidity.
It is an iron law of nature that simply reporting one accounting figure or another, does not change the value of an asset. It may well defraud some suckers into over-paying or over-lending, but it has no real impact on value.
The only constructive idea I can think u\p is to set up some kind of exchange or central marketplace where everyone with an asset to sell can advertise an offer and everyone who wants it can post a bid. This would remove that part of illiquidity caused by incomplete market information.
Yes, I volunteer to set one up if the Tarp pirates will fund me with a billiion or two. Chump change!

Apr 01 10:13 PM

[Rafael Carn...:]

Fellow Concerned Citizens and Investors,

Sadly, I believe that the FASB has succumbed to pressure from main street. One of the FASB's guiding principles has been consistency. For example, I should report my depreciation by the straight-line method every period for the rest of the asset's useful life, unless I find that another method of depreciation would better reflect the assets decline in value as it is used. In much the same way, a bank should continue to report its assets as being marked-to-market if has done so in the past as was required in the past. And no, there is no justification for reporting the assets under this modified, "orderly sale" principle. Panic is never a sound reason to change one's principles, and it is clear that panic is what has motivated Main Street, which has led to Main Street's pressuring the FASB. The fact of the matter is, these banks (along with Main Street) should have had the intellectual prowess to realize that making sub-prime loans is not a sound business practice. These are truly sad times that we live in. It is almost as if Main Street and the FASB have said, "Well, we can't win this game, so let's change the rules." My only question is, how much and how long can we change the rules before game becomes meaningless?

With Regrets,

Rafael Carnicer

Apr 02 12:37 PM