FASB Watch: Who Should Make the Economic Calls?

Last week saw the FASB proposals for some modest adjustments in the mark-to-market rules. We were on the road for a campus guest lecture, trying to do a little giving back.

The coverage of this was amazing. Seeking Alpha had a block of stories, all Editors' Choices. They all were very opinionated and critical about the decision. Apparently Seeking Alpha could not find anyone who thought it was a good decision, since there were no Editors' Choices in support. Bloomberg and other MSM sources bemoaned the "political pressure" on FASB.

These commentators all need to go back to school. We have so many blogging economists now. Why can't we get some help from some blogging political scientists or public policy types?

There is no subject where the gap between the self-perception of knowledge and the actual understanding is so great.

Let us try some examples.

How Experience and Education Color Advice

Let us take a problem like environmental policy. Let us further suppose that you had our job, teaching young people about these issues. Your team included an economist, a scientist, and you.

Would it surprise you to learn that the economist favored a free-market solution with minimal regulation?

Would it surprise you to learn that the scientist thought that all pollution was bad?

The public policy problem is one of reconciling competing viewpoints and finding outcomes that generate something good for society. (Defining this is difficult, so books are written about it. Defining the public interest is beyond our scope. For the moment, let us just accept that there is a broad public interest, and it would be good to find it.)

On the environment, the solution might be a recognition that driving pollution to zero is too costly. We might recognize that some firms can improve more readily than others. The trading of "pollution rights" was an idea from the 70's and we are still debating it now.

Please note well that there is no criticism of either the economist or the scientist. They are very intelligent and have great knowledge. They are smarter and know more than most of those pundits evaluating their comments. They are good! The problem is that they see the world through their own experience.

We need a broader viewpoint.

Let's try another example, one that is familiar in the decision-making literature - the Cuban Missile Crisis. Briefly put, the US discovered that the Russians were building missile bases 90 miles from our shore. It was a challenge that could not be ignored.

A team of advisors presented information and options to President John F. Kennedy. For those of us who are old enough to remember, this event was the closest we came to nuclear war. It was important.

(An aside -- Art Cashin uses this as a training story, since he was then a rookie trader. The question was how to trade the crisis. The answer was to buy, since if it was not solved, trading longs would not matter!)

The Air Force advisors recommended a "surgical air strike." Further evaluation showed that the strike might not be as precise as hoped.

The Army thought that an invasion of Cuba was called for.

The Navy recommended a blockade, preventing further delivery of missiles and material.

The State Department sought a political solution. They thought that the Russians were bargaining about Berlin. They suggested that we might give up our Turkish missile bases, something that was no longer really relevant for US strategy.

Political advisors thought that a quid-pro-quo in Turkey would be a sign of weakness. If we did this, it should be through a back channel.

Please note that all of these advisors were very intelligent and had great knowledge. They were all good -- very good!

The public policy problem was to reconcile the differing advice. The actual decision -- a "moving blockade" giving Khrushchev time to respond and to allow the back channel to work --is hailed as an example of excellent Presidential decision making. We did not go to war, and the missile bases were removed.

Implications for FASB

So what does this have to do with the Financial Accounting Standards Board (FASB) and the mark-to-market decision?

The first thing to understand is that the SEC, which has the decision about where to vest accounting rules and oversees FASB, is not a branch of government, like the Supreme Court. It is an Independent Regulatory Commission. There is insulation from normal politics, since it is not wise for routine politics to govern accounting rules. The SEC must have at least two members from each party in a five-member commission. The President has the power to appoint, but not to fire members. There is significant insulation from routine politics, but it is not like the Supreme Court.

The Problem

The mission of FASB is accounting. The intelligent and expert members of this group make very good decisions, but they look at the world from the perspective of accountants. They want to force companies to reveal information to investors. It is their mission, and they do it well.

The current problem is that FASB instituted FAS 157 at the worst possible time. It was a new rule and probably a good one. The implementation of this rule led many accountants to take the most conservative view of assets held by financial institutions. While the rule provided some flexibility in implementation, most accounting firms in the post-Enron era chose a conservative course. Many had the government-dictated death of Arthur Andersen and the loss of accumulated partnership interests at the forefront of their thinking. Why take such a risk?

Meanwhile, the problem was much broader than the accounting question. The new rules might have been implemented quite safely a few years ago. Accountants could learn the rule and also the exceptions.

Instead, the implementation came at the worse possible time. The forced write downs of assets contributed (did not cause, but contributed) to a death spiral. Capital was subtracted from firms faster than the government could add TARP money. Private capital was frightened away by the threat of further write downs.

Some misguided pundits and bank analysts have seized upon the continuing losses as evidence that they were right. In fact, the rules were designed to make them right. Had the rules been addressed in a timely fashion, the death spiral might have been stopped.

Enter Congress

Many in Congress noted that there was a wider public interest, something extending beyond the strict notion of accounting rules.

Congress, as part of the original TARP legislation, mandated a study of these rules within 90 days. Former SEC Chair Christopher Cox and company conducted the study. There was plenty of evidence, including some from us. The Cox group made a finding, just before the door hit them on the way out. Their conclusion was that the FAS 157 rules were not that important for bank failures. This conclusion, an official finding by the SEC, is rightly viewed as biased by many of us. It is nevertheless cited by many in supporting the current rules.

Unhappy with this outcome, a sub-committee of the House Financial Services Committee held hearings and expressed some displeasure. There was some tough questioning of SEC and FASB leaders.

Is this political pressure? Of course. It is a completely appropriate exercise of Congressional oversight, warning FASB that their viewpoint was too narrow for the circumstances.

There is absolutely nothing wrong with this Congressional action. There was not even any legislation -- just some nudging in a public hearing. This is precisely what Congress should do -- focusing attention on the broad public interest.

The Outcome

The result of this political "pressure" was a very modest tweak to the FAS 157 interpretation, much less than many thought was needed.

The pundit reaction to this has not been accurate. Various opponents of change claim that FASB caved in to political pressure. This is an easy story for journalists to write and for pundits to criticize. None of them exhibit any understanding of how the American political system works. They are writing to a receptive audience, which shares their pre-conceptions about how government should work.

We are still awaiting the actual new guidance from FASB, but it seems to be pretty tame.

The delay in addressing this issue has been a failure of the political system, which moves slowly and must deal with those in power. Had the issue been raised earlier, or if the crisis had come later, the outcome might have been quite different.

Takeaways

We have had many emails from accountants. Please note what we are not saying. Accountants are intelligent and serving their mission. Like the Air Force in the Cuban Missile Crisis they are good -- very good!

The problem is that their perspective is too narrow. We need rules that provide information to investors without crippling the US economy. Since concern about declines in regulatory capital is not their defined mission, they do not make it part of their decision.

FASB is not elected by anyone. FASB should not run the economy. That is what we mistakenly allowed to happen.

Comments

[Hillsfar:]

"FASB is not elected by anyone. FASB should not run the economy. That is what we mistakenly allowed to happen."

FASB doesn't run the country, but y'know, I think shareholders have a right to know whether a bank's balance sheet was full of junk that they only pretended was not....

Apr 10 02:32 AM

[Tom Armistead:]

Good article. Accounting is about information, compiled and interpretted. For mortgage and mortgage backed securities, the interpretation requires an opinion on the future trajectory of the economy and the housing sector. As originally presented and implemented, FAS 157 made popular opinion primary: in effect Nouriel Roubini and other doomsayers dictated the writedowns.

Geithner's stress tests, which supply alternative scenarios under which to evaluate the assets, are a step in the right direction. Mortgage backed assets have a value which depends on unknown future events. Balance sheets should include a clear statement of the assumptions that are driving the values assigned, assumptions which should be consistent with consensus opinions of qualified economists.

I don't think FASB was running the economy, it was more like they opened the door to doomsayers, who overwhelmed CYA auditors. Going forward, perhaps accounting rules should explicitly recognize and require the input of economists on the value of assets which are dependent on factors such as housing, employment, and real estate markets.

Apr 10 07:34 AM

[Opossum:]

I have an old motorcycle which is worth $500 ... maybe. If I can't sell it for $500, only $200, I can argue and intellectualize till the cows come home but it's still ONLY WORTH $200. That's what the market is willing to pay: that's it's true value, it's what the guy taking out his wallet is willing to pay. If a bunch of pointy-headed government (or regulatory agency) bureaucrats and accountants come along and say, "hey, wait a minute, it's worth $1,000," carry it on your home balance sheet at $1,000" it doesn't mean a darn thing. The guy with the money will only pay $200. THAT'S IT'S VALUE. A long time ago I learned people who would do something such as the FASB did are frauds, dishonest types, thieves who can - and do - bamboozle the public and "The Press" for their own advantage. Then they'll try and justify it! Mr. Miller doesn't make sense ... and if you follow his investment advice - that money can appear on balance sheets out of thin air - you will lose. By the way Mr. Miller, will you buy my ratty, broken junk motorcycle for $1,000? I also have a bridge in Brooklyn cheap!

Apr 10 09:35 AM

[ferguson:]

I am not an accountant, but my suspicion is that the problem here is more a matter of hysteria than substance. As Jeff Miller reports, we haven't yet heard from FASB as to what the revised standards might be.

The only guidance I have heard is that the revised standards might allow the use of "income generated" as a measure of value in addition to "current sale prices."

This would seem to raise a common sense comparison in a world where hysteria reigns. In the real estate world, appraisals of the value of commercial property may be based on 1. comparable sales; 2. replacement cost; or 3; income generated. I am not a real estate appraiser either, so any correction will be appreciated.

That suggests that there just might be reasonable measures of value othere than current sales prices which, if there is no market, are judged to be close to zero.

Of course assessing "income generated" involves the hard work of actually looking at these collections of "toxic assets," adding up the income they are generating and can be reasonably expected to continue to generate. But that would mean substituting hard work for hysteria which is a lot less fun and doesn't sell well in on Bleeker Street or in Hollywood.

An aversion to substituting hard work for hysteria is perhaps inevitable in the entirely fraudulent financial landscape which has allowed so many of the opportunistic but marginally qualified shell game operators to make millions and spend it on Palm Beach and Oyster Bay lifestyles.

The evidence is in. Arthur Laffer was wrong. "Trickle down" doesn't work. The true wealth of nations lies in providing opportunity, education and health care to the population as a whole.

Apr 10 09:55 AM

[Larrysyr:]

I'm starting to feel my age.

In economics classes, we were taught the efficient market hypothesis which basically asserts that the participants in the market collectively look at the whole picture of an organization and arrive at a consensus of the proper price for any security. This hypothesis was so widely accepted that it supported the dramatic growth of the index mutual fund industry. You can't beat the market over the long run, so why try?

FASB issued its mark-to-market requirements as an outgrowth of this principle that market values are the most accurate and verifiable indicator of a security's worth. FASB's mission is to make financial statements more useful to investors. FASB is supposed to be concerned about the accuracy of valuations and the completeness of disclosure, not the fate of companies implementing new accounting principles. (This is a simplified analysis, since there are obviously many other considerations like cost/benefit that FASB needs to consider before issuing a new rule.)

If implementing FAS 157 caused many banks to show balance sheets with too little capital, that is a regulatory problem, NOT an accounting problem. Unless we have abandoned the principle that the market is the best judge of value, FASB should not be tweaking their rules to keep companies in business. I don't believe we have abandoned the market-based valuation of assets. Or have we?

The appropriate response to the accounting change would be for the bank regulators to make one of two decisions. They could decide that the publicly reported balance sheets of the banks show the true underlying picture of the institutions and take action to close them. OR they could grant temporary regulatory relief from capital requirements until the mess could be sorted out. The institutions and their assets and liabilities are the same regardless of accounting treatment; however, they are very different from a regulator's point of view.

The political pressure on FASB and the resulting "tweak" announcement in response is extremely disturbing. Mr. Miller is 100% correct that the issues of mark-to-market are not solely accounting issues, but pressuring the accountants to change their approach destroys the objectivity on which markets rely to evaluate financial information.

Apr 10 11:05 AM

[Roland Cycan:]

How about issuing two statements, side by side.

One is in accordance with FASB's rules. The other is an accordance with Barney Frank's rules.

Let people rely on whichever they choose.

Apr 10 12:30 PM

[CaptainJJack:]

As I understand the issue, it is not so clear cut.

If you were to put your house up for sale, you might expect a price close to what houses like yours has sold for in the neighborhood. I think we would all agree that this would give a pretty good indication of the market.

But, what if there was only one house sold, and that was by someone who HAD to sell within a week? Do you think that provides a good indication of the value of your house?

What if there were no houses sold, and the only thing close that has sold was a double wide in a trailer park 5 miles away? Do you think that you should rely on this sale as the basis for your house value?


On Apr 10 11:05 AM Larrysyr wrote:

> I'm starting to feel my age.
>
> In economics classes, we were taught the efficient market hypothesis
> which basically asserts that the participants in the market collectively
> look at the whole picture of an organization and arrive at a consensus
> of the proper price for any security. This hypothesis was so widely
> accepted that it supported the dramatic growth of the index mutual
> fund industry. You can't beat the market over the long run, so why
> try?
>
> FASB issued its mark-to-market requirements as an outgrowth of this
> principle that market values are the most accurate and verifiable
> indicator of a security's worth. FASB's mission is to make financial
> statements more useful to investors. FASB is supposed to be concerned
> about the accuracy of valuations and the completeness of disclosure,
> not the fate of companies implementing new accounting principles.
> (This is a simplified analysis, since there are obviously many other
> considerations like cost/benefit that FASB needs to consider before
> issuing a new rule.)
>
> If implementing FAS 157 caused many banks to show balance sheets
> with too little capital, that is a regulatory problem, NOT an accounting
> problem. Unless we have abandoned the principle that the market
> is the best judge of value, FASB should not be tweaking their rules
> to keep companies in business. I don't believe we have abandoned
> the market-based valuation of assets. Or have we?
>
> The appropriate response to the accounting change would be for the
> bank regulators to make one of two decisions. They could decide
> that the publicly reported balance sheets of the banks show the true
> underlying picture of the institutions and take action to close them.
> OR they could grant temporary regulatory relief from capital requirements
> until the mess could be sorted out. The institutions and their assets
> and liabilities are the same regardless of accounting treatment;
> however, they are very different from a regulator's point of view.
>
>
> The political pressure on FASB and the resulting "tweak" announcement
> in response is extremely disturbing. Mr. Miller is 100% correct
> that the issues of mark-to-market are not solely accounting issues,
> but pressuring the accountants to change their approach destroys
> the objectivity on which markets rely to evaluate financial information.

Apr 10 12:54 PM

[BerkeleyBob:]

There has always been a certain element of unreality in accounting. What is the "value" of good will and how do you price intellectual property? The retreat from mark to market rule will result in a prolongation of the economic turmoil. It is difficult to determine the realistic price level of an asset when there is a sharp secular decline in the asset class, but the assets were mis-valued to begin with based in part on poor underwriting and overly-optimistic appraisals. I long ago bailed on FRE and C and only recently took a small position in JPM. Not all economists are free-market Friedman-ites, not all political scientists are interested in policy. If the collective opinion of the people who read and intelligently comment on Seeking Alpha is negative about the FASB rule change, I think that collective opinion is more probably correct than yours.

Apr 10 03:13 PM

[Fabien Hug:]

Mark to market is an attempt to value a corporation on its liquidation value; how much do we get if we sell all the assets today and pay back the liabilities. No corporation is ever in this situation or it is bankrupt.
The problem in these opinion blogs is that few come with figures to sustain their points. My understanding is that these famous bonds backed up by sub prime loans have a market value between 10 to 20 cents on a dollar, meaning that the market anticipates a 80 to 90% failure rate from the borrowers. First, this is not the situation as of today. Default rates are far away from that (I think around 5% to 10% in this particular category). Second, I don't think that market expectations are any more valid now than they were before the crash in those days when risk was dead.
If I agree with Mr Miller about this change of rule I strongly disagree about the fact that it should have ever been implemented. I disagree with his political view; it was a good rule with a bad timing. You can't rub everybody's backs; choose your camp comrade!
Can you imagine the mess we create if those who rule our miserable lives start to "market time" the rules?
The real question is why was that rule implemented and what problem was it supposed to solve? Did it solve the problem at least or is it still lurking around the corner?
For disclosure, I hold bonds in JPM, AMEX, GE, LYG.

Apr 10 03:27 PM

[THofler:]

OMG!!
Opossum, Does your motorcycle generate substantial income every month? I didn't think so.

Larrysyr, I understand that someone taught you the "efficient market hypothesis," but do you still believe it applies to this environment? Does it apply to a CDO or ARS market with virtually zero trades? If you do, then you really haven't been paying attention over the last 6 months.

BerkeleyBob, SA commenters do not constitute a scientific poll.

Nice work Mr. Miller. Keep it up.

Apr 10 08:06 PM

[Hmm?!:]

Mark to market. It is worth what the market will pay.

If you think it can be worth more, then you buy it with your own money.

Apr 11 03:04 AM