The FAS 157 Accounting Standard and Marking to Market

A few months ago we wrote some articles pointing out the misconceptions around the new FAS 157 accounting standard. (This one is a good example, with links to prior articles as well).

The FAS 157 accounting standard requires that companies use actual market data rather than models when possible, providing different levels of treatment. Level III assets are valued by model, but only when there is no comparable trading. The nature of the business means that specific bonds of specific companies may not be trading much, so there the modeled assets are large.

Some portion of modeled assets are more complex derivatives. We described the errors by those making extreme predictions about Level 3 assets, including this typical comment by Alan Abelson. Even Andrew Ross Sorkin placed the emphasis on worry in a New York Times blog, although anyone reading to the end of the article would catch a key point:

Make no mistake: Level 3 isn’t simply a code word for “worthless.” Morgan Stanley and other firms generally classify private-equity investments as Level 3, for example, because they aren’t traded on any market. Those investments can be worth quite a bit when they are eventually sold.

Despite this observation, Sorkin (and everyone else) incorrectly uses Level 3 as some sort of proxy for worrisome assets.

There has been a lot of misleading piling on. Those predicting "doomsday" on November 15th and a conspiracy to delay the FAS 157 implementation were wrong. The date came and went without the predicted results. That has not slowed anyone down.

A Refreshing bit of Sanity

There seems to be a bidding war among those trying to make the most frightening forecasts. Since most people do not understand Level 3 assets and the models have names that are easy to ridicule, it is open season for those on a bearish mission.

Tom Brown at Bankstocks.com writes as follows:

I am continually surprised by the overgeneralized predictions about eventual subprime mortgage credit losses lately being thrown around by people who ought to know better. As I’ve discussed here before, Egan Jones’ Sean Egan came up with his preposterous estimate that the guarantors need $200 billion in new capital based on . . . well, no research at all. Bill Gross says that eventual credit default swap losses will tally to $250 billion. How does he come up with that number? He doesn’t say.

He does his own calculation to place some limits on the problem. His method is easy to understand, and readers should check out the entire article.

In his excellent Market Movers blog, Felix Salmon took a good look at the misleading impact of these rules as applied to AIG (AIG). After leading readers through the technicalities, he clearly stated the key conclusion:

In other words, there's something on our books which we're pretty sure is worth $3.628 billion, or was worth $3.628 billion at the end of November, but we're going to ignore that when we release results as of the end of December.

He goes on to question whether this type of FAS 157 application is really helpful to investors.

In Barron's Jonathan R. Laing does a nice job of showing the actual impact of the rules for AIG, where he sees an investment opportunity. We are especially interested in how he describes the issues between the company and the accountants, and how they are resolved:

Other esoteric accounting conventions lay behind AIG's accountants' insistence that the company boost its most recent mark-to-market charge by $3.6 billion. AIG had held that the value of its synthetic-guarantee contracts hadn't deteriorated by nearly the amount that the insured CDOs had. But since there's no real trading market in its highly customized swap paper, the insurer couldn't offer sufficient evidence of that contention. And these days, accountants are leery of accepting mark-to-model pricing that many financial institutions have used in the past to reduce valuation hits to earnings.

Conclusion

Many financial companies have chosen to keep assets on their books rather than selling them at distressed levels. The accounting rules -- perhaps incorrectly -- are creating a need for additional capital.

Meanwhile, there is a very real chance that many of the writedowns of the last year will prove incorrect as the assets work out over time. These are not realized losses, but marked losses.

Investors who realize this and have a good shopping list can benefit from the misconceptions of the many.

Disclosure: We have no AIG position.

Comments

[WAKEUP]

Does this mean that the adage, "Figures don't lie, but liars can figure" is finished? Doubtful, especially with AIG.

[Chancer]

I have a very simple recommendation to resolve a lot of this.

Whenever there is no independent standard (appraisal) to value these assets, you are required to write down 50% on the first pass. That gets the worst of the bad news out fast. Future write downs will not be worse news, because there is only 50% remaining to write down.

Assuming for example that assets are eventually determined to be worth 20% in the end: there would be a first write down of 50% in one reporting quarter and an additional write down of 30% in the quarters that follow.

Although this is a big fast hit for an individual company, the market regains confidence quickly, because the worst of the bad news is out quickly.

Such a requirement might also cause companies to improve their on risk assessments at the start.

[Questioning Logic]

I am sure there are a number of homeowners that agree with your way of thinking Jeff. "I bought my house for $700,000 two years ago but no one is willing to buy my house now except for the guy that offered me $250,000. I am going to ignore that bid and continue to believe my house is worth $700,000. I am really looking forward to receiving approval on my 5th home equity loan!!!!"

[Jeff]

O' Cynical one --It is not "my way of thinking" and it is not like the homeowner. I agree with what homeowners are thinking. Many investors think this is the same, apparently including you. The remaining big accounting firms, especially in the post-Arthur period, apply some pretty tough rules, as they did with AIG. The point is to give investors an accurate look at corporate earnings. The company can't just say anything it wants (like your homeowner example).

The question is whether using prices from illiquid securities really informs investors. I try to help people by showing some good thinking from various sources, picking topics where many are wrong. I hope that some will benefit. Those that start with an idea that corporations and accountants are liars are of two types: those who consider new evidence with an open mind (my intended audience) and those whose minds are made up. The latter group probably should not invest in stocks.

I expect that you are in the former group, or you would not bother reading and commenting. I appreciate this, since it helps me in future articles.

Thanks -- Jeff