SFAS 157: Accounting Rules Do Not Affect Cash Flows

At my congregation, I have a friend who is a lawyer at the Justice Department.  (Such is life for a congregation located near DC.  I am one of the few that does not derive his income from the government.)  He has asked me a couple of times about SFAS 157, and the effect it is having on the current crisis.  My recent comment to him was:

Accounting is a way of portioning economic results by time periods.  It doesn’t affect the cash flows, but tries to allocate economic profits proportional to release from risk.  If we were back in an era where the financial instruments were simple, then the old rules would work.  But once you introduce derivatives, and securities that are called bonds, but are more akin to equity interests, you need to mark them to market.

Equity instruments have always been marked to market, because of their volatility.  Similarly volatile debt instruments should be marked-to market.  Even the the old-style “hold-to-maturity” bonds would get marked down if there was a “permanent impairment of capital.”  Even today, the same rules apply, the companies could specify certain volatile bonds as hold-to-matutrity or available-for-sale.  But when the auditors look at the bonds, and ask what the market price is, the challenge is to explain why there is no permanent impairment of capital.

Those that are complaining about SFAS 157 and SFAS 133 are barking up the wrong tree.  They wouldn’t be complaining if the companies in question had not bought inherently volatile assets.  These accounting rules reveal the results of their actions.  The regulators could ignore the rules of FASB, and allow the financial institutions to balue them otherwise. The regulators have a different attiuude; they don’t care about profitability, but they do care about solvency, and avoiding “runs on the bank.”

A very well-established rule in academic finance is that changes in accounting rules do not have much impact on stock prices on average, because they don’t affect cash flows, and free cash flows are the major basis for evaluating stock prices.  If a financial company holds an impaired security, eventually that will factor into the cash flows regardless of what the accounting rules are.

There are a number of articles today on this issue:

• SEC, FASB Resist Calls to Suspend Fair-Value Rules (Update2)

• Mark-to-Market Relaxed

• Auditors Resist Effort To Change Mark-to-Market

• Fair-Value Accounting & FASB 157

• Regulators Ease Securities-Valuation Rules

FASB has offered a little more room to interpret the mark-to-market rules, but only a little.  Congress could mandate more latitude, though I think it would be a mistake.

Mark-to-market accounting should pay a role in valuating volatile financial instruments.  Now that financial institutions have bought financial instruments more volatile than tha buy-and-hold attitude of the old days would have done, ther rules must adjust to present a fair value.

I don’t see any way that lets the markets gain from the suspension of the rules.  The rating agencies will still do calculations of risk based liquidity on financial firms to set ratings.  Here’s a way to test though.  Go back to my old proposal that we have two income statements and two balance sheets.  Let the market see both a fair value and an amortized cost appproach.  If fair value is distorting, then investors will welcome and use the amortized cost figures in their calculations.  More information is better than less, and it is trivial to add back an amortized cost balance sheet and income statement.

For complex balance sheets in volatile times, I know which one that investors will prefer — fair value.  Let the advocates of eliminating fair value explain why reducing information to investors is such a great benefit.  In the end the cash flows will be the same, and maybe it will take a little longer, but the results of bad investment decisions will be revealed, and the same firms will fail — perhaps in yet more ugly ways, as their shenanigans will go on longer, with less to recover for the bondholders, and wiping out the equity entirely.

In the absence of fair value, suscpicion will take the place of information, and companies will still get marked down as failure takes place in fixed income assets classes.  The same things will happen, just in a messier way.  You can’t fight the cash flows arising from bad investment decisions, and too much leverage.

Comments

[sr9web:]

If you can't see how MTM has hurt firms holding certain mortgage/debt securities, then you are unfit to write here. If I hold your mortgage and you pay me, my MTM stays at the value of your mortgage. However, if I hold 10,000 bundled mortgages (CDOs, CMOs) and they are opaque to outsiders trying to guage the total potential defaults, the MARKET price on that security wil drop SUBSTANTIALLY. Now, every loan in there might be to someone just as good as you - but the FEAR that there's junk in there - drives the CDO value to MUCH LOWER levels than if those mortgages were owned individual as per me owning yours. In this instance, the MARKET - especially during a crash, is a WARPED measuring stick which DOES NOT reflect the actual economic value of the underlying loans accurately. If you can't see this then, how shall I say this delicately... you are STUPID!

2008 Oct 01 05:41 PM

[Tom Armistead:]

Mark to market accounting is a serious error. As sr9web mentions, the cash flows of a CDO containing 10,000 mortgages can be projected with a fair degree of accuracy and accordingly can be discounted to arrive at a present value. Any number of insurance companies and asset managers have access to data bases, software, and trained personnel to perform these computations.

Mark to market accounting does not represent management's best estimate of either current earnings or current asset/ liability values. Instead, it represents the worst fears or insinuations of a panicked or manipulated market as if they were truth.

When these distorted figures become the basis for determining regulatory or rating agency capital, serious harm is done to solvent financial institutions, creating unnecessary liquidity crises and forcing the sale of assets at fire sale prices.

You mention matching the timing of expenses and revenue as a primary objective of accounting. Mark to market accounting brings future losses into today's income statement, while leaving reasonably predictable future revenues out of it.

2008 Oct 01 07:30 PM

[jimmy46:]

I agree with the other 2,
mark to market is not helpful when accurate quotes are not available and the company expects to hold the security for more than a few years.

2008 Oct 02 05:04 PM

[mfinlay:]

I generally agree with sr9web, but there is slighly more to the story.

Mr. Merkel is saying that he doesn't care if there is a difference between the market value of a security and the true economic value of it -- if a firm is required to sell that security in order to provide the cash flows it needs to survive, then the most appropriate measure of its value is that which it would currently fetch in the marketplace. OK.

The issue is: what if the firm does NOT need to sell such security in order to conduct its business? In this case, if like securities are trading in the marketplace for a substantial discount to its true economic value, then there is a real divergence of interests.

Because of capital requirements (at banks) and traditional credit analysis (at other institutions), mark to market accounting has the ability in this situation to create a self-fulfilling prophecy.

We have already determined that the true value of a security may be relatively high, but it's mark to market value may be quite low notwithstanding. If accountants then come into an institution and demand that those securities be marked down to the lower value, even though the institution, under normal circumstances, would not be required to sell such securities (and thus could maintain its capital base), then we have articificially created a deflating balance sheet. A deflating balance sheet means that other institutions will not lend to the impaired institution, leading to a liquidity crisis, forcing such institution to sell opaque securities at firesale prices, and, presto bammo, the equity has thus PERMANENTLY disappeared, notwithstanding that the true economic value of the securities, if held, would have meant a higher equity value.

Mr. Paulson eloquently described this as the difference between hold to maturity values and mark to market values when he was allowing that the public might not actually take a bath on the $700 billion of securities he was proposing to purchase.

Now, Mr. Merkel, after such further enlightenment, you still do not understand how FAS 157 could wreck a financial institution, I agree, you are unfit to write here.

2008 Oct 03 06:09 PM