Friday, March 13, 2009

Jack Ciesielski sheds some actual information on the debate (not for the first time)

I'm a big fan of Jack Ciesielski's blog, and I think he's been especially on target with his discussion of mark-to-market accounting, and how most critics appear woefully uninformed about the newness of the fair value requirements. Read the whole thing.

The Lynch Mob Forms
So there's only one thing left to do: blame the accountants. There's an angry mob forming, and it looks like they brought a rope. They're converging at the Rayburn House Office Building in Washington, DC on Thursday, March 12, when Congressman Paul Kanjorski holds a hearing to "address problems facing mark-to-market accounting."

The press is having a field day with this: it's been a long time since an accounting standard was in the news so much. Ben Stein
threw a tantrum in the Sunday New York Times, calling for someone, anyone, to "immediately end the near-universal applicability of the accounting rule formally known as FAS 157." Ben: get a grip. Statement 157 is universal, all right - it applies to any balance sheet account that had been given fair value treatment before the issuance of Statement 157. The most pervasive and confidence-destroying myth about Statement 157 is that it's somehow requiring fair value reporting for the first time in places where it hadn't ever been used before. 
If folks like Ben would maybe just READ Statement 157, they'd understand that. If they'd really stretch and read the SEC's Congress-mandated study on fair value accounting, they'd know that at the banks where all the alleged fair value damage has been wrought, only about 31% of total assets are given the fair value treatment - hardly "near-universal." The biggest assets on banks' balance sheets are their loans - and they do not receive fair value treatment. Their greatest amount of assets were unaffected by the implementation of Statement 157. It's easier to deflect blame on an accounting rule than face culpability for bad loans made, however.

The conventional wisdom (hard to call it that) that Statement 157 is creating fair value reporting where it had not been applied before. It's simply misinformation: Statement 157 put one definition of fair value into the accounting rules and added more disclosures for users - including the widely-used Level 1, 2 and 3 fair value hierarchy disclosures.

Good and bad news on mark-to-market accounting

Some good news and some bad news on the mark-to-market accounting (MTM) front.

First the bad news:
Speaking to my dad a while ago, he argued that much of the current problems would go away if we got rid of MTM accounting and reinstituted the uptick rule for short sales. Yay for Fox News/CNBC talking points!

The good news:
There are some intelligent discussions of some of the nuances in MTM accounting. Two examples:

Nobody Says Mark to Market Doesn’t Matter as GE Falls
When I saw the headline, my immediate reaction was huge disappointment. "Not another badly-written article talking superficially about how MTM is the root cause of everything." But I was pleasantly surprised when the article spoke about exactly the opposite. The whole article is worth reading, but here's the punch line:

"For more than a decade General Electric Co. could easily avoid disclosing the value of its real estate and business loans. Not any more.

Since Jan. 2, GE has lost 45 percent on the New York Stock Exchange, mostly because shareholders are no longer willing to accept whatever the Fairfield, Connecticut-based company tells them about its finance subsidiary unless it’s based on so-called mark-to-market accounting rules."

That’s an excellent antidote to the arguments against MTM. Yes, firms are currently forced to reveal the substantial decreases in market value for their financial instruments, and that’s making them look bad. Maybe that decrease is temporary (liquidity-driven), maybe it’s permanent (reflecting changes in estimated future cash-flows). But it’s providing information to the market, which is likely better than not having that information at all. It seems investors may have been skeptical of GE’s non-MTM financial instruments because the absence of information is probably worse than the presence of (perhaps) noisy information.

The second piece of good news relates to the supposed consequences of MTM accounting. The critical issue for MTM accounting is this: What do you actually do with the MTM adjustments?

One of the big arguments against MTM accounting claims a sequential, recursive process:
  1. MTM accounting forces Firm A to write down the value of certain assets (perhaps residential mortgage backed securities) because they have declined in value since origination/purchase.
  2. After writing down those assets, Firm A is in violation of regulatory requirements and must de-leverage. The firm can de-leverage by raising capital through equity issuances or by selling off some assets and paying down debt.
  3. In the current environment, capital isn’t available, so Firm A has to sell off assets.
  4. When Firm A sells off those assets with highly uncertain value, it is forced to accept fire-sale prices, because investors require steep discounts to make up for the uncertainty about future cash flows.
  5. Firm B, which holds similar assets, is now forced to use the fire-sale price as the measure of market value, which to reduce the valuations on their balance sheets.
  6. In order to meet regulatory requirements, Firm B must de-leverage by selling off some of its assets.
  7. Firm C uses the new marks, ad infinitum.

Critics of MTM have said, “Stop the madness! End MTM accounting and you will end this recursive death spiral.” But what the critics should be saying is, “Stop the madness! Stop taking mechanical actions based on marks if those marks are uncertain. Keep the MTM accounting, but loosen up the regulatory requirements.” (This assumes that there is something wrong with the current process, which I’m not sure is a premise I agree with.)

I am not surprised to find myself agreeing with Warren Buffett, as conveyed by Holman Jenkins in the WSJ:
Buffett's Unmentionable Bank Solution
“Now comes Warren Buffett, a big investor in Wells Fargo, M&T Bank and several other banks, who, during his marathon appearance on CNBC Monday, clearly called for suspension of mark-to-market accounting for regulatory capital purposes.

We add the italics for the benefit of a House hearing tomorrow on this very issue. Mark-to-market accounting is fine for disclosure purposes, because investors are not required to take actions based on it. It's not so fine for regulatory purposes. It doesn't just inform but can dictate actions that make no sense in the circumstances. Banks can be forced to raise capital when capital is unavailable or unduly expensive; regulators can be forced to treat banks as insolvent though their assets continue to perform.


CNBC, sadly, has been playing a loop of Mr. Buffett's remarks that does a consummate job of leaving out his most important point. Nobody cares about the merits of mark-to-market in the abstract, but how it impacts our current banking crisis. And his exact words were that it is "gasoline on the fire in terms of financial institutions."