Subscribe: RSS Feed | Twitter | Facebook | Email
Home | Contact Us

Putting Perfume on a Pig!!

Posted by Larry Doyle on April 2, 2009 9:45 AM |

***Bumped up from original publication time of 7:30AM. The FASB has now just voted its approval of the change in mark-to-market accounting.

It is speculated that the FASB (Federal Accounting Standards Board) will today relax its rule known as the mark-to-market. This rule requires firms under the FASB’s purview to mark their assets to changing market prices on an ongoing basis. The institutions subject to this rule have been lobbying FASB and Congress for a change because the markets for these assets have imploded and in certain cases totally dried up.

What does the FASB plan to do? The FASB is going to cave to the lobbying pressure and will allow institutions to use their own internal models based upon cash flow analysis to price these assets. This change in the mark-to-market will not only allow institutions the flexibility to not mark down certain assets, but simultaneously mark up other assets.

The media only presents the impacted assets as “hard to value” or the dreaded “mortgage-backed securities” or “securitized assets”.  In fact, many of these assets are very simple and plain vanilla. Let’s enter the world of the Federal Home Loan Banks.

The FHLB system consists of 12 regional banks and it provides liquidity (capital) for its respective members to operate. The FHLB system invests its own capital, primarily in plain vanilla conventional mortgages (Freddie Mac, Fannie Mae, Ginnie Mae) and Jumbo ARMS (adjustable rate mortgages) and fixed-rate pass-thrus. Certain banks within the FHLB system may have moved slightly off the plain vanilla path to purchase a small percentage of sub-prime assets, but that was much more the exception than the norm. 

The FHLB funds itself by issuing simplistic debt issues.

The point I am raising is that the FHLB business model is a VERY simple model. The fact of the matter is the valuations of their assets have fallen through the floor. If the FHLB system marked these assets at levels at which the assets are currently trading (and yes, they are trading everyday….I could get a bid on a large block of bonds within the next 10 minutes!!), then the FHLB would need significant capital injections.

Who gets this? Charles Bowsher, who resigned just last week as chairman of the Federal Home Loan Banks Office of Finance. Bloomberg’s Jonathan Weil does yeoman work in profiling Mr. Bowsher and the joke that is FHLB accounting:

Bowsher, who was comptroller general of the U.S. from 1981 to 1996, had a simple reason for resigning last week as chairman of the Federal Home Loan Bank System’s Office of Finance. He didn’t want to put his name on the banks’ combined financial statements, because he was uncomfortable vouching for them. Bowsher, 77, had held the post since April 2007.

With so many top executives complaining they can’t figure out what their companies’ assets are worth, the real wonder is that more corporate directors haven’t quit rather than certify financial reports they don’t understand.

The job Bowsher left is a crucial one. The Office of Finance issues and services all the debt for the 12 regional Federal Home Loan Banks. That’s a lot of debt — $1.26 trillion as of Dec. 31, making the FHLBank System the largest U.S. borrower after the federal government. The government-chartered banks, which operate independently, in turn supply low-cost loans to their 8,100 member banks and finance companies. If any of the FHLBanks were to fail, taxpayers could be on the hook.

Where have we seen this nightmare before? Freddie Mac and Fannie Mae were the poster children for private profit and social loss. While I know of nobody at Freddie Mac or Fannie Mae who willingly exposed the holes in their internal accounting, Bowsher will not acquiesce:

“I was not comfortable as an audit-committee member in signing off on the financial statements, after I became aware of the standards and processes for valuing the mortgage-backed securities,” Bowsher told me.

In typical political fashion, the finance office was less than forthcoming about Mr. Bowsher’s departure.

The finance office didn’t say why Bowsher was quitting, when it issued its March 24 press release announcing his resignation. On March 30, a spokesman, Michael Ciota, told me the people who work there didn’t know, including its chief executive, John Fisk. “We’re not aware of any reason,” Ciota said. “There’s not a whole lot to tell.”

After I told Ciota yesterday about Bowsher’s comments to me, Fisk called me back. He confirmed that “Mr. Bowsher has expressed his concerns to me around the complexity of valuing mortgage-backed securities and the process of producing combined financial statements from the 12 home loan banks.” He added: “I don’t think it’s appropriate for us to speak for Mr. Bowsher.”

For what it is worth, John Fisk formerly worked at Freddie Mac. With all due respect to Mr. Fisk, his experience at Freddie Mac is not exactly a resounding vote of endorsement.

Thus, the equity markets will rally on news of this accounting change, but as they do, please do not forget about Mr. Bowsher and his principles. His principles are being run over in the name of “creative accounting.” To wit,

The year-end balance sheet at the FHLBank of Seattle, for example, showed $5.6 billion of non-government mortgage-backed securities that it says it will hold until maturity. Yet the estimated value of those securities was just $3.6 billion. The bank, which reported a $199.4 million net loss for 2008, said the declines were only temporary. They’ve been anything but fleeting, though. Most of those securities have been worth less than they cost for more than a year.

The FASB’s rules on this subject, which have never been well defined, are now in flux. Today, after caving in to pressure by the banking industry and members of Congress, the Financial Accounting Standards Board is set to vote on a plan to relax its rules on mark-to-market accounting, so that companies can disregard market prices and ignore losses on their securities indefinitely.

While that wouldn’t make the banks any healthier, it would make their numbers look prettier. The FHLBanks have been among the most vocal lobbyists pressing for the change.

I commend Mr. Bowsher for having the character and integrity to stand his ground on this topic. I commend Mr. Weil at Bloomberg for profiling him and highlighting an Honest Man Emerges From Banking Crisis.

The cost to taxpayers is not only in the risk of real losses on FHLB finances, but also the lack of capital that will flow through the system. This relaxation in the mark-to-market is, in my opinion, a classic Japanese style move of not recognizing losses. I believe we will look back at this day and this rule change as a watershed event.

In my opinion, this change in the mark-to-market for an entity such as the FHLB system is the equivalent of “putting perfume on a pig!”

LD

  • Ben Simeone

    Larry,This is frightening.It seems like a case of the inmates running the asylum!.No one is addressing the core problem which is that banks are carrying toxic asstes on their balance sheets and can now carry them at a higher cost than they are actually worth.

  • Larry Doyle

    Ben…you are right. There are certain assets, such as commercial real estate loans which probably warrant a modified relaxation of the mark to market, but AAA plain vanilla mortgage securities trade all the time.

    Make no mistake, our politicians just ran our accounting system and our markets over. Bowsher said, “not on my watch!!”

    I would never buy a bank stock after this charade.

  • http://financialexecutives.blogspot.com/ Edith Orenstein

    Larry,

    You report above that “FASB is going to cave to the lobbying pressure and will allow institutions to use their own internal models based upon cash flow analysis to price these assets.”

    I don’t see FASB as ‘caving’ as much as trying to amplify the words that are already present in FAS 157, and I worry that some of the critics of FASB’s recent attempts to provide guidance on fair value in inactive markets as being a debate between one of pure mark-to-market (which is not what FAS 157 requires across the board, in terms of how to arrive at ‘fair value’) vs. internal cash flow modeling (which is actually one of the permissible methods in FAS 157, although external indicators cannot be ignored).

    I wonder if some of the critics are unware of what FAS 157 really says about distresed transcations, and permissible methods for arriving at fair value. I’m not sure if you’d moderate your viewpoint that ‘FASB is caving’ if you considered these paragraphs present in FAS 157 (numbers correspond to paragraph numbers in FAS 157; emphasis added):

    “5. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

    “7. A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale). The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (an exit price).”

    “C25. The definition of fair value in this Statement retains the exchange price notion contained, either explicitly or implicitly, in earlier definitions of fair value. However, this Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the principal (or most advantageous) market for the asset or liability. The Board affirmed that the transaction to sell the asset or transfer the liability is an orderly transaction, not a forced transaction (for example, if the seller is experiencing financial difficulty), that assumes exposure to the market for a period prior to the measurement date to allow for information dissemination and marketing in order to transact at the most advantageous price for the asset or liability at the measurement date. To convey that notion more clearly, the Board revised the definition of fair value in this Statement to refer to an orderly transaction, as do other definitions used in valuations for purposes other than financial reporting that are similar to fair value (for example, fair market value).”

    In addition to the above paragraphs cited, FAS 157, para. 17 provides some indicators for when ‘a transaction price might not represent the fair value of an asset or liability.” Additionally, para. 18 describes three valuation techniques, the market approach, income approach, and cost approach, and para. 19 states “Valuation techniques that are appropriate in the circumstances and for which sufficient data are available shall be used to measure fair value.” These paragraphs are copied below:

    “17. In many cases, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, the reporting entity shall consider factors specific to the transaction and the asset or liability. For example, a transaction price might not represent the fair value of an asset or liability at initial recognition if:
    a. The transaction is between related parties.
    b. The transaction occurs under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.c. The unit of account represented by the transaction price is different from the unit of account for
    the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction, the transaction includes unstated rights and privileges that should be separately measured, or the transaction price includes transaction costs.
    d. The market in which the transaction occurs is different from the market in which the reporting entity would sell the asset or transfer the liability, that is, the principal or most advantageous market.
    For example, those markets might be different different if the reporting entity is a securities dealer that transacts in different markets, depending on whether the counterparty is a retail customer (retail market) or another securities dealer (interdealer market).”

    “Valuation Techniques
    18. Valuation techniques consistent with the market approach, income approach, and/or cost approach shall be used to measure fair value. Key aspects of those approaches are summarized below:

    a. Market approach. The market approach uses prices and other relevant information generated
    by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different
    multiple for each comparable. The selection of where within the range the appropriate multiple
    falls requires judgment, considering factors specific to the measurement (qualitative and quantitative). Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’
    relationship to other benchmark quoted securities.

    b. Income approach. The income approach uses valuation techniques to convert future amounts
    (for example, cash flows or earnings) to a single present amount (discounted). The measurement
    is based on the value indicated by current market expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black- Scholes-Merton formula (a closed-form model) and a binomial model (a lattice model), which incorporate present value techniques;9 and the multiperiod excess earnings method, which is used to measure the fair value of certain intangible assets

    c. Cost approach. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). From the
    perspective of a market participant (seller), the price that would be received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. Obsolescence encompasses physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (based on specified service lives).”

    “19. Valuation techniques that are appropriate in the circumstances and for which sufficient data are available shall be used to measure fair value. In some cases, a single valuation technique will be appropriate (for example, when valuing an asset or liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (for example, as might be the case when valuing a reporting unit). If multiple valuation techniques are used to measure fair value, the results (respective indications of fair value) shall be evaluated and weighted, as appropriate, considering the reasonableness of the range indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.”

    Finally, the discussion in para. 29 and 30 of FAS 157, regarding Level 2 and Level 3 inputs, is relevant:

    “29. Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability. Those factors include the condition and/or location of the asset or liability, the extent to which the inputs relate to items that are comparable to the asset or liability, and the volume and level of activity in the markets within which the inputs are observed. An adjustment that is significant to the fair value measurement in its entirety might render the measurement a Level 3 measurement, depending on the level in the fair value hierarchy within which the inputs used to determine the adjustment fall.”

    “Level 3 inputs
    30. Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Therefore, the reporting entity’s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.”

    I believe FASB, in trying to provide guidance on fair value in inactive markets (the proposed FSP FAS 157-e), tried to remain consistent with the fundamental tenets of FAS 157, shown in the paragraphs above, rather than as some say “caving.”

  • Larry Doyle

    Edith….nice try but what you are doing is taking a definition and backing into your result as opposed to appreciating the dynamics of the market.

    This rule change is an enormous benefit for the FHLB system and Freddie and fannie. The assets in those institutions are not hard to evaluate. In fact, they are easily evaluated nad trade everyday. It jsut so happens that they are trading at prices far below what these insitutions want to mark them at.

    There are bonds trading EVERYDAY!! Be honest with the public.

    This relaxation is a means to cook the books.

    To emphasise orderly is to nullify the market.

    Commercial reasl estate loans may be one thing, but plain vanilla conforming or Jumbo ARMS or fixed rate pass-thrus is something else. I can get you a bid right now!!






Recent Posts


ECONOMIC ALL-STARS


Archives