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Who Kidnapped GAAP?
The mark-to-market zealots, and they're holding the economy hostage, as well.

Gary Townsend
Posted 03/09/2009
Hill-Townsend Capital
gary.twnsnd@gmail.com

Fair value accounting has hijacked GAAP accounting. It is one of the great ironies of the day that the Financial Accounting Standards Board’s own rulemaking has managed to undercut public confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles, turning financial reporting on its head. Value is now based on a bankruptcy model, one that assumes that a firm’s value is only that in distressed liquidation, rather than the net present value of cash flows generated as a going concern. The damage to our economy and its growth prospects is enormous and gives life to many of the misguided, unhelpful policy prescriptions (the recent push for a general bank nationalizations being one), that would take a bad situation and make it worse.

Fair-value accounting needs to be fundamentally reformed. “Fair market value” concepts in accounting are long-standing, but the “fair value” measurements of FAS 157 became effective just this past year. And it’s not that the new rule required banks to mark more of their financial assets to “fair value”. Though most commercial banks mark only a small portion of their balance sheets (e.g., General Electric marks just 2% of assets), FAS 157 required that all banks disclose in footnotes the “fair value” of their financial assets and liabilities. So, in our unhappy present economic circumstances, these disclosures became the perceived reality. The math is easy. Many banks that are well-capitalized and solvent in accordance with GAAP are simultaneously insolvent when GAAP results are adjusted to “fair value”. Look, for example, at Capital One.

To many market participants, GAAP has become irrelevant. That’s crazy. Even crazier is the confidence that so many investors attach to these “fair value” results. As promulgated by FASB, fair value’s conceptual flaws are fundamental and run deep.

It’s worth noting, first off, that “mark-to-market” accounting is a misnomer. FAS 157 actually removed “market” from the definition of “fair value.” Under previous rules, “fair market value” meant the value implied by the non-compulsory exchange of property between willing buyers and sellers, with equal knowledge and equity to both. Now, FASB defines “fair value” as a sale in an “orderly transaction” between “market participants.”

The differences are subtle, but they yield strikingly dissimilar results. The prior definition, for instance, determined “fair market value” from an actual transaction between willing participants. But under FAS 157, “fair value” is premised on a hypothetical, immediate sale to yet another “market participant.” Recall from Economics 101 that when a market is in equilibrium, the marginal buyer is induced to purchase only when price falls. As defined, then, “fair value” tends to impair asset values even in stable environments.

In unstable environments, by contrast—well, you’ve seen what’s happened. According to the FASB and the SEC, forced or liquidating sales represent neither “fair market” nor “fair” value. And yet such sales nonetheless must be taken into account under FAS 157. Consider Merrill Lynch’s sale of its large securities book at 22 cents on the dollar. The company was surely an “unwilling seller.” But the transaction was nonetheless “orderly,” as ownership was transferred to the hedge fund buyer. Was the price paid, then, “fair value”? It is really a judgment call, but under FAS 157, the answer, ultimately, was yes.

What about investments that the owner has no intention of selling? Why should those investments’ “fair value” matter to investors at all? In the FASB’s conceptual framework, remember, the objective of financial reporting is to provide information to help “assess the amounts, timing, and uncertainty” of an entity’s cash flows. But users of financial statements are actually misled if losses are recorded based on the market’s perception of an asset’s value, if in fact that asset has experienced no credit problems and is performing fully in accordance with its terms. In recent quarters, we’ve seen frequent examples of “other than temporary impairment” (OTTI) losses in precisely such circumstances.

In a recent article in Strategic Finance magazine, Alfred M. King, a recognized expert in the art of financial valuation, concludes persuasively that the “very essence” of valuation is professional judgment, and that FAS 157 is “fundamentally flawed.” “One can argue that management should be willing to sell any and all assets,” he says, “but we have not reached the point where creditors and shareholders actually run the company. In fact, the only time creditors do … make such decisions is after the company has filed for bankruptcy … There is a vast difference between valuing assets for the purpose for which they were acquired, and valuating them as though they would or could be liquidated.”

It astounds me that the SEC, FASB, Treasury, and the bank regulators are not engaged in a full-court public relations press to affirm GAAP financial results, while at the same time emphasizing the conceptual problems and doubtful accuracy of “fair value” in such a highly stressed and illiquid economy as this one. What’s the matter with these people? They give idleness and bureaucracy a bad name.

It’s time to suspend this misguided and flawed rule. Mary? Tim? Are you listening?

What do you think? Let me know!

Mark-to-Market Mayhem

Mark-to-Market Insanity

Mark-to-Market: Stop the Madness

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Comment:

Observer Posted On 3/9/2009 3:55:54 PM

Once again, your issue with the accounting is fine. But your presumtion that accounting is causing or magnifying the current problems remains highly questionable. Financial markets are not waiting for FAS 157 disclosures to decide which companies have problems. They are making their own assumptions about real economic losses imbedded in companies' balance sheets (irrespective about whether those assets have yet experienced any cash flow problems). Argue about whether those assumptions are correct or not, but I still don't see why the accounting is any more than a side-show in the main event.

JOEEXEX Posted On 3/9/2009 3:56:49 PM

Seems like every one agrees with you except the idiots keeping it in full force with no moderation in any shape or form. Hope you keep up the pressure in your articles maybe one of them will respond,when looking up FAS 157 i dont remember voting for any of them but lots of information there.

banker Posted On 3/9/2009 3:58:24 PM

Finally, Someone gets it. It's like no one else understands. The industry will be wiped out if something is not done soon.

Jake Posted On 3/9/2009 3:59:09 PM

That's so dumb. The collective wisdom of the entire investing universe, speculating with their own hard earned cash seems to be worth less than the say-so of a CEO according to your "lets mark to pure fantasy" preferred accounting method. Yes, mark to market is not always right. However, it is clearly better than mark to imagination accounting. Do innocents get hurt in mark to market - yes. do more innocents get hurt in enron style mark to whatever I say - yes. If I'm selling a $1 Million house, and the market is paying $500,000 - isnt' that a better estimate of its true worth than my own "i say it's worth $1Million"? Bloody obvious - Its so obvious that bankers and Wall street can't see it.

banker Posted On 3/9/2009 4:02:56 PM

Observer- If you take a bond that is still paying it's interest every month why should I care what the current market value of the bond is? NOTHING has changed as far as me getting paid. Until we see serious problems with payments there is nothing that has really fundamentally changed. In the meantime we continue to rasie more capital to protect against "possible losses" that don't exist. You will run out of captial before the values are correct.

Observer Posted On 3/9/2009 4:26:30 PM

Banker: If a bond is paying interest now but won't in six month's time (or 12 or 18 or 24), it still matters. You will have a loss and those extra coupons you clipped will only help you offset that loss modestly if your recovery is pennies on the dollar. You don't see the problems, but the market does (or thinks it does). The market may be wrong, but with all due respect, the market has been far more accurate than bankers so far. I'm sure it will eventually overshoot (hopefully, it already has). You only run out of capital if you can't hold the assets or are forced to recognize losses. But you are forced to deal with the market's view on this whether you account for them under "fair" value or amortized cost.

i disagree Posted On 3/9/2009 4:50:01 PM

You guys are making far too much of mark to market accounting. Most of the assets on banks' books, especially the mid to smaller banks, are held at cost less a provision. The problem is that the managers are not provisioning enough. Your rant against mark to market is growing so boring. For the larger banks that are engaged in the securities business, they should be marked to market, or they should get out of the business. This was the point of Glass Stegall. The fact that the Congress repealed Glass Stegall at Greenspan's request, was stupid, as we are all coming to see. Your assumption that the market doesn't understand the accounting is completely misplaced. Only you guys get it and nobody else. Interestingly, you've been wrong for the past two years.

Brett Scheiner Posted On 3/9/2009 5:54:08 PM

You are assuming the banker is omniscient and the market is blind. Probably not the right framework.

OM Posted On 3/9/2009 7:26:15 PM

Is this an alternative universe site? I have been listening to this argument for several years now. Originally, the financial guarantee insurance companies were misunderstood - that was two years ago. On Feb. 7, 2007 Ambac sold $400 mil of 6.15% Notes with the proceeds to be used to buy back stock. ABK stock was $88 on that day. It is $0.40 today and those bonds are quoted at $18.875. I am still waiting for the misunderstanding to rectify itself. So is ACA Holding, Assured Guaranty, MBIA, MGIC, PMI, Primus, Radian, SCA, Triad Guaranty, and a host of others. Soon enough "true" value will assert itself, so the line goes.

bob Posted On 3/9/2009 7:29:06 PM

Observer - accounting is not the issue. Having the disclosure is a good thing. The problem is banks being forced to raise capital and/or shrink balance sheets based on fair value write downs. The latter is dumb because a) the market does get it wrong; b) it can lead to a self-reinforcing negative spiral; c) it would be so easy to force further disclosure from management who wanted to ignore a fair value mark; and d) it ignores 'franchise value'. Take, for example, JPM. The bank is forecast to make $40b pretax, preprovision in 09. Tax that at 35% and apply a modest 5X multiple to arrive at a 'fair value' franchise asset of $130b.

KC Kid Posted On 3/9/2009 7:41:01 PM

So, if we are making our house payments on time but the banks or the markets think we won't six months from now I guess we should be happy to put up more capital in advance at a difficult time to cover the assumed loss of payments? It goes both ways. -------------- Trust is the real issue and with companies like Enron it's understandable why trust in marking to models has been eroded. ------------- However, it doesn't help to throw all pricing to a destructive thin and jittery market tail that wags the banking and economic dog just so we don't have to think. ----- Marking to a good transparent model that adheres to well thought out and regulated standards takes the extreme emotion out of the ridiculous market prices such as we've seen during the last few bubbles. ----- Those booms and busts have created much more collective damage than Enron and their sleazy executives. Obviously that’s little consolation to those who lost their retirement funds and we all certainly sympathize with them. ----- The plain and simple fact is that BOTH Markets and Models can be "mark to fantasy" but good models with conservative assumptions tend to take the emotion out, reduce volatility, and also open up the destructive positive feedback loop created by FAS 157. ----- Today's market price, regardless of how extreme, is only accurate if we absolutely positively have to or want to buy/sell today. ---- Many good traders buy low knowing a stock is grossly undervalued and sell high knowing a stock is grossly overvalued. ---- Thus it is clear that markets ARE inefficient which can be very good or very bad thing depending upon your situation.

BANKER PAST Posted On 3/9/2009 8:06:41 PM

IF MARK TO MARKET IS TO BE THE FUTURE THEN DO NOT EXPECT BANKERS TO MAKE LOANS (INCLUDING REAL ESTATE) AT THE CURRENT BELOW MARKET RATES --IN A FEW YEARS R.E.M.RATES WILL BE 6% TO 8% AND THEY WILL BR FORCED TO 'WRITE DOWN' ALL THE CURRENT MARKET REM'S BECAUSE OF THE BELOW MARKET RATES OF THE FUTURE,,,,COLLECT 5% FOR 3 YEARS AND THEN WRITE DOWN THE PRINC. 15 TO 20 % DUE TO MARKING TO MARKET ....??????????????

The Terminator Posted On 3/9/2009 10:16:26 PM

Observer, You can argue that the market is not waiting for Fas 157 to decide who has problems, but I'd argue that the market has been taught to start hunting for names with MTM risks because it is these companies that have gone down a lot. Look at State Street (STT) for example. On January 16th, the last trading day before its fourth quarter earnings release, the stock cosed at $36. On January 20th, despite reporting good operating results, the stock plunged over 50%, falling to $15. Why? Because it reported a large $1.5 billion increase in the "accumulated other comprehensive loss" component of its equity (i.e. MTM). (Incidentally, State Street will tell you that all of the securities that are being marked down are 100% current on cash flows.) Judging from the huge one day decline in the stock price, the "market" didn't know about these marks until State Street actually reported its results. Because the "market" is a learning machine (like me) and is unwilling to suffer similar surprises, it is selling all financial companies with big balance sheets, creating the self-fulfilling downward cycle that we are seeing. FAS 157 has to go. But let's go ask the people that FAS 157 is supposed to help and protect. Attention, shareholders of State Street! Shareholders of Wells Fargo! Shareholders of Bank of America! Has FAS 157 helped you or has it harmed you? We all know what the answer is.

KC Kid Posted On 3/9/2009 11:12:52 PM

The Terminator...... Excellent example and excellent comments. And, yes we do know the answer. FAS 157 must be terminated.

Market Wisdom Posted On 3/10/2009 12:56:27 AM

There will be books written some day about the level of incompetence and stupidity by many of the participants who are involved in various roles in our very mature economy. That book will spend a lot of time in Washington D.C., Wall Street and the accounting profession. FAS 157 will no doubt be ridiculed as a fumbling policy driven by a bunch of bean counters who have no idea how markets work and don't work. In their theoretical world there is always a market with adequate liquidity and pure information. Since that logic has fallen apart they now move to "fair value" between "market participants." I understand what they are trying to do but this rule is only good in a vacuum not in the real world. Send the bean counters to the back room. We should never be marking long term assets against short term markets with their inherent volatility and liquidity swings. The short term market is only a guide but when the market is only liquid at fire sale prices then its guiding power becomes a destroyer of capital or at best a head fake. I believe it was Benjamin Graham who commented on the terrible predicatablity of the market in the short run as an indicator of value. He likened it to a business partner who would come in drunk one day and offer to sell you the business for a song and on other days when he was feeling good he would not sell it for anything. The point was that only a discounting of future cash flows was a good indicator of the value of the business.

Observer Posted On 3/10/2009 8:34:45 AM

bob--You're right. The problem isn't the accounting. The problem is that nobody is sure what the assets are really worth. And the "cost" from believing they are worth more than they really are is typically far greater than the cost of shrinking and/or raising capital today. But I agree with the self-reinforcing spiral. Just don't see that MTM accounting makes much difference in whether it happens or not. As for The Terminator, yes, the market was surprised by the MAGNITUDE of the losses reported by STT. But the market had already been making its own assumptions about the value of STT's assets (and the assets in its conduits) for months. But STT is an interesting example as almost all its issues stem from securities as opposed to loans at most of the banks. The problems at WFC or BAC...they're not MTM accounting issues.

The Terminator Posted On 3/10/2009 11:49:37 AM

Observer, You have some good points and I don't think suspending MTM is the cure-all, but it is definitely hurting more than it is helping. And as far as Wells, MTM has been a huge problem. When they acquired Wachovia, they were forced to mark down all of the acquired loans. Now, when you look at Wells' financials, it is impossible to see where these write-downs are (and the implied benefit that many future losses have already been taken). Under the old accounting standard, Wells would have just taken a large loan loss provision expense which would now sit in its loan loss reserves. Instead of a 2.5% loan loss reserve ratio, Wells would be reporting something near an eye-popping 5.0% loan loss reserve ratio. When determining capitaly adequacy, investors are focused on tangible common equity and the reserve ratio. Unfortunately, when investors superficially look at Wells' books today, they see a low 2.8% TCE ratio and a rather pedestrian 2.5% LLR ratio. The stock has gotten annihilated since closing the deal. MTM requirements has been one of the factors limiting good banks from taking over weak banks, typically one of the best solutions to dealing with troubled banks. But any healthy bank thinking about making an acquisition today would be crazy after seeing what has happened to Wells and PNC.

Banker Posted On 3/10/2009 1:29:21 PM

Observer- We are holding bonds that 80 % of the mortages have to go into foreclosure and sell for 50 cents on the dollar for us to realize a loss. Do you know what the highest default rate in history was? Around 18% during the great depression. The assets have been valued as if everyone will be forclosed on and there will be nothing that we get out of selling the asset. Totally absurd. Give me a 50% foreclosure rate and I still can't lose real money. However I am required to mark these things down 38 million on a potential loss of 600k over the next 10 years. You guys don't get it. We aren't talking about a loan that you foreclose on. This is a package that pays interest.... Some people just don't understand and that's fine but don't try to tell us how to run something you don't understand.

Observer Posted On 3/11/2009 2:30:26 PM

Banker, then you will make money on that package as long as you are correct and you can hold them to maturity (or at least until the market comes to believe you are correct). But an investor has a right to make their own judgement about whether you are correct in those two assumptions. And whether you report that mark or not, investors will still make those judgements if they know you hold it. If they don't know if you hold it (because you don't disclose it), they'd still have to assume some probablity that you do. I understand both sides very well, thank you.

banker Posted On 3/12/2009 11:41:13 AM

Observer-http://news.yahoo.com/s/nm/20090311/bs_nm/us_financial_banks_assets;_ylt=Aghzaqxsal.H47aO2slijDK573QA second paragraph. Is this a joke??? Even Shelia says there is more value.

Observer Posted On 3/12/2009 3:53:49 PM

Banker, you're getting in knots over the wrong issue. Some of the securities out there will no doubt yield reasonable, or even highly attractive, returns to the right buyer. But the question at hand is whether changing the accounting will change the actions of the actors (investors, management, regulators, rating agencies, gov't, etc.) and, by itself, address many of the problems we are currently facing. You (or others here) MIGHT be able to convince me that some of the actors might do so if you were to try. However, I have thought through what some of these changes might be and the end result that I see is that the market is going to remain concerned about the real losses in the system and will make their own value assumptions (and assumptions about what all the actors will do). Thus, suspending MTM accounting will generate a nice rally in the markets but, absent any other underlying change or fundamental improvement, will only set up another retreat. This conversation would be much easier over lunch or drinks, so I think I've said my piece on it for now. We'll see how things go.

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