Accounting rules

[awriter]

To what extent have current accounting rules contributed to the current financial problems? I heard one commentator suggest that suspending some of these accounting rules that force frequent mark to markets might help companies get through the crisis and allow for the longer-term viability of those companies as markets recover. Is that a realistic alternative?

[Fuzzy]

If there is no market for the sub-prime loan then it's mark-to-market value drops to $0 (or near $0). Since the loan was originally listed as an asset, suddenly your assets have dropped. If the level of your assets in relation to your liabilties, or reserve requirements, is important (say, to your creditors...), then you're in trouble!

If you didn't have to drop the value because the rules allowed you to not recognize the "loss" (i.e., delay the recognition until you were "certain" that the loan was no good, or not drop the value at all because it was actually proved to be good in the first place), then your balance sheet would not be out of wack and there is no problem with your creditors...or regulators.

[wooHoo]

FASB to issue guidance..

http://financialexecutives.blogspot.com/2008/10/senate-passes-financial-rescue-bill.html

FASB Requests Comments by Oct. 9 on Proposed FSP on Fair Value; Guidance is In Addition to SEC-FASB Guidance Issued Sept. 30
FASB voted yesterday to issue further guidance on the application of FAS 157, Fair Value Measurement in inactive markets, in the form of an illustrative example(s). This decision follows by one day the Sept. 30 clarification of fair value accounting in inactive markets issued jointly by the SEC and FASB.



http://www.fasb.org/board_handouts/10-01-08.pdf

[California]

SEC Commences Work on Congressionally Mandated Study on Accounting Standards
FOR IMMEDIATE RELEASE
2008-242

Washington, D.C., Oct. 7, 2008 — The Securities and Exchange Commission today announced additional details on the process and initial steps that the SEC has undertaken to conduct a study on "mark-to-market" accounting, as authorized by Sec. 133 of the Emergency Economic Stabilization Act of 2008, signed into law by President Bush last Friday.

Under legislation enacted last week to help stabilize financial markets, the SEC is required to conduct a study of "mark-to-market" accounting. The study is to be completed by Jan. 2, 2009, in consultation with the Secretary of the Treasury and the Board of Governors of the Federal Reserve System. Under the terms of the EESA, the study will focus on:
1. The effects of such accounting standards on a financial institution's balance sheet
2. The impacts of such accounting on bank failures in 2008
3. The impact of such standards on the quality of financial information available to investors
4. The process used by the Financial Accounting Standards Board in developing accounting standards
5. The advisability and feasibility of modifications to such standards
6. Alternative accounting standards to those provided in [Financial Accounting Standards Board] Statement Number 157

SEC Chairman Christopher Cox announced that James Kroeker, Deputy Chief Accountant for Accounting at the SEC, will serve as staff director for the study. As Deputy Chief Accountant, Mr. Kroeker is responsible for resolution of accounting issues, rulemaking projects, and oversight of private sector accounting standard-setting efforts. Prior to his current position, Mr. Kroeker was a partner at Deloitte and Touche, LLP in the firm's National Office Accounting Services Group, where he was responsible for providing consultation and support regarding the implementation, application, communication and development of accounting standards. Mr. Kroeker also served as a Practice Fellow at the Financial Accounting Standards Board, where he assisted in the development of accounting guidance related to evolving accounting issues.

The SEC also announced that it is scheduling public roundtables to obtain input into the study from investors, accountants, standard setters, business leaders, and other interested parties."

[Guilty Bystander]

One of our asset managers thinks that the current crisis would be much less severe, maybe not even a "crisis," if there had been no mark-to-market for the thinly traded stuff.

[JMO]

One of our asset managers thinks that the current crisis would be much less severe, maybe not even a "crisis," if there had been no mark-to-market for the thinly traded stuff.
:iatp:

The whole idea of mark-to-market only works when there is an actual market. The accountants seriously need to rethink this. It looks like they are going to take a bit longer than was spent on the bail-out bill.

Does anybody remember the S&L crisis? The one that ultimately brought down Executive Life? The S&Ls had to sell off all their junk bonds. The fire sale effect drove down the "market" value, causing Executive Life's investment portfolio to be marked down as well. And does anybody remember what a windfall was eventually made by the folks who bought up the Executive Life assets after the regulators broke it up?

[Fuzzy]

The whole idea of mark-to-market only works when there is an actual market. The accountants seriously need to rethink this. I agree, but, JMO, got any suggestions on how to balance the "no market" value against the (apparently just as ridiculous) "book" value? For a well defined mortgage, maybe a new PV of future monthly payments at a risk adjusted rate? But what do you do with those weird packages of "securities" where no one seems to be able to define a cash flow? (let alone unravel who owns what part of it...) Although outlawing them seems appropriate from certain points of view, it probably isn't practical, although some of this c**p should probably never have been thought up in the first place (I have no idea what the answer is, I'm just askin' here...):tfh:

[Glenn Meyers]

Floyd Norris of the NYT made a commment about this a few weeks ago.

"But if one wants to look at accounting rules as a cause, it would be more productive to examine the rules that permitted the crisis to grow without being noticed, not at the rule that finally brought the truth to public attention."

For my two cents, the real question is capital adequacy, not the particular way we "value" the assets.

In the same article Norris also offers some interesting opinions about the use of internal models.

Here is the link to the complete article.
http://www.nytimes.com/2008/09/29/business/29norris.html?pagewanted=1&_r=2

[Shaft]

This is what happens when accountants are allowed to fudge.

[Jack]

:iatp:

The whole idea of mark-to-market only works when there is an actual market. The accountants seriously need to rethink this. It looks like they are going to take a bit longer than was spent on the bail-out bill.

Does anybody remember the S&L crisis? The one that ultimately brought down Executive Life? The S&Ls had to sell off all their junk bonds. The fire sale effect drove down the "market" value, causing Executive Life's investment portfolio to be marked down as well. And does anybody remember what a windfall was eventually made by the folks who bought up the Executive Life assets after the regulators broke it up?

If companies are overinvested in these securities then failing to mark to mark will hide the huge (and I mean huge) liquidity risk they face.

[Guilty Bystander]

Floyd Norris of the NYT made a commment about this a few weeks ago.

"But if one wants to look at accounting rules as a cause, it would be more productive to examine the rules that permitted the crisis to grow without being noticed, not at the rule that finally brought the truth to public attention."

For my two cents, the real question is capital adequacy, not the particular way we "value" the assets.

In the same article Norris also offers some interesting opinions about the use of internal models.

Here is the link to the complete article.
http://www.nytimes.com/2008/09/29/business/29norris.html?pagewanted=1&_r=2


In my opinion I don't think one can separate "capital adequacy" from "the particular way we 'value' the assets." For any given basis of determining capital adequacy, that judgment is inextricably linked to how assets are valued.

[Glenn Meyers]

Perhaps I should be more precise. Perhaps I should have said "asset adequacy" meaning that a risk bearing entity should have adequate assets to cover its liabilities with reasonable (and well defined) certainty.

If you define capital as the difference between assets and liabilities, then how you value the assets or the liabilities will have an effect on what is called capital.

Here is one way to determing adequate assets. TVaR(Assets - Liabilities)=0. A consequence of this equation is that if assets are more volatile, you need more of them. If liabilites are more volatile, you need more assets. This equation can hold no matter how you value the assets or the liabilities.

[Guilty Bystander]

Glenn, are you suggesting that a TVaR approach will give an answer independent of how assets (or liabilities) are valued?

[Glenn Meyers]

"Independent" might be subject to too broad of an interpretation. For assets, it should be independent of marking assets to book value or market value. For liabilities, is should be independent of whether or not the liability includes a risk margin.

What it does assume is that the methodology of determining the distribution of results is sound and agreed upon.

[JMO]

If companies are overinvested in these securities then failing to mark to mark will hide the huge (and I mean huge) liquidity risk they face.
Marking to market didn't do a thing to prevent the huge understatement of risk on mortgage-backed securities, back while the bubble was expanding. When trouble arrived, I believe that the mark-to-market numbers then overcorrected, leading to a global crisis that is still unwinding.

[California]

The lead article in the 2008/3 Emphasis discusses Market Consistent Embedded Value. Below is a link to the online version.

http://www.towersperrin.com/tp/showhtml.jsp?url=global/publications/emphasis/2008/3/index.htm

[JMO]

Thanks, CA.
Here's what that website says about Finance CEO's view of Risk Management.
http://www.towersperrin.com/tp/showdctmdoc.jsp?country=global&url=Master_Brand_2/USA/News/Spotlights/2008/Sept/2008_09_30_spotlight_cfo_survey.htm

[Ganymede]

Marking to market didn't do a thing to prevent the huge understatement of risk on mortgage-backed securities, back while the bubble was expanding. When trouble arrived, I believe that the mark-to-market numbers then overcorrected, leading to a global crisis that is still unwinding.

JMO - Can you think of any other accounting treatment that will do better than mark to market? Marking to book value hides the risk. At least in principle one can look at a time series of market values to quantify the risk.

Granted, we need to learn how to quantify that risk, but retreating on mark to market is not the way to go.

[JMO]

The main problem with mark to market as it has been used is that it was a case of the blind leading the blind. The risk managers who spoke against the excesses were shouted down with the classic excuse, "Everybody's doing it." I actually prefer mark to model, provided the model assumptions are subject to some kind of peer review / regulatory oversight.

[Ganymede]

JMO - If there is a robust market, I hope that we would both agree that mark to market is the way to go. There are those who argue that "mark to model" is the way to go when there is not a robust market. So far, I have been unimpressed by the various model assumptions I have seen. The KISS principle should apply here. IMO we should value at the actuarial present value of the cash flow, at a discount rate somewhat lower than a risk free rate.

I will grant that the determination of the discount rate could be dicey, but when this is done, the rate should be disclosed.

[JMO]

We are in substantive agreement, I think. A robust market is essential if we are going to use it for calibrating our models.

I believe that a proper assessment of the uncertainty of the cash flows will give a result that corresponds to discounting assets at a higher rate than risk-free, or discounting liabilities at a lower rate. So it is important to disclose either the risk factor used or the corresponding discount rate.


For the mortgage derivatives, it seems clear in retrospect that the cash flow models failed to recognize (a) the entire historic record of mortgage defaults, and (b) the effect of changes in underwriting rules regarding creditworthiness of the borrowers. I'm not sure why nobody noticed these issues at the time. I admit I was more focused on the expansion of credit card debt than mortgages, but that may just mean that there are some more defaults coming. . .

[sanki]

IASB just announced new reclassification rule for fair value accounting

http://www.iasb.org/News/Press+Releases/IASB+provides+update+on+applying+fair+value+in+ina ctive+markets.htm

http://www.iasb.org/NR/rdonlyres/2F9525FD-4671-439D-B08E-27C18C81C238/0/PR_FairValue102008.pdf

[BIS]

To what extent have current accounting rules contributed to the current financial problems? I heard one commentator suggest that suspending some of these accounting rules that force frequent mark to markets might help companies get through the crisis and allow for the longer-term viability of those companies as markets recover. Is that a realistic alternative?

Several other questions come to mind when thinking about this.

To what extent new accounting rules contributed to the current financial problems—simply because they happen to be new at the same time that we've run into financial problems that arose independently?

Think of the mortgage financing of recent years as a bubble that was tied to the real estate bubble. If fair value had been the norm a few years earlier, would it have added to the euphoria, making the bubble worse? Or, would it have made the bubble more obvious and helped to dampen it before it burst?

If fair value had been the norm for the past few decades, would investors have become accustomed to the volatility that it reveals and therefore been less inclined to panic?