Comment The long-used FASB acronym (Financial Accounting Standards Board) is referred to as SFAS in this letter (Statement on Financial Accounting Standards).
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The Securities and Exchange Commission – Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)
Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157. -
Floyd Norris (NYT Blog) – If Market Prices Are Too Low, Ignore Them
That sounds to me like an invitation to fudge. Some people on Wall Street think that nearly every sale today is a forced sale. There are entire categories of collateralized debt obligations where most, if not all, of the trades, occur because a holder has received, or expects, a margin call. What the S.E.C. should require is a disclosure when a company concludes that a market price should be ignored because it came from a “forced liquidation or distress sale.” Then there should be a disclosure of how much lower that distress price was from the value the company is using in its own valuation. Alternatively, there could be a simple rule, at least for banks. If you will ignore this price as irrelevant when you decide whether to send out margin calls to those to whom you have lent money, then you can ignore that market price when you make your own reports. But if you won’t lend based on a valuation that ignores actual market prices, then you should not use that valuation for your own accounts. -
naked capitalism (Blog) – Yves Smith: SEC Gives Permission to Fudge Mark-to-Market
Moreover, we’ve seen plenty of unintended consequences, or worse, backfires, as regulators intervene trying to alleviate the credit crisis. Banks have been reluctant to extend credit to each other precisely because they don’t trust their creditworthiness. That’s tantamount to saying they already don’t trust their public financial statements, since according to their public filings, virtually all major financial institutions have more than the required statutory capital. So this move, to stem the balance-sheet-shrinking impact of mark-to-market accounting in a falling price environment, may further undermine liquidity. Companies will less able to judge whether their published financials are telling the whole story, And where the numbers are in doubt, rumors are taken more seriously. Now in fairness, the entire letter wasn’t a gimmie to the securities industry. Entities that report Level 3 exposures have to talk about them at great length: To paraphrase Winston Churchill, it has been said that mark to market accounting is the worst form of financial accounting except for all the others that have been tried. But it looks like we are going to try them anyhow.
Comment Back in August The Wall Street Journal had this story:
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The Wall Street Journal – (August 10, 2007) Seeking Hidden Losses, Regulators Comb Books Of Wall Street Titans
Securities regulators are checking the books at top Wall Street brokerage firms and banks to make sure they aren’t hiding losses in the subprime-mortgage meltdown, said people familiar with the inquiry. The SEC is looking into whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory, as well as assets held for customers such as hedge funds, the same people said. The concern: that the firms may not be marking down their inventory as aggressively as assets held by clients. While the issue is a technical one, and such checks occur routinely, it is sensitive for the markets. That is because, at least through their latest earnings reports, few big Wall Street firms have reported big subprime losses despite the turmoil roiling the markets.
So it looked like the SEC was following the strict letter of the law eight months ago. Then in October the AICPA (American Institute of Certified Public Accountants) released this white paper:
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AICPA – (October 3, 2007) MEASUREMENTS OF FAIR VALUE IN ILLIQUID (OR LESS LIQUID) MARKETS
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) (FAS 157, par. 7).
In October the AICPA reminded everyone that the original FASB 157 ruling included provisions for distressed sales. But, as of August, the SEC was implicitly telling everyone to ignore these provisions. As of Friday, it appears the SEC has “re-thought” this view and is now more sympathetic to the idea that distressed sales might distort fair value.
So, we agree with the sentiment above. The SEC appears to have “changed its mind” about how to apply FASB 157. And, we also agree with the sentiment above that this is not a good thing; the SEC is telling management it’s ok to “fudge” some of these numbers. Announcing this just a few days before the end of the quarter suggests panic by the SEC over the upcoming numbers.
The problem is that, back in December, the exact same things were said about the market measures used to calculate level 3 assets.
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The Wall Street Journal – (Dec. 12, 2007) A ‘Subprime’ Gauge, in Many Ways?
Some analysts contend the value of some ABX indexes imply a catastrophic outcome for the subprime-mortgage market that seems remote. For instance, Wachovia Capital Markets analysts Glenn Schultz and John McElravey say the price of the ABX that tracks AAA-rated mortgage debt implies losses of around 49% among pools of subprime mortgages issued in 2006. A cumulative loss of 49% would be achieved if all 2006 subprime mortgages were to default and recover only half their value after foreclosing on the homes, or if half were to default and recover nothing. Most Wall Street analysts expect 10% to 15% in cumulative losses for these loans. As of August, the delinquency rate on all subprime loans was around 20%. For 2006 subprime mortgages, around 27% have already been paid down, many through refinancing, and 2% have defaulted.
See the next chart in which we highlighted the levels on December 12. Assume the levels in the weeks before December 12 were also considered “distressed.”
Now look at the current levels. The SEC is arguing they are too low. So, what is the proper level? Is it December 12 levels? Last October? Last summer? Here is the problem with announcing that markets are distressed. What is the correct level to use? Is it double or triple the current levels, as the A- and BBB- rated tranches suggest?
<Click on chart for larger image>
Finally, as we noted in our recent Conference Call, this decision is not for management to make, but rather the auditors. Here is the relevant excerpt.
Auditor Opinion, Not Management Opinion
The losses in the financial system will continue because of FASB 157– one of the several hot point discussions during the credit crisis.
This is the mark-to-market rule. It was brought into place because the old rule of held-to-maturity, available-for-sale in trading accounts, frankly, did not work. They were being abused and the old system was inadequate. That is why FASB 157 was created.
The problem with 157, of course, is that Level 3 assets and the CMBX and ABX indices are important in valuing these assets. Level 3 assets are valued using “management judgment.” By contrast, level 1 assets would be more like listed equities on a stock exchange. Level 2 assets use generally accepted models, like stock options using the Black-Schols Option Pricing Model. It’s not controversial to price and option based on this model. Level 3 is where you just have the controversy.
The problem isn’t management judgment; it is auditor judgment. Whether it’s Price Waterhouse Coopers or Deloitte & Touche, or down the line, every auditor remembers 2001.
When Enron got into trouble, the first thing done was to liquidate Arthur Andersen. After they were given the death penalty, only then did we ask, “What was the problem?” We even heard rumblings of this earlier this week. How could Bear Stearns book value be $85 per share and the stock gets bought at $2? The conclusion was the auditors screwed up and should be investigated.
FASB 157 is not the problem. The problem is that it is not management judgment; it problem is it has become auditor judgment.
The auditors are putting the value on Level 3 assets, not management. And in this highly charged environment, no management wants a fight with its auditors.
That is why you have seen the problems at Credit Suisse a few weeks ago, when the auditor said, “You had the wrong marks on some CDS positions,” and they had to take the write-downs. The big controversy at AIG was the same thing. The auditors said, “We don’t like these numbers so you will change them.” The recent controversy at Citibank with some hedge fund valuations is another example. They had to take them onto their balance sheet because the auditors didn’t like the valuations of their portfolios.
I think that the answer is not to have FASB 157 rescinded. It’s not that mark-to-market accounting is killing us. It’s that we are not allowing management judgment to hold sway. It’s auditor judgment, and the auditors are fighting for their professional lives because they are afraid of what happened to Arthur Andersen and what people are now saying about Bear Stearns. If they don’t put the most conservative mark on Level 3 assets, and there is a problem, then everybody is going to scream, “The accountants screwed up like they did at Anderson, let’s just liquidate the auditing firm for making that kind of mistake.”
This is where I think that most of the problems with Level 3 assets are coming from. I think that the answer would be to get the auditors out of the business of valuing Level 3, and let management do it. They only need to sign off on “reasonableness”, not “exactness.” I don’t know if that means exonerating them from future lawsuits or something else. But that, in essence, is the problem with Level 3 assets is the auditors.
The fact that the ABX and CMBX are at their worst levels in the last several days suggests we are going to see more write-downs, because the auditors are in charge. They are going to look at these kinds of benchmarks, and they are going to demand big write-downs coming in the first quarter. This means further shrinkage of the financial system; and further shrinkage of the financial system then means that we are going to have more rationing of credit and bigger problems.
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The Washington Post – Roger C. Altman: Piercing This Bubble For Good
Third, the books of our largest financial institutions are not sufficiently transparent. The retained risks on their off-balance-sheet financings, for example, were not known to their shareholders. This is inappropriate. The Financial Accounting Standards Board, working with the Securities and Exchange Commission, should expand public disclosure requirements applying to these transactions.
Comment Mr. Altman, see above. The SEC is doing the opposite of what you suggest this morning.