Why Despite FASB's Efforts To The Opposite, MTM Change Is A Non-Event

Despite the financial stocks jumping the shark yesterday, and investors gobbling it all up happily, Richard Ramsden of GS says this is just a load of hot air.

Mark to market is not the bottom

Our views on banks do not change following the FASB mark to market rule changes. Our core view is that banks will not bottom until nonperforming asset growth decelerates. All of the data points we track in 1Q point to acceleration.

Mark to market accounting changes provide banks with a little bit of Tier 1 capital relief, less earnings volatility from securities impairments (OTTI) as banks now estimate the credit loss rather than take the mark to market charge, and maybe more flexibility in putting assets into Level 3 and marking to model.

Against that, however, we note: (1) investors are not focused on Tier 1, (2) for securities, ultimately the losses are what the losses are and if the bank is wrong it will come at a later date, and (3) we believe investors will look through increases in tangible common at the expense of a big increase in Level 3 assets. Also, to the extent that banks do mark up risky securities it will make PPIP even harder to execute as banks will be marked further from the bid.

Richard's prediction is that until non-performing assets decelerate there is no bottoming in sight for banks. The math: bank assets are going bad at a 3% annual rate while the rate of pre-provision earning is 2.5% for the industry, that is loans are going bad faster than banks earn money.

Looks like the FASB just sold they souls for pennies on the dollar.

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Brutalizing The FASB's Attempts At Piglipsticking

Jonathan Weil of Bloomberg goes apeshit on the FASB, whom he affectionately calls the Fraudulent Accounting Standards Board, claiming that the FASB whored away its soul earlier this week when it "unveiled what may be the dumbest, most bankrupt proposal in its 36-year history."

Here’s what the board is floating. Starting this quarter, U.S. companies would be allowed to report net-income figures that ignore severe, long-term price declines in securities they own. Not just debt securities, mind you, but even common stocks and other equities, too.

All a company would need to do is say it doesn’t intend to sell them and that it probably won’t have to. In most cases, it wouldn’t matter how much the value was down, or for how long. In effect, a company would have to admit being on its deathbed before the rules would force it to take hits to earnings.

So, if these rules had been in place last year, a company that still owned shares of American International Group Inc. or Fannie Mae, for instance, could exclude those stocks’ price declines from net income entirely. It would make no difference that the companies were seized by the government last year, or that both are penny stocks. The loss would get buried away from the income statement, in a balance-sheet line called “accumulated other comprehensive income.”

Jonathan then goes off on an almost personal vendetta with the 3 members of the 5-person FASB board who voted in favor of the proposal.

These are the earnings we get when the people who write accounting standards give in to desperate bankers. And it’s no mystery why the three FASB members who voted for this -- Leslie Seidman, Lawrence Smith and Chairman Robert Herz -- did so. (The two who opposed it were Tom Linsmeier and Marc Siegel.)

Since the credit crisis began, the board’s members have been under assault by the banking industry and its wholly owned members of Congress. The most recent display came last week at a House Financial Services Committee hearing, where Democratic Representative Paul Kanjorski and other lawmakers beat Herz like a dog. Herz declined my request to be interviewed. A FASB spokeswoman, Chandy Smith, confirmed my understanding of how the rule change would work.

The banks want unfettered license to value their assets however they see fit, and to keep burgeoning losses out of their earnings and regulatory capital. The FASB had been holding its ground, for the most part. Now, though, the board has assumed the fetal position.

Zero Hedge applauds Jonathan for his passion and his desire to out those who first create, then flip flop on, core critical accounting matters. However, while the FDIC's action is at best deplorable, Jonathan's rage may be a little over the top. The reason for that is that more sophisticated investors realize all the accounting tricks in the book, much better than the FASB itself.

In its essence, the recent FASB proposal is a fudge on the often ignored FAS 115 rule, which Zero Hedge wrote about previously (in a post also dealing with FAS157 and Level 1-3 asset evaluation: I recommend it for anyone who wants to catch up on these two most critical accounting standards). That rule deals with the distinctions of marking-to-market three types of assets: trading, available for sale and held-to-maturity. In its essence the proposed rule does not change anything materially. As Weil himself points out, to every fudge the FASB proposes, there is a counterfudge. While the FASB has tried to make Tier 1 as the critical threshold for balance sheet viability, investors have realized that Tier 1 adds intangible assets, ignores certain losses and treats some liabilities as assets. As such Tangible Common Equity has become the defacto marker for healthy balance sheets, and even the administration has been forced to adopt TCE in its stress test evaluations as anything else would be immediately singled out as fluff by the sophisticated crowd and would not get no credibility. And as Tier 1 is to the balance sheet, so is Net Income to the income statement: the proposed changes will provide a vastly inflated net income line items for most commercial banks (not so much for pure broker dealers). However, once the garbage FASB standards become prevalent, their entire impact can be ignored by avoiding the Net Income line altogether and instead looking at Comprehensive Income which differs from Net Income by an adjustment line known as Accumulated Other Comprehensive Income (AOCI).

As more investors focus exclusively on Comprehensive Income, what the FASB does with FAS 115 or any other rule fudging is irrelevant. But this is old news to credit investors who haven't looked at "below the line" items for decades, and instead have focused exclusively on EBITDA and Free Cash Flow.

It is time people learn to read between the lines of the garbage the government spews forth, in its pervasive agenda to push "transparency" all the while covering every single pig in the U.S. economy with lipstick, restylane and botox. In the meantime, as Weil says "Enough with the fluff. Net is dead." Sphere: Related Content

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In Preparation For An End Of Mark-To-Market, One Last Look at FAS 157... and FAS 115

The newsflow from D.C. over the next two days will make the lives of capital markets participants very exciting. Among the key expected news items is the rumored (temporary) abandonment of Mark-To-Market accounting principles, which caused quite a market rally on Thursday of last week. So as we prepare to say goodbye to the last relic of what was once an efficient market, it might make sense to reevaluate just what it is in the current accounting rules that is so inconvenient for the administration and Wall Street. Among these, chief is the Statement of Financial Accounting Standards No. 157 (here for the full 158 pages of FAS 157) as well as its lesser known cousin, FAS 115.

FAS 157 was fast-tracked for adoption in Q1 2008, with a simple goal: to streamline the valuation of an increasing plethora of hard-to-evaluate securities to a "Fair Value" price. FAS 157's mission statement is the following:

This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.

As investment and commercial banks, mutual, hedge funds and other investment vehicles had accumulated trillions of opaque, illiquid, and highly complex securities over the past decade, the FASB implemented the FAS 157 rule to make accounting for these assets more transparent. The outcome was the distinction of assets into three key categories (Levels 1, 2, and 3) and the guidelines for valuation, disclosure, and risk evaluation for each class. A summary of key terms is presented below:

fasb157 - Free Legal Forms

The problem is the FASB could not have picked a worse time for the implementation of this rule: as Q1 2008 saw massive market dislocations, reporting entities had to not only grapple with a totally new methodology for evaluating asset portfolios, but had to do it in a time when Jerome Kerviel, Bear Stearns and the bursting of the credit bubble caused volatility to spike to unprecedented levels and trading in whole classes of securities to virtually disappear. Furthermore, some rather nebulous language in a letter sent out by the SEC in March of 2008 to CFOs of public companies, caused a panic among investors who focused on the following paragraph:

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.

Whereas it was likely not the SEC's suggestion that companies use the least transparent of asset valuation techniques (Level 3), numerous investors read it exactly that way. As the Level 3 designation was to be applied to assets that were priced using models with unobservable inputs (mostly relevant for assets that had no active or liquid markets), in a market already beset by increasing opaqueness, investors decided to jettison most securities en masse, worried that companies would increasingly migrate to Level 3 determinations (from Level 2 and even Level 1) using the volatile market as an excuse. And as Level 3 assets could use a company's own internal models (or some other external unknown and untrusted model) for valuation, companies could easily game the system and use optimistic inputs to come up with artificially high asset values.

This concern was not unfounded: in 2008 many subprime and Alt-A assets migrated from Level 2 to Level 3 categorization. Additionally, the table below shows just how aggressively banks pushed assets from Level 2 to Level 3 in the Q4 2007 - Q1 2008 transition.



The chaos resulting the interpretation of 157 forced Sandler O'Neill to send a letter to the SEC requesting the organization "issue emergency interpretive guidance for determining fair value and assessing other-than-temporary impairment in the context of the extraordinary current market dislocations." As a result, another accounting rule was implicated in the Fair Value accounting mess: FAS 115, which deals with the definition of other-than-temporary impairment.

The table below, courtesy of UBS, summarizes some of the key concepts incorporated in FAS 115, but the gist of the rule is that losses or impairments are handled differently depending on the categorization of the asset: trading, available-for-sale or held-to-maturity. This rule will likely gain more visibility in the coming months, as it provides a tidy loophole for commercial banks (which post September 15 includes virtually all major financial institutions), which make heavy use of the available-for-sale security categorization. Securities classified as available-for-sale or held-to-maturity can be categorized at temporarily impaired when Fair Values fall below amortized cost: this is relevant since impairments defined as temporary are reported as a component of Accumulated Other Comprehensive Income (AOCI) and have no effect on income or regulatory capital. The issue arises when an impairment is defined as other than temporary, or written down from a previous temporary status, as the securities then must be written down to fair value, which impairs earnings and regulatory capital. The fair value also becomes the new cost basis and may not be written up for subsequent recoveries in Fair Value, but rather hit AOCI, thus not having a favorable impact on regulatory capital in an improving economic environment! As a side note, unlike commercial banks, broker dealers can not use the temporary impairment loophole as all their assets are categorized as trading, and thus all gains and losses are transparent and immediately have an impact on the bottom line and capital.


fas115 - Free Legal Forms

An interesting point that UBS brings up is whether the upcoming wave of financial company earnings releases will show commercial banks with significant available-for-sale holdings recording temporary impairments. And if that is in fact the case, what is the nature of these assets and what is the likelihood these will eventually have to be written down over time if values do not recover. FAS 115 requires that disclosure of temporarily impaired securities be broken down into those impaired for less than 1 year and more than 1 year, together with a security description, and calculation of unrealized losses (FV - cost) for each type of security. It is expected that after 12 months of temporary impairments, commercial banks may be pressured to take write-down on many categories of temporary impairments.

It is not surprising that as we anniversary the events from Bear Stearns, which set off so many asset reclassifications in motion, there is a substantial push to do away with Mark-to-Market altogether. It is feasible that banks anticipate having to disclose significant temporary impairments on RMBS, CMBS and other wholesale impaired portfolios in this, and likely even more so, the next quarter, and have been lobbying the administration behind the scenes for much loosened accounting standards, while maintaining a public facade which extols the virtues of Mark-To-Market. As the earlier clip with Kanjorski indicates, the administration is terrified of a repeat bank run, so Wall Street has a carte blanche to "educate" Congress and Senate in any way that benefits its interests, it is a highly likely outcome that Mark-To-Market will be done away with entirely. Even though this event will incite another brief market rally as the ugly truth is hidden from investors, this time however with the government's blessing (and the assumption that taxpayers will foot the bill for any Fair Value-to-Cost disparities), we believe that the ultimate outcome will be a destruction of value of unseen proportions. All MTM abolition will do is stop dead in its tracks the weak ongoing attempt at market transparency, and veil the entire market with a shroud of inability to calculate the true worth of any single asset. And of course, the ultimate beneficiary in the near-term will be Wall Street, while taxpayers will, as always, foot a staggering long-term cost. We hope we are wrong.

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