I’m not an accountant.  I have never taken an accounting course in my life.  Yet as an actuary and a financial analyst, I have had to use accounting rules to understand financial statements, both in the production of them, and the interpretation of them.  (I even remember writing a paper explaining the effect of the then-current FAS 52 on foreign exchange when I was a grad student.)

There are a number of Statements of Financial Accounting Standards that I think have been mistakes.  We are between paradigms.  The central question is this: how often do we want to re-estimate the value of balance sheet items, and if they change, how should they be reflected in the income statement?

There are two consistent ways to do this.  Other methods are a kludge in my opinion.  Method one is amortized cost on both sides of the balance sheet.  Method two is the estimation of fair market value on both sides of the balance sheet.

But SFAS 159 allows companies to elect which assets and liabilities (with some restrictions, and subject to SFAS 115) they can value at amortized cost or at fair market value, together with disclosure on how the assets/liabilities are valued.

Now, I know that the FASB is trying to create standards that will be more consistent with international accounting standards, but what they are doing here will make accounting less comparable across US companies, particularly given that adherence to SFAS 159 is optional.

For companies with no long term agreements, SFAS 159 will not have any major impacts, but as for me, given that I follow the insurance industry, this will make my life more complex, without any equivalent increase in understanding.

As I said once to a panel of the IASB and FASB, create two consistent financial statements, one amortized cost, and one fair market value.  This would mean two income  statements and two balance sheets, and one cash flow statement.  They though that was too much work, but I disagree; companies are doing that work now, but they are not reporting it.  Better they should disclose what they know.

When Wall Street comes up with a good idea, they overdo it until the system chokes on the product they created. After the market failure, the system becomes more sophisticated and risks are priced better.

The ABX.HE indexes were created to have a uniform way of trading tranched subprime mortgage credit on a consistent basis. This would allow parties to go long or short, and in greater volume than the underlying cash market would support. They started with the 06-1 deal, which reflected subprime mortgage deals from 20 different originators from the second half of 2005.  They have gotten as far as the 07-1 deal,which reflected subprime mortgage deals from the same 20 originators from the second half of 2006.

Well, now what?  Many of those originators are gone, and most of the rest have scaled back massively. Will there be an 07-2 deal?  In some ways, I wonder if the existence of the ABX.HE deals didn’t help to create part of the problem, in that the 20 originators had to come out with at least one deal of a certain size every six months.  Being in the index would mean cheaper funding, so an originator would want to do that if possible.

I don’t see how the ABX.HE 07-2 gets done, and honestly, the system might be better off if it doesn’t get done.  The existence of subprime mortgages encourages some people to take on onerous debt that they would be better off not incurring.  Anything that encourages more subprime lending (and other high interest forms of debt) is in my opinion, a bad thing.  Let people learn to defer their gratification, put more money down, and on the whole, they and the whole nation will be better off.

What a week. The yield curve disinverted with ten-year Treasury yields moving above two year yields. 30-year bonds traded off 11 basis points, 10-years 7 bp, 5 years 5 bp. The short end of the curve was largely unchanged.

But now look at Treasury Inflation Protected Securities. TIPS 10 years and longer fell a mere 3 bp. TIPS 5 years and shorter were flat. Now, I have a large allocation of my balanced mandates in TIPS and short-term debt, so my downside was protected this week.

So why did the bond market move that way? The FOMC shifted its monetary policy language this week in a way that said that they no longer have a bias to tighten policy, but they do have have a bias to worry about inflation. The Fed’s announcement this week says that they are willing to tolerate a little more inflation. The bond market reacted accordingly, and required more yield on bonds with no inflation protection.

What else happened? The equity markets rallied, both before and after the FOMC announcement. Credit spreads largely tightened, and the dollar fell on the FOMC announcement, before rallying back to flat the rest of the week. In general, the carry trade currencies, the yen and the swiss franc, underperformed, and higher yielding currencies did better.

What can I say, then? The willingness to take risk is alive and well, and the carry trade is re-emerging. M&A isn’t suffering; note the possible deals on Tribune, ABN AMRO, Chrysler and Volkswagen. And, at least according to Bloomberg, there are a scad of CDO deals in the pipeline waiting to be done. So, let the party continue; let others ignore the rising inflation (at your peril), and enjoy the punch that the Fed is serving. As for me, I’ll just enjoy my mug of tea, slowly reduce risk, and watch the spectacle.