Comments on: Accounting Rules Do Not Affect Cash Flows

By: David Merkel

David Merkel — Wed, 22 Oct 2008 17:19:17 +0000

MC, Assetman – thanks. Personally, I’m a little surprised at the debate on this in the US, and the willingness of the regulators to “roll over and play dead.” The academic literature on accounting rules are clear – investors look through to the cash flows. Suspending fair value will not change the cash flows, and may not buy banks more time. That said, fair value is often misapplied to mean “last trade,” which isn’t even the way we value things as simple as mutual funds in the US.

The CFA Institute took the right path on fair value; let’s see if they can maintain it against political pressure. Thanks for commenting.

Henry Buttal, all I can say is that SFAS 157 may have played a minor role, but owning illiquid assets, financed by illiquid liabilities, with insufficient slack assets (surplus in excess of risk requirements) is a recipe for disaster.

By: MC

MC — Fri, 10 Oct 2008 19:25:21 +0000

Wow. This is the most reasoned site I have stumbled across in terms of this debate. As a UK-based auditor of hedge funds, I am constantly amazed at the US usage of the term “fair value” vs the European paradigm. To us, if an accounting requirement provides the market with more data, it is a good thing, no matter what the pain: investors should be able to distinguish between accounting consequences and cashflows and investing entities (be they banks or funds) are only letting themselves down if they don’t give investors the info required to make their own decisions – sentiment CAN be managed as non-GAAP info can be published alongside GAAP info.

It seems that on your side of the pond, there are big hitters saying that FV is the cause of the current difficulties and this monopolises our view of how your entire nation sees things.This blog is therefore refreshing as it robustly sets out why this is not the case.

Aside from this, the way FAS157 is set out, really doesn’t help: people take FV to mean mark to model, as a result of the way the standard is drafted. This allows jingoism and gives currency to the FV paradigm’s detractors.

FV is mark to market, as far as I am concerned, and only becomes mark to model where markets do not exist. Thin markets are still functioning ones.

There IS a real point about M2Mkt vs M2Model, but FAS157 and IFRS7 (in my geography) both deal with this, and – when properly applied – are an aid to efficient capital markets, not a hindrance, and won’t cause a run; provided communication is balanced by requiring inclusion of non-GAAP measures and proper disclosure of strategy: a fund that invests (broadly equivalent to “buy to hold”) is not the same as a fund (or a bank) that trades, and context is everything.The corporate communications industry is clearly missing a trick here – balanced communication is what is required, not moaning about accounting disclosures.

Let the bad guys fail, but it’s a shame if those who ARE transparent on FV are punished because they are naïve around communications or because the other guys choose not to apply FV in the first place

By: q1

q1 — Thu, 02 Oct 2008 23:08:08 +0000

David,

I now see that I misinterpreted your comment. Thank you for taking time to respond.

By: David Harper

David Harper — Thu, 02 Oct 2008 21:34:52 +0000

But M2M vs fair value is not quite the issue. (I still agree with David, I am just pointing out the devil’s advocate). If an otherwise relatively liquid asset becomes suddenly illiquid, then a FAS 157 fair value will be market to model; the “fair value” invariably will need to include a illiquidity discount. The systemic problem is that, a bank has capital adequacy (leverage) requirements and, all other things being equal, the bank now must react by shrinking its balance sheet, which transmits. So, the problem with “fair value” is that it should incorporate a discount for temporary illiquidity. This causes pain. FV is the worst approach, except for all the others.

By: Eric

Eric — Thu, 02 Oct 2008 20:23:24 +0000

Insurers are hot news today with all of the stuff that Senator Reid never said. Hartford now at $25.

By: Henry Buttal

Henry Buttal — Thu, 02 Oct 2008 19:58:48 +0000

Hi David,
I agree with Jeff. The accounting “framework” breaks down here b/c of real world realities. Mk to Mkt & 157 were appropriate for entities like GS, Lehman, Bear that were broker/dealers. Not for banks, where using impairment would make more sense. Even if you are an entity with $$ to invest, the “deadly embrace” of MtoM transactions would cause you to hesitate to do it; this reinforces illiquidity. Cash Flow becomes irrelevant when your reporting must be approved through SarBox, auditors, and then interpreted by rating agencies. The excesses aren’t the fault of the accounting, but the unintended by-product is like frontier justice – any guilty plea is followed by a hanging, even for parking your horse in the wrong place!

By: Assetman

Assetman — Thu, 02 Oct 2008 16:53:22 +0000

David -

While your point is accurate about the CFA Institute’s position reagarding accounting for capital adequacy– they are just as strong in their position supporting market to market and fair value.

The reason? Investors demand transparency, and SFAS 157 and 133 helps provide just that. Of course speculators can overlook such things… to their own demise.

Very well written article, by the way.

By: David Merkel

David Merkel — Thu, 02 Oct 2008 04:50:24 +0000

Jeff, I haven’t made that error. I know the difference, and have written about it previously. If you have thin markets, you are not required to mark to “last trade.” You can use your model.

But suspending fair value rules is foolish. SFAS 157 and 133 require best effort to come up with “fair values” for volatile instruments. They are as volatile as equity, so they ought to be valued as such — at the best estimate of the market clearing price between uncoerced buyers and sellers.

By: David Merkel

David Merkel — Thu, 02 Oct 2008 04:44:50 +0000

q1 — If I may, nothing smarmy here. Wherever I have lived, in any church I have belonged to, there is usually a dominant employment influence. Since my congregation is near DC, it is no surprise that it is the US government. I respect my brothers and sisters in my church, but I am in the minority in not working for the government. What is interesting with my lawyer friend is what passes for information in attacking economic problems.

My congregation is fairly non-political, as evangelical congregations go, because neither the Republicans nor Democrats fit what we think.

I have also learned not to probe my friends who have security clearances… in general, I don’t want to know.

Does that help? The comment was innocently meant.

By: Jeff

Jeff — Thu, 02 Oct 2008 04:39:59 +0000

Thousands of institutions hold thousands of corporate bonds that trade infrequently. Just because this is not your business model (nor mine) does not mean that it is wrong. Investors purchase bonds or other instruments with the plan to hold to maturity.

You make a fatal error — confusing “fair value” with “mark to market.” Astute observers are coming to the conclusion that distressed pricing of illiquid securities is not “fair value.” It is something between the distressed price, and the face value price.

What is needed is a method of price discovery so that the actual fair value can be determined. In the meantime, many regular banks with normal investments are being unduly punished by FAS 157. This is about to be fixed.

And it should be…