Of Course not at Par; That’s Par for the Course
There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157. (Really SFAS 133, but SFAS 157 clarified it.)
- Accounting rules have little impact on stock prices. Almost every academic study on accounting rules supports that idea. Why? Investors attempt to estimate the stream of free cash flows that an asset will throw off. Accounting rules can help or hinder that. Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
- Parties involved confuse regulatory with financial accounting. Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes. This was foolish, because there is no one accounting method that is ultimate. Every financial statement answers one main question. For GAAP, the balance sheet asks “What is the net worth?” Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
- There are always two ways to do accounting. You can do mark-to-market, or you can do book value accounting with impairment. Darkness encourages skepticism. In a period where there are few credit risks, book value accounting will be well-received. In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided. Regardless, the cash flows will still flow.
- Equity-like investments deserve equity-like accounting. They should be market to market, as equities are. With derivatives, this is the reason that we mark them to market, their values are so variable. So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
- But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression. Here’s the problem: we have a lot of people alleging that those values can’t be right. Let them stand up and start buying to prove it all wrong. Part with precious liquidity to gain uncertain yield. It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall. Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
- Some argue that there is an inconsistency between loans and bonds. Bonds get marked to market, while loans are marked at book. There is no inconsistency. The loans are held to maturity, unless sold. The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans. Most companies have not chosen that option, largely because they want the right to sell assets if they want to. But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
- We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors. SFAS 157 does not mean last trade. In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
- Now all of this said, practically, SFAS 157 leads to overestimating the value of assets. In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse. They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression? In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.
The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner. We are in a situation where marginal cash flows to purchase dud assets aren’t there. Mean reversion is a long way off, and the valuations of financial assets reflect that consistently. Try selling a bunch of whole loans held at par. See what the offers are. Why aren’t banks doing that to raise liquidity? Because the prices don’t justify it.
You can’t fight cash flows. Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured. In the end, cash flows win out, regardless of the accounting methods.
Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally. There are misapplications of SFAS 157, forced by auditors, I believe. SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more. After that, let the regulators set their own solvency rules.
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PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.
It’s like the FRAM oil filter ad — “you can pay me now or pay me later.” There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack. (Much as I had hubris toward the end of the bull phase… let me stab myself.) In ordinary bear markets, there is some strength somewhere to support asset values. That is not true now. We are dealing with something not normal over the last 70 years, and overall market values are reflecting that. Eventually accounting values will get there, as they did in the thirties.
March 31st, 20096:19 am at
Of course not at par; that’s par for the course…
There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting….
March 31st, 20091:23 pm at
Right on, David, you nailed it:
“It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall.”
This is the core issue, everyone else is just talking their own book, hoping that things will get better.
Assets will be dirt cheap. Figuring out how to improve the utilization of the excess asset base will be the key challenge in generating better-than-average cash flows in the upcoming Brave New World. IMO.
April 1st, 20094:29 pm at
David, you really have no idea on the “cause and effect” of Mark to Market accounting, do you? The very essence is to magnify economic strength or weakness when what the desired effect should be steadying/ minimalizing the swings. M to M artificially restricts capital well past “the true levels” which in turn constricts the economy at a time when it should be the most profitable lending cycle for financials (upsloped yield curves w/ lower priced securitization) this is the BOON period for the banks BUT…M to M has their hands and capital tied…and has choked off the natural recovery stage for these financials. If defaults actually hit the 45% that markets are currently pricing paper at, well let these firms take the losses as they occur, my guess is they will earn enough to stay afloat thru new lucrative loans. To choke off the natural ebb’s and flows of the financials also does the same to the economy…maybe that’s why we haven’t had a meltdown since M to M was thrown out in ‘38.
April 1st, 20097:40 pm at
John Thomas, the regulators are not constrained to using MTM, they can change that any time they want. It was an industry request to move to MTM for regulatory purposes during the boom phase. The industry can request the regulators change now — that doesn’t involve SFAS 157 — investors deserve to know the state of affairs at their companies. Regulatory capital is another thing.
In the life insurance industry, we do tests to avoid these scenarios. If a scenario has surplus go negative, we have to allocate reserves for it, equal to the present value of the deficit. It’s a good system — perhaps the banking regulators should adopt it.
The banking industry made too many risky loans on inadequate capital bases. Their overlending, individually and as a group, created a situation where there is not enough balance sheet capacity to hold long-duration assets. Thus the prices sag.
I’ve worked for firms that said in a crisis they could write their way out of it. That rarely works. The high quality companies get a disproportionate amount of the new business, and those on the ropes don’t make it.
MTM was a best a bit player in this crisis; besides, most of the banks I know have been using the flexibility of SFAS 157 to overmark, not undermark assets.
The big issue was overleverage; the banks played with inadequate capital. Now asset defaults are overwhelming that capital.
April 1st, 20097:52 pm at
Another way to say it is, if the regulators use MTM, the bank should run at lower levels of leverage to reflect that pro-cyclicality — i.e., put in a provision for adverse deviation; don’t count on any capital that mysteriously appears due to MTM during the boom phase.
Oh, the insurance regulators force life insurers to do just that. Could it be that the conservative state insurance regulators did a better job than the Feds on banking? Yes.
April 2nd, 200910:41 am at
One thing that would help is for banks to provide investors with much more transparent and granular data about what the assets are, the performance to date, and the assumed future performance of these assets. I thought the recent marathon GE Capital conference call was a good step in that direction.