The Financial Accounting Standards Board (FASB) today voted to relax the mark-to-market accounting rules that some in Congress have criticized for compounding the credit crisis. While this is not a blog about accounting rules, today’s FASB action is significant because the mark-to-market rules are involved in the pricing issues surrounding the so-called “toxic” assets held by banks.
What is Mark-to-Market?
Put simply, mark-to-market accounting rules require that an asset be priced at its current in the market as it is. The problem for banks is that the market for the derivatives that many of them hold has disappeared, and there lies the uncertainty that has roiled the credit markets and in large part caused the credit crisis. When a market becomes dysfunctional (or non-functional) the assets normally traded in that market must be priced at “fire-sale” prices. What are those? Well, that depends on one’s interpretation as to what the price of an asset would be if there were a forced sale of that asset. On one hand, the math is easy, the lowest price is zero. But then, these assets still have some value. So the price is between zero and some number that is much lower than the value one year ago. That’s why no one can figure out which banks are insolvent and which are healthy enough to survive. We need to ascertain a price for the toxic assets and then see where each bank’s balance sheet stands, above or below the water line.
The Treasury’s Public-Private Partnership Investment Program was supposed to create a market for the toxic assets by offering government incentives for private investors to participate. But Congress decided instead to pressure FASB to relax the mark-to-market accounting rules, which they now have. So now what?
FASB’s Decision
At the end of this post I have reproduced the summary of FASB’s as posted on its website. After that is an analysis from Fitch Ratings, which favors the new rules. Here are some key points: 1) Rules effective Q1 2009; 2) FASB says the objective of mark-to-market accounting is to set a price that would be received by a bank in an “orderly” transaction in the current, inactive market. It says an “orderly” transaction for accounting purposes does not include the forced liquidation or a distressed sale of an asset; 3) FASB agrees to drop the presumption in mark-to-market accounting that all transactions in an inactive market are distressed unless proven otherwise; 4) FASB clarifies when banks are required to take write downs on impaired assets, letting them record smaller losses on their income statements –> see Theoretical Aspect of Fair Value and Mark-To-Market Accounting: Is There A Better Alternative?
It appears that now banks can essentially imagine a functioning market and plug in whatever price they think the assets should be worth, rather than facing the reality that they are probably worth next to nothing. As someone with an economics background, I can appreciate that. Economists generally make grand assumptions to fit their theories. My biggest concern here is how does this help matters? It would seem that Treasury’s PPPIP program would be severely weakened. Why would banks sell their assets when they can pretend there’s nothing wrong and wait for some future date when those markets return to normal. The stock market was certainly happy about this turn of events today (DJIA was up over 200 points to nearly 8,000), as financials jumped on the news. I guess since they no longer have to report losses, they’re suddenly worth more? This all just seems like the same kind of fiction that got us into the credit crisis in the first place.
Most of my comments here are pure conjecture. For a more detailed analysis of the view expressed here, see an article by William Buiter, Professor of European Political Economy, London School of Economics and Political Science, on his blog, Maverecon. Here is an excerpt from Buiter’s post:
Basically, the new guidance allows banks to shift a whole load of toxic and impaired securities from level 2 to level 3. Up till now, a frequent source of level 2 information were prices achieved by competitors’ asset sales to help determine the fair-market value of similar securities they hold on their own books. Banks are now allowed to ignore prices achieved in competitors’ asset sales when these transactions aren’t “orderly”. This includes transactions in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements. This is vague and broad enough to drive a coach and horses through fair-value accounting for most imperfectly liquid assets.
Leaving the valuation of illiquid securities to managerial discretion will lead to systematic and systemic overvaluation. Banks with significant amounts of toxic assets and plain bad assets on their balance sheet have lied, lie and continue to lie about what they have on their balance sheets. This has now been made easier. No wonder bank stocks rose and bank credit default swap rates declined. Reported asset values will be boosted.
There is only one way, in my mind, to see whether this and other efforts are making a difference, and that is to look to credit spreads. If credit spreads drop back to their pre-crisis levels, then maybe happy days are here again indeed. My next post will take the pulse of the credit markets.
SUMMARY OF BOARD DECISIONSSummary of Board decisions are provided for the information and convenience of constituents who want to follow the Board’s deliberations. All of the conclusions reported are tentative and may be changed at future Board meetings. Decisions are included in an Exposure Draft for formal comment only after a formal written ballot. Decisions in an Exposure Draft may be (and often are) changed in redeliberations based on information provided to the Board in comment letters, at public roundtable discussions, and through other communication channels. Decisions become final only after a formal written ballot to issue a final standard. April 2, 2009 Board Meeting Determining whether a market is not active and a transaction is not distressed. The Board discussed comment letters received on proposed FSP FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. In response to comment letters and additional feedback received, the Board decided to make significant revisions to the proposed FSP. The Board decided that the final FSP would
The Board also affirmed its previous decision that the FSP would be applied prospectively and that retrospective application would not be permitted. The Board decided that the FSP would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity early adopting this FSP must also early adopt FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, Recognition and Presentation of Other-Than-Temporary Impairments. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, it must also elect to early adopt this FSP and FSP FAS 115-2, FAS 124-2, and EITF 99-20-2. The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot. Recognition and presentation of other-than-temporary impairments. The Board discussed comment letters received on proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments. The Board made the following decisions in response to comment letters and additional feedback received:
Scope Recognition Presentation Disclosures When adopting the new guidance, an entity will be required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of a previously recognized other-temporary impairment from retained earnings to accumulated other comprehensive income if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery. The cost basis used to calculate accretable yield will also be adjusted to reflect this adjustment (that is, the entity will no longer accrete the noncredit component of a previously recognized other-than-temporary impairment through earnings). The Board decided that the FSP will be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, or FSP FAS 157-4, it must also elect to early adopt this FSP. The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot. Interim disclosures about fair value of financial instruments. The Board redeliberated proposed FSP FAS 107-b and APB 28-a, Interim Disclosures about Fair Value of Financial Instruments, in light of comments received and decided to proceed to a final FSP. The final FSP will amend FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to require an entity to provide disclosures about fair value of financial instruments in interim financial information. The Board affirmed its previous decision that the FSP would apply to all financial instruments within the scope of Statement 107. The Board also affirmed its previous decision to require entities to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments, in both interim financial statements as well as annual financial statements. The Board decided that only public entities would be required to provide the fair value disclosures in interim financial information. The Board decided that the FSP would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed, and FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, Recognition and Presentation of Other-Than-Temporary Impairments. The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot. Insurance contracts. The Board continued deliberating the joint project on accounting for insurance contracts by discussing what cash flows an entity would use in measuring the fulfillment value of an insurance contract. The Board agreed that a measurement of the fulfillment value of an insurance contract should use expected cash flows rather than a best estimate of cash flows. The Board also agreed that those expected cash flows should be updated each period. The Board discussed whether market inputs should be part of the measurement of cash flows when a fulfillment value notion is used. The Board agreed that the measurement of cash flows should consider all available information that represents the fulfillment of the insurance contract. All available information includes, but is not limited to, industry data, historical data of an entity’s costs, and market inputs when those inputs are relevant to the fulfillment of the contract. Conceptual framework: objective and qualitative characteristics. The Board reviewed responses to the Exposure Draft, Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information, and tentatively affirmed the proposals in the chapter on Objective, including the proposals on the objective of financial reporting and the primary user group. The Board decided to clarify that financial reports do not necessarily exclude forward-looking or prospective information. The description of an economic phenomenon should be amended to reflect this decision. The Board directed the staff to proceed to drafting:
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Fitch: FASB’s Impairment and Fair Value Proposals – More Disclosure Would Benefit Investors
31 Mar 2009 1:02 PM (EDT)Fitch Ratings-New York-31 March 2009: Fitch Ratings has released a special report in response to the Financial Accounting Standard Board’s (FASB) recent impairment and fair value proposals which suggests transparency and added disclosures by issuers would benefit investors.
Because much of both proposals hinge on either the intent and/or estimations provided by management, the proposed qualitative disclosures by themselves may not be sufficient for financial market professionals‘ understanding of the impairment and fair value conclusions reached by an issuer.
“Absent increased disclosures, investors and analysts may assume the issuer has taken the least conservative approach to valuation and impairment,” said Dina Maher, Senior Director, Fitch Ratings.
The FASB proposes to change the method for determining whether an investment is other-than-temporarily impaired and for identifying inactive markets and distressed transactions when measuring fair value.
Fitch believes that should these proposals be adopted, disclosures by issuers should be expanded to allow for thorough and meaningful analysis, regardless of the minimum requirements.
Fitch’s full report is titled “FASB Impairment and Fair Value Proposals — More Disclosures Would Benefit Investors” and can be accessed on the Fitch Ratings web site www.fitchratings.com. The report provides a summary and example demonstrating current and proposed accounting practices, as well as a description of the types of disclosures that would be helpful in analysis.
If you have trouble viewing the report please follow this link
http://www.fitchratings.com/corporate/reports/report_frame.cfm?rpt_id=430894Fitch’s rating definitions and the terms of use of such ratings are available on the agency’s public site, ‘www.fitchratings.com’. Published ratings, criteria and methodologies are available from this site, at all times. Fitch’s code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the ‘Code of Conduct‘ section of this site.
Contact: Dina M. Maher +1-212-908-9175, Sharon Haas +1-212-908-1362, New York; or Julie A. Burke +1-312-368-3158, Chicago.
Media Relations: Cindy Stoller, New York, Tel: +1 212 908 0526, Email: cindy.stoller@fitchratings.com.
Gregg D. Killoren
victoria1014
