Frankly A Step Backwards (for the US)?

Yesterday the Financial Accounting Standards Board (FASB) has voted to ‘relax’ fair-value or mark-to-market accounting rules.  This is, in our view, a big step in the wrong direction. We believe that it has done this under huge pressure from politicians, lawmakers, and, particularly, financial institutions. In essence, the reversal means that companies will no longer have to value their assets at available market prices (real prices), but will be able to use some amount of ‘judgement’ in their valuation. Why do we have a problem with this? Quite simply and quite clearly, if you have a company valuing its own assets, there’s a clear incentive to value assets for management’s purposes. And this is when assets are valued incorrectly.

Since 1993, with FAS 115, financial statements have been put together with certain large components of companies’ balance sheets reported at market, executable, fair values. But not all assets have to be valued in this manner. If you can argue successfully to your independent auditors and your audit committee that you are likely to hold a security to maturity, then there are other methods of valuation which do not require current market prices, and so which avoid volatility in earnings and capital.

However, companies (especially financial institutions) will be able to value many more assets than hitherto at other-than-fair-values. These are values that depend on ‘judgement’ from management, and perhaps some black-box computer model for illiquid securities. And if the financial sector is rallying, as it is, and companies are trying to reinforce confidence in them by posting profits, then there is a clear incentive for these companies to use ‘judgement’ in valuing their assets.

Rather than reflecting market illiquidity in pricing their assets, as you would expect in times of crisis, and so marking assets down in value, we now expect banks to avoid doing this by recategorising these investments as held to maturity, and so value them at a depressed, stale value, and only recognise a loss or a gain when the asset actually defaults or pays you back. So effectively this accounting change will present the banks with a means to draw a floor value level below large swathes of assets. We are losing the transparency that FASB as well as IFRS worked so hard to gain.

We have now seen $1.3 trillion of realised losses at financial institutions around the world this cycle. According to some we are closer to the end than the beginning. According to others we are closer to half way through. Whichever camp you sit in, yesterday’s event will mean we won’t know who is right for a lot longer than we would have done had this change not been made. After all, how many assets that default had a market value of par the day before they default? None. In almost all cases, the day before an asset defaults, its value would have been at a steep discount to par. So we are losing a very important piece of information. Sure, banks can’t avoid recognising losses on the assets that default, but they can avoid having to recognise large movements in value if the markets take another deep turn down.

This accounting change would not have prevented the $1.3 trillion of realised losses that financial institutions around the world have taken so far. But if these banks want to own so many securities, then the market values of those securities should be recognised in the accounts for all to see. It gives an indication of risk appetite and risk management, two key measures of bank strength at all times. And just as banks lending to us want to have all information on their borrowers as is possible, so do we as their clients and investors want to have some up-to-date, real, current information on them. Yesterday’s action is a blatant double-standard in this regard. We really hope that this US action does not gain global traction. It’s remarkable how the banks managed to get themselves mark-to-market accounting through the boom years, and so were able to recognise huge gains to asset values on the way up, and now in a downturn are allowed to relax these rules so as to avoid downward valuations. What is desirable above all at this moment is a regulatory system which ensures that banks are capitalised adequately for all markets: if the banks were capitalised appropriately, then we wouldn’t have seen this change today.

Finally, is it not particularly striking that whilst banks are arguing strongly and successfully for an end to mark-to-market accounting on their assets, which are falling in value, these very same firms are exploiting market value accounting rules of their liabilities by buying their subordinated bonds at a discount to par and recognising a gain to equity? And does it not make a bit of a mockery of the Public Private Investment Program (PPIP) initiative, in that banks are clearly less likely to sell assets at distressed prices in order to cleanse their balance sheets when they have greater control over the levels they can mark their portfolios? It seems that what the banks want, the banks get.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Ben Lord

Job Title: Fund Manager

Specialist Subjects: Corporate bonds, inflation markets, financial institutions and credit default swaps

Likes: Sport, weekends, cooking, countryside

Heroes: Ron Burgundy, Superman, P.G. Wodehouse

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