New Fair Value Rules – How Risky is the Game?

The banks got it finally as lawmakers literally forced FASB to relax the fair value or mark-to-market rules and the market celebrated it as if by wave of magic wand all the underlying risk has magically vanished.

The Bloomberg report (linked above) says:

“Changes to fair-value, or mark-to-market accounting, approved by FASB today allow companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ write downs and boost net income. Firms could apply the changes to first-quarter results.”

According to a MarketWatch report:

“Another provision that the FASB board approved would allow companies to put certain illiquid debt assets, such as mortgage securities, they would otherwise have been forced to write down into a category called "other comprehensive income." As a result, financial institutions' operating income is improved because they can record a lower amount of loss in their income statements.

These are illiquid securities that are "impaired," which means companies no longer believe they can collect all the amounts due."

It is estimated that this move would help raise the bank industry earnings by about 20 percent. And what would be illiquid or distressed asset? The rule will applicable to all transactions for which there is no active market and will be considered distress unless proven otherwise!

Of course the board also called for additional disclosure. As per the above report:

“The measure also requires expanded disclosure: Corporations must provide more details, on a quarterly basis, about the methodology they used to justify putting certain assets in the "other comprehensive income" category.”

An informed writer commented thus:

“I'd argue that this won't result in banks writing up their asset valuations. Think about it. Say XYZ Bank announces some huge quarterly EPS figure, but when the analysts look deeper into the number, it turns out it was all paper gains on Level 3 assets. Investors would universally pan the earnings figure, claiming it was all phantom profits on marks to make-believe valuations.

Conversely, let's say the same bank reports break-even earnings with no change in Level 3 and a healthy increase in loan loss reserves. Now what does the market think? Analysts would say that the bank has potential latent gains in their Level 3 portfolio that haven't been recognized.This market is all about imagination.

If you are a bank (or any financial), the market isn't going to just accept your balance sheet as reported. The market is going to try to imagine what your balance sheet is really. Since no one knows what it is really worth, investors are going to imagine. I argue that a bank is better off convincing the market that it is being too conservative, thus guiding the imagination to better times.”

Another author amplified this further:

“The second thing I learned as a bank trainee, back in the good old days, was that it is impossible to learn anything useful about a bank by reading its balance sheet. Whether a bank is strong or not, depends upon the quality of its assets — information that is woefully absent from financial statements.

Once we understand that banks are insolvent and require government guarantees to continue in business, the question becomes what percentage of liabilities have government guarantees and which assets are good, or whether the government will eventually have to step in, liquidating the bank and paying off depositors, leaving zilch for shareholders.

Now accounting rules don’t require banks to list their loans, nor to indicate terms and covenants of each financial asset. You’re not told the credit rating of borrowers, or even the weighted average of credit ratings (even if you put faith in credit ratings).

Nor do accounting rules require that auditors actually evaluate the likelihood that a bank will get its money back on a particular loan, or any group of loans. Bank auditors don’t visit bank borrowers one by one and look them in the eye to see if they seem credit worthy, or whether they are drunken bums that have just blown the bank’s money at the racetrack.

Moreover, large international banks are so huge and complicated, composed of thousands of subsidiaries, affiliates, side ventures, and special deals, and subject to the risk that some obscure trader in one of hundreds of countries where they do business may be hatching up a scheme that will bring the bank to its knees tomorrow morning — these banks are so complicated that it is literally impossible to contrive any document that could possibly “protect investors” by supplying all relevant and material information.

Now, auditors don’t like to admit that bank balance sheets are bullsh*t, and that that the millions spent on auditing — for the benefit of “investors” — might just as well have been donated to charity. So they try to find some way to get someone else to give an opinion on how much bank assets are worth — at least some part of the assets.”

So are we in a better position to assess banks post the accounting changes? In other words are bank financials better than before the rule change? Remember most CEOs sometime back said things were hunky-dory and sub-prime was not a big problem! They either did not have a clue or knew but purposely suppressed facts. I do not see how this behavioral aspect can be altered by a change in accounting rule... even if they became government run banks.

Has the underlying risk really changed? Credit markets have improved because of government guarantees and not due to any change in the inherent risks the bank balance sheets carry. So it is the government manipulation that is carrying the day and how long it will last is a moot point. Remember this is a shift of risk to taxpayers and politically not very conducive for the medium to long term.

The market sooner or later has to adjust to this reality. The E part of PE can be boosted by change in accounting but given that the underlying risk has not altered much, it will have to be factored-in the PE ratio with price adjusting at some point in time. Will it allow the real E to improve because banks can lend more, only time will tell? But given the way US unemployment and savings rate are growing the demand for goods is not going to move up in a hurry and so will demand for credit.

By incremental lending the risks that banks face in an environment currently prevailing will only increase its risk at the margin. Sample this from Shadow Government Statistics:

“BLS Jobs Reporting Is Seriously Flawed, at Best. This morning’s (April 3rd) reported March jobs loss of 663,000 again was close to consensus expectations, but, as has been common in recent releases, major downward revisions to prior reporting helped to mute the current headline jobs loss significantly. In each of the six most recent monthly payroll reports, the prior month’s payroll level was revised lower. For October 2008 to March 2009 reporting, the downward revisions to the prior month’s seasonally-adjusted payroll level were respectively: 179,000, 199,000, 154,000, 311,000 (still significant net of benchmark revisions), 161,000 and 86,000. Five of the six revisions exceeded the Bureau of Labor Statistics’ (BLS) 95% confidence interval of +/- 129,000 jobs for monthly change.

Net of revisions, the March jobs loss would have been 749,000. Net of the Concurrent Seasonal Factor Bias (CSFB), which reflects the reporting problems, the loss would have been 750,000, in line with my estimate in the March 29th Flash Update.

Payroll Survey: The BLS reported a statistically-significant, seasonally-adjusted jobs loss of 663,000 (down 749,000 net of revisions) +/- 129,000 (95% confidence interval) for March 2009, following an unrevised 651,000 jobs loss in February, but January’s jobs loss was revised from 655,000 to 741,000. Annual contraction (unadjusted) in total nonfarm payrolls continued to deepen, down 3.56% in March, versus a revised 3.10% (was 3.12%) in February. The annual decline in March was the deepest since July 1958. The seasonally-adjusted series also continued contracting year-to-year, down by 3.48% in March versus a revised 3.08% (was 3.02%) contraction in February."

Savings rates are expected to touch 10 to 12 percent.

And here is the icing on the cake. According to the above referred MarketWatch report:

“However, the battle over mark-to-market may not yet be over. Bankers are pressing lawmakers to urge FASB and its parent regulator, the SEC, to set up a procedure to retroactively recoup losses financial institutions have already taken on impaired illiquid assets.

House Financial Services Committee Chairman Barney Frank, D-Mass., told the American Bankers Association on Tuesday that he will take their concerns about reversing retrospective losses to the SEC and Congress. "They [bankers] ought to be able to go back and say they took that loss on an asset that is being held to maturity and recoup that loss," Frank said.

However, Willens said it would be extremely unusual for FASB to allow banks to go back and restate their existing earnings. "FASB doesn't traditionally do that, but Frank's pressure could make it happen," he said."

Post the new fair value rules we should have restatement of financials over the last five years so that we can compare ‘apple to apple’. Let’s see how things look if the entire ‘fair value gains’ are taken away. It would be revealing to see what PEG the markets were pricing-in and how it should re-look at it post the change in rules.

The past track record of banks in their ability and skills to value assets does not give any major comfort. The capability and the possibility of auditors doing so – the less said the better. In terms of evolving models we have seen how capable these banks were in risk modeling and managing it. It is very difficult to believe that they would do a better job this time and that such models will be neutral - not biased in their favor. The fact that bailed out banks are now looking to bid for the toxic assets under the Geithner plan says it all! In all probabilities it will now be a mutually beneficial exchange between them.

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