Thursday, April 02, 2009

FASB: The Dark Side clouds every thing

The new FASB ruling is getting more play than it deserves.

I've written on mark-to-market many times. I've always felt it was a good concept but has been applied incorrectly. When the rules were written, it was never assumed that generalized risk aversion would ever rise to the extent that it has. Thus the rules assumed that a $30 decline in a bond price would always and every where indicate a security-specific problem. The rules (and/or the auditors) also assumed that securities that seemed similar at a glance could be used to value each other. They never assumed that various securities would ever become as granular as they eventually became. For example, a whole-loan RMBS with 15% California exposure suddenly was valued drastically differently than one with 25% CA exposure. But both were valued off the ABX as if they were the same, because the ABX was the only thing trading.

Anyway, the key thing that changes with this FASB guidance is the assumption of distress. Now any trade that occurs in an inactive market is presumed to be a distressed trade unless proven otherwise. I'd expect this means that most Level 3 asset prices will become more PV model-based and less trade based.


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.

Otherwise the bank will only stimulate the imaginations of the "its all worthless" crowd, which I realize is the majority of the blogosphere. I don't get this point of view, and I think its all rooted in some sort of visceral desire to see the banking system crash and burn. I think Jim Cramer said it well on TheStreet.Com today:

"The first side is the "it doesn't matter and it is bad" camp. This is the camp that says it [the FASB ruling] is a mistake because it will give the banks too much latitude, and they don't deserve it. "Deserves," as they say in Unforgiven, "got nothing to do with it." This is a completely worthless position that makes you no money. Who the heck cares whether they "deserve" it? What is this, some sort of civics lesson? We are now going to invest on whether someone should be punished? This is about money. I could care less about "deserves". "

Its similar to my position on politics. As an investor you need to forget about what "ought" to happen and worry about what will happen. That's how you make money.


Jakedeez said...

I hear what you and everyone else seems to be saying about a lack of trust or clarity on bank balance sheets. But first of all, I think it is crazy to say, "now we can't trust them," as if anyone trusted them before...

Why I am so against the mark-to-market thing is that it is making a bad situation worse with the regulators... I don't care what other traders thing nearly as much as what bank regulators and auditors think...

Donald Pretari said...

I liked this post:

"If you read the headlines (and most people don’t bother to go much farther beyond the headline than the lead paragraph –- to our collective disgrace), you already think FASB eased the rules for measuring fair value on Thursday. You might believe that it has at last caved in to pressure from banks and Congress, and decided to allow “preparers” and their auditors to use judgment when valuing illiquid assets.

Not so. They are reiterating for the third time that “fair value is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date.”

Don the libertarian Democrat

cap vandal said...

Gotta agree that this is over played.

There are documented problems using the ABX as a proxy for credit risk.

"This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure."

M2M is totally appropriate for derivative books -- that's where the idea came from.

When it was considered a good idea, there was a belief, now unfounded, that the financial markets were efficient, liquid, and deep.

Anyway, the idea of using credit derivatives like ABX to price assets for regulatory capital purposes is nutty. These types of credit indices are relatively new, unregulated, and opaque.

Anything to break a feedback loop that is accounting driven.

Depending on the details of implementation, it probably won't have a big impact but could add some stability and provide some regulatory relief on capital levels.

GS751 said...

Interesting position on the changes in loan loss reserves, versus paper L3 marks.

Unknown said...

Why is it crazy to think the banks don't "deserve" this? You (and Cramer) sound as if politics has nothing to do with economics. Now who's crazy? Yes, it is a civics lesson. Right now, the lesson we have learned is that if you are rich and powerful you can make blunder after blunder without any repercussions. Many people don't think this is right. Does every action have to make money for it to be worth doing? That last paragraph gives you a very twisted Machiavellian attitude. I realize this is a trading/econ blog, but c'mon, you have to have some ideals and morals that you stand by, don't you?

I don't want to see the banking sector crash and burn. But I firmly believe nationalization (or whatever they want to call it) is our best way out of this mess. The fact that we are so against it despite all of the actions over the last 6 months is what perplexes me. The FASB ruling appears to be just another delay game. What really changes? Who are the banks going to lend to with all of this extra capital?

If the banks had been held to normal leverage ratios, would mark to market have been a problem? Could they not have just taken a massive write down *without* going bankrupt? What if we were to regulate this opaque derivatives market? Wouldn't this be a much more lasting step in preventing this from happening again? I guess at this point, every person I have seen in favor of this ruling acts as if there are no other alternatives and that this is the only course of action other than no action. I completely disagree and feel we are still treating the symptoms and not the disease.

Unknown said...

I agree with Don. There has been no "relief" provided on the M2M rules. It is a regurgitation of what has been said before. That said, there was some easing of what portion of that M2M makes its way into the income statement if the asset is deemed impaired.

In the end, I don't think it will have an impact as the analysts will account for this accordingly via the additional disclosures required attached to the easing.

In Debt We Trust said...

AI, I have to disagree w/you here. If FASB's m2m change is such a good thing then how come IASB chose not to follow through?

al fin said...

If you remember, after William Munny said "deserve's got nothin' to do with it," he shot Little Bill in the head at point blank range with a buffalo rifle.

Are you suggesting that is how we should treat politicians (Barney Frank) and investment bankers who helped create this mess?

If so, count me in, brother.

Credit Cruncher said...

It's an interesting implication (if that is what you meant, AI) that assets that are not market to market (ie. it would be a distressed sale) are automatically put in level 3. I'm not sure that's so clear cut, but I'd love to have someone knowledgeable weigh in.

If I have an asset at 80 cents, there is a trade at 50 cents in the market, which I decide not to use (effectively using the distressed asset argument), do I then have to move that asset to level 3? If that is not the case, I think your scenario where an analyst can monitor level 3 assets for shenanigans is a bit weaker...

Chrisfs said...

People are people, by which I mean they have emotions and concepts of justice, they get angry, feel betrayed, and get greedy. If there was none of that, there wouldn't be a mess, because people wouldn't have gotten greedy. So yeah, it's a civics lesson.The faster companies and govts catch on, the less stupid pointless riots (like in the UK) and public flogging of execs in front of Congress there will need to be. "Trust us, we wouldn't do anything self destructive, why would we" was the chant before the mess got started. There was a magic formula by which bad loans would make good money as long as you gave the companies even leeway. M2M sounds like that whole thing all over again.