naked capitalism

Gretchen Morgenson of the New York Times has a story on proposed new reporting rules for credit default swaps that in passing raises the question that if implemented on the envisioned schedule (becomes effective in fiscal year financial statements after November 15, 2008, so the impact could be soon in coming), it may lead banks to try to pretty up their balance sheets.

Now I will concede that a lot of the byplay in the article is annoying, starting with the breathless first sentence:

Everybody knows that the market for credit default swaps is one of the hottest investment arenas around. At the end of last year, according to the Bank for International Settlements, the fair value of credit default swaps outstanding totaled $2 trillion, up from “just” $133 billion three years earlier.

Funny, the article is all about how opaque the CDS market is, yet she fails to connect the dots that the BIS “fair value” figure is therefore a guesstimate. More on that:

The entire amount of insurance that has been written, also called the notional amount, is $62 trillion. The fair value of C.D.S.’s is a more meaningful figure, though, as it represents a more precise assessment of potential losses and gains. The fair value of these derivatives has had a growth rate far steeper than that of the notional amount in recent years.

Ahem. The $62 trillion number (as of its reporting date; no doubt the total now is higher) is more accurate; the fair value figure is more significant but less accurate. “Precise” and OTC markets do not go together. And calling the change in economic exposure a “growth rate” is a tad misleading. It indicates that the riskiness of the CDs has increased (as in higher risk credits have higher spreads). Is this because more CDS are being written proportionately on riskier companies, or because CDS spreads are widening on many existing credits due to the weakening of the economic environment? While what Morgenson has written is technically accurate, it should either be explained or the observation omitted (it isn’t germane to the thrust of the piece).

While this isn’t the only lapse, the article is nevertheless useful. From what I can tell (Google News search and blog search), this story hasn’t gotten much (any?) coverage, so Morgenson is seemingly out early with it. Here’s the guts of the piece:

To help investors get a grip on the financial implications for companies that have sold credit default swaps, the F.A.S.B. has suggested a list of new disclosures to be effective in financial statements for fiscal years that end after Nov. 15, 2008. That very specific deadline may ensnare some of the nation’s biggest brokerage firms with fiscal years ending in November — Lehman Brothers, Morgan Stanley and Goldman Sachs….

The F.A.S.B. proposal would cover sellers of C.D.S.’s, the entities that act as insurers. They would have to disclose such details as the nature and term of the credit derivative, the reason it was entered into and the current status of its payment and performance risk.

In addition, the seller would provide the amount of future payments it might be required to make, the fair value of the derivative and whether there are provisions that would allow the seller to recover money or assets from third parties to pay for the insurance coverage it has written.

However, if you go to the FASB website, things get curiouser. The proposal was issued at the end of May; the comment period closed on June 30. Morgenson only quotes one expert (“Jack Ciesielski, an accounting guru and the publisher of The Analyst’s Accounting Observer, an accounting advisory service for investment professionals”) which unwittingly creates the impression that he pitched the story to her and she relied on him overmuch.

And there is more sloppy drafting. The use of the term “credit derivative” above tracks the language in the proposal, but the proposal provides a definition:

…the term credit derivative includes groups of similar credit derivatives

In fact, the use of “credit derivative” sent me running to the FASB site, because without the definition, it reads as if financial firms are required to make instrument-by-instrument disclosure, which is clearly not happening. Again, oddly, that section largely tracks the FASB language but omits the fact that CDS writers would also disclose the amount of collateral held.

Now the “accounting guru” does make an important observation:

As the requirements of the new disclosure sink in among companies in the next few months, Mr. Ciesielski said he expects increased volatility to emerge in the C.D.S. market. Fearful of how investors will react to the extent of their swap holdings, companies may move to unwind them or offset them when they can.

“This is something that will change behavior,” Mr. Ciesielski said. “If you don’t want to look so bad, you’re going to have to be busy in the next few months to work these down, wriggle out of them or offset them.”

The lack of apparent interest in this rule change is surprising, particularly if firms wind up shuffling exposures before the first time they become subject to the disclosures. Normally, interbank liquidity starts drying up in December; last year, it started early, in November. Let’s hope this otherwise useful proposal doesn’t increase year-end stresses.