Extend and Pretend Reaches A New Level

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Just when you thought financial firm accounting couldn’t get more dubious…it gets worse.

Deux Ex Macchiato (hat tip FT Alphaville) tells of the disconcerting changes to what was formerly called FAS Rule 157, which brought us Level 1, 2, and 3 accounting. A brief recap:

Readers may recall that the Financial Standards Accounting Board implemented Statement 157, which required financial firms to identify how they arrived at the “fair value” for their assets. Level 1 are ones where there is a market price. Level 2 are those where there may not be much of a market, but they can nevertheless be priced in reference to similar assets that have a market price, or their price can be derived from “observable inputs” which are presumably from financial markets (the use of sunspots, skirt lengths, the Mayan calendar, or a model using, say, a ratio of bullish versus bearish stories on Bloomberg presumably does not qualify).

Level 3 assets are priced using “unobservable inputs,” and is therefore colloquially called “mark to make believe.”

Almost as soon as this regime was in place, the officialdom started giving waivers. The refinements to these valuation rules that become ever-more bank flattering. For instance, consider this item from March 2008 (post Bear, natch), which discussed a Floyd Norris article, “If Market Prices Are Too Low, Ignore Them”:

Norris, who is usually pretty understated, disapproved of one of the items in the SEC letter, as do we…

In the last couple of months, there has been increased worry that mark-to-market accounting leads to the operation of a destructive “financial accelerator.” As prevailing values go down, banks have to lower the value of their holdings. This leads to a direct hit to their net worth, which will lead them to contract their balance sheets, either by withholding credit or selling assets. More sales in a weak market lead to further declines in the prices of financial instruments, leading to more writedowns and sales of inventory.

Funny how no one had a problem with mark-to-market when asset prices were rising. The process in reverse leads to mark-to-market gains, higher net worths fueling balance sheet growth and credit expansion, which led to more demand for financial assets. That gives you higher securities prices which least to more mark-to-market gains. Sounds like a bubble, doesn’t it?

The SEC’s solution for the contractionary version of this dynamic is simple: ignore those market prices if they are too ugly. From the release:

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).

Quite a few observers had argued that the windups of SIVs and the failure of hedge funds, and even Bear Stearns, would be a good thing because they would force price discovery of assets that are normally illiquid and/or hard to value. That in turn would resolve a great deal of uncertainty of what bank and hedge fund positions were really worth.

But now the SEC has given banks and brokers a huge out. No matter how small or easily absorbed by the market a forced sale might be (think of a hedge fund hit by a margin call), a financial institution can ignore the price realized. In fact, they get to determine what trades constitute a forced sale. As Norris dryly notes:

Some people on Wall Street think that nearly every sale today is a forced sale. There are entire categories of collateralized debt obligations where most, if not all, of the trades, occur because a holder has received, or expects, a margin call.

Back to our current post. The FAS changed the name of the rule from Rule 157 to Topic 820 last year, and Deux Ex Machhiato reports on the continuing devolution on this front. He finds a change he likes (FAS text first, his commentary second):

Financial statement users indicated that information about the effect(s) of reasonably possible alternative inputs [to level 3 valuation models] would be relevant in their analysis of the reporting entity’s performance.

So, with a reasonable amount of luck, 820 will require firms not just to state the value of their level 3 assets, but also to assess uncertainty in that value. This would be a major step forward in accounting disclosures for financial instruments, and I commend the standard setters for it.

Yves here. I hope he is right, but his interpretation looks optimistic. First, this is not a done deal yet, and second “reasonably possible alternative inputs” would appear to give some companies the latitude to define ‘reasonably possible” pretty narrowly, or simply contend that using other “reasonably possible alternative input” made an adverse difference only in a trivial percentage of scenarios. After all, VaR-based models computed the odds of the most two extreme moves in the Dow in October 2008 as being possible only once every 73 to 603 trillion billion years. Since our universe is maybe 20 billion years old, we’d need to wait at least a trillion universes to expect to see one month like that. Weren’t we all lucky?

Here’s the part Deux Ex Macchiato does not like:

I used to think that level 2 assets were things valued using a model, but where all the model inputs were current market observables. In other words, a swap valued using a discounted cashflow model calibrated to the quoted libor rates is level 2, but a quanto option valued using historic correlation isn’t, as correlation is not a current market observable (but rather an historic property). In fact anything valued using a model where one input is an historic property – historic vol, historic prepayment rates, etc. – should be level 3.

Unfortunately the text of 820 now includes the clarification that anything based on a market input is in level 2. And since historical volatility is based on a price history, an option priced using historic rather than implied is in level 2. This is not good. There is a crucial difference between a current price used as an input (or equivalently a convention for quoting prices, like implied vol) and anything else. Level 2 should be kept for purely price based model inputs. That, of course, would also make the level 3 uncertainty disclosures much more useful.

Eeek. Having crawled in the bowels of some financial firms, I’ve been skeptical of whether an investor can make head or tails of the performance of a financial institution of any complexity. This move should give the skeptics even more cause for pause.

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20 comments

  1. Mogden

    Is there anyone who believes a thing on any financial statement from these firms? Seems that we’re at credibility zero to start with.

    1. fajensen

      I think they will manage to inflate stock prices just fine – because, at the present time, there are no “investors” to persuade, the entire market is made by trade-bots with feeder-tubes connected directly to central bank credit facilities.

  2. Abhishek

    If financial firms think that they can manage to raise the share prices this way , they are wrong.Once you lose the trust of the investors in your financial statements you are never going to get your stock up.This move could backfire on the companies

  3. Sydney Weinberg

    I do believe the bonuses paid to executives and employees are real. These are after all the smartest people around.

  4. Alton Cogert

    One also must wonder how much more ‘flexibility’ will be available to financials (and others) once IFRS replaces GAAP (on target for just a few years from now). Principles based accounting….indeed.

  5. Paul Tioxon

    The sociology of epistemology can be a breath of fresh air compared to the professional obfuscation of accounting practices in the service of maintaining power and privilege during crisis situations, aka, when the jig is up. Trying to paper over the misdeeds, mistakes and bad timing with the official mediating associations standards and practices for the noble professions, is one way to gracefully exit the crisis with the general public perceptions of sounds business practices intact. The mortally wounded reputations of the entire financial services industry, including ancillary rating firms, accounting and consulting practices and even less than aggressive federal and state regulators leaves any move suspect. While you faithfully report, illuminate and sound the alarm when needed, are you really doing what many in the social sciences have already done when they have seen for over a century the false consciousness so ably manufactured as incontrovertible objective social reality? Honestly Yves, you are like Hercules cleaning out the stalls, only to wake up as Sisyphus, but still, it is stalls you are doomed to clean, and not just an odor free rock on an incline.
    The damage control and spin is amazing, as is your energy to let us see into this world. Thanks, if I have not already thanked you.

  6. ab initio

    Fantasy accounting to make financial statements increasingly obtuse only means managements can pay themselves as much as they want as they can create statements that reflect what they want to game compensation. Of course such statements will never reflect the actual financial condition of the firm. In any case that is never of any concern as the taxpayers are always there to hold the bag when reality catches up.

    1. alex black

      The taxpayers will hold the bag unless and until they grab hold of Obama’s bags and squeeze with all their might.

      I’ll bet his baritone will be a few octaves higher after that.

  7. Richard Kline

    In the last Administration, it was those at the Department of Defense that thought they created their own reality. In this Administration, it’s those at the Department of the Treasury who think they create their own reality. If forced to choose . . . I’d pitch them both out the window, and let the Devil sort his own.

    1. Valissa

      Agreed… and to take this a step further, one could say the Dept of Treasury and their fellow oligarchs are using the financial system as weaponry (war) as well as ideological domination (religion) to attain their desires for wealth and power for the few against the many.

  8. Doug

    Not sure anyone had to crawl into the bowels of a financial firms to conclude they were black holes. Complexity and intentional obfuscation that brings things beyond human comprehension in an Orwellian sense. That is what bankers do when the ship is going down. Big Bonuses. That wasn’t just greed – that was get some before the ship goes down. But then again, some of the brightest minds in the game have taken enormous stakes! Like freakin FAMOUS trader GOD super genius John Paulson and his huge BofA stake. Warren Buffet and his GS stake. The list goes on. Know this, friends – there is a saying “Too old to laugh, too young to cry” that applies here.

  9. But What Do I Know?

    Having seen what can be done with the accounting statements of a manufacturing company, I can only imagine what a financial firm can do. This just makes it easier, and assures that no one can ever be prosecuted for mispricing assets.

    IMHO, one should assume that the bank (insurance company) is lying, and their statements are not worth the paper they are printed on.

  10. Francois

    All this fairly visible mark to bullshit begs the simple question: How can anyone (be stupid enough to) invest in the stock of these companies to begin with?

    Oh sure! One can use a trend following strategy, as long as the proper puts and calls are in place at all time. But again: Why go through all this trouble to begin with?

    In these very troubled times, I can only agree with Seth Klarman; only buy equities that are at very steep discounts, to the point of nauseating other investors.

  11. Peter G

    THIS is why all trust in our “regulators” is gone…

    They are all owned by the very banks doing the crime. Don’t like the rules?? Just change em…

    THE SYSTEM IS BROKEN!

  12. ben there done that

    The real shame is there actually is a population of independent quants and super quants that could provide pretty good prices for these esoteric, exotic, hard to value assets. They are creating tools to value the crazy stuff – and yes, they know from crazy. The problem is similar to the derivatives issue – darkness and secrecy help propel an inefficient market and allow certain players to extract disproportionate fees and asymmetric market power. No one really wants a baseline, independent and market driven pricing model. The banks are particularly nimble at setting up and sponsoring multi-member institutions that are meant to level the playing field and provide transparency – LSTA, ISDA, to name a few. When market efficiencies have removed the ability to overplay one’s hand, it is usually the one whose hand is no longer in power that insists that the market embrace a standard bearer for that particular market or product. So – we can belly ache all we want about whether FAS 157/820 makes sense. What we should be fearing is as long as the market players refuse to move towards a commonly adopted pricing system for hard to value assets, you can bet there are big winners and big losers – it is just a little harder to tell who is who in the dark.

  13. steelhead23

    Can we talk a little more about risk? I do not believe that accounting which allows non-market pricing of assets and liabilities is ever going to be perfect. That is, a balance sheet would always be wrong. Now, if you are a banker, you might prefer that your balance sheet be wrong in a good direction – it keeps the regulators at bay and improves your ability to raise capital. Thus, logic tells us that at each step along the way in modeling value, the assumed values of unknown parameters (like the assumed volatility function in a Black-Scholes model based on historical volatility) would favor the outcome the banks want. The solution would seem to be to assume that the value of a bank’s tier 3 assets is some fraction of their stated value – say 50%. This may not even be conservative enough. Also, at its core, I believe this modeling bias is a root cause of the current catastrophe. That is, bankers and regulators alike were duped because they believed the bankers’ lies. Obviously the Magnetar and Abacus stuff was pure fraud, but given this tendency to overstate a bank’s health, to similarly understate risk, and the scale of credit creation, I believe the catastrophe would have occurred anyway – perhaps a little later. Thank you for another wonderful post Yves. For you next little bit of magic, would you please stop the Gulf oil leak?

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