Abolish Fair-Value Accounting

In our post of October 9, 2008, “What’s Fair About Fair-Value Accounting?” we commented on the process of marketing-to-market when there is no market, that is, when there is a dearth of willing buyers and sellers and essentially no fair price to clear the market. As we noted, U.S. banks are required to mark-to-market most financial assets other than loans. Our recommendation was that the SEC should instruct FASB to abolish fair-value accounting once and for all.

Well, somebody was listening, at least across the pond, as the Wall Street Journal reports today (“EU Banks Get Leeway on Making Write-Downs,” October 20, 2008, page C1, C2). New accounting riles in Europe would allow banks to reclassify some assets as investments, allowing more flexibility in deciding what they are worth. The risk of course is that banks will cook the books, possibly leading to abuses in the reporting of the actual value of certain assets and impacting reported earnings.

At the risk of being repetitious, banks (whether U.S. or elsewhere) should follow the following procedure:

  1. Model the worth of assets based on discounted cash flow projections of the present value of interest and principal payments.
  2. If permanently distressed, write down the assets as appropriate, based on reduced or omitted interest and/or principal payments.
  3. Subject all asset write downs and valuation to external auditor reviews.
  4. Further subject all asset write downs to bank examiner reviews.
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What’s Fair About Fair-Value Accounting?

Our recent blog discussed the credit freeze being experienced in the current financial crisis, which can only be thawed by coordinated actions of the U.S. Treasury, Congress and the President, and the world’s central banks to bring confidence and liquidity back to the markets. Many of the necessary steps have been taken, and there are few additional major actions that should be required to restore some elements of which President Warren Harding called “normalcy” during his 1920 campaign. This blog focuses on valuation and the failed concept of mark-to-market accounting.

Banks are required to mark-to-market most financial assets other than loans. The practice of marking-to-market (or fair-value accounting) began with commodities dealers who accepted nominal amounts of margin (often as little as 5 or 6%) to hold futures contracts for clients. Each night that day’s settlement prices from the exchanges were used to revalue positions, so that margin calls could be made the next morning if the value of holdings had deteriorated and more cash was required. The idea was extended to bank investments in FAS 157 issued by the Financial Accounting Standards Board (FASB), taking effect after November 15, 2007. This re-pricing works when there is a deep and liquid market, and willing buyers and sellers can clear the market based on normal conditions of supply and demand. The concept does not work when the market is illiquid and/or when there are insufficient numbers of buyers and sellers.

We are going through a period of panic selling and sharply falling prices for certain assets, and mark-to-market is inappropriate in these conditions. The alternative is to use discount cash flow valuations of assets, bringing the expected future stream of interest payments and the repayment of principal back to present value. The unknown is whether the issuer can reasonably be expected to honor its debt contract, that is, will those interest and principal amounts be paid or has the quality of its assets or earnings been so affected that there is a permanent deterioration in its financial position? If so, the asset would be written down to reflect that change. What a radical idea – recognizing losses (or gains) when the investment has clearly lost value or when it is actually sold!

The SEC and FASB issued new guidelines on fair-value accounting just about the same moment that Congress was debating the $700 billion Emergency Economic Stabilization Act of 2008 (EESA), Public Law 110-343, October 3, 2008. The new rules permit the designation of “distressed” to certain investments so that less emphasis is placed on market prices. The EESA instructs the SEC to investigate whether mark-to-market rules deepened the problems in the credit markets and to suspend the rules if appropriate.

The SEC should instruct FASB to abolish fair-value accounting once and for all. Instead, banks should treat investments in the following manner:

  1. Model the value based on discounted cash flow projections of the present value of interest and principal payments.
  2. If permanently distressed, write down the assets as appropriate, based on reduced or omitted interest and/or principal payments.
  3. Subject all asset write downs and valuation to external auditor reviews.
  4. Further subject all asset write downs to bank examiner reviews.

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Deep Freeze?

My last blog recommended a consolidated approach to financial regulation to oversee the strategic objectives and decisions of financial services organizations, rather than the specific product lines and operations considered in our current ineffectual regulatory approach. Beyond that change, there are several other issues to consider. Should we put a halt to the real estate lending practices of the banks? This involves making loans, the earning of origination fees, the sale of the loans, and then making new loans with the freed capital. 

 

There is nothing inherently wrong with this process so long as borrowers have adequate income and the collateral (the house or other real estate) is properly appraised at an amount reasonably close to the market value. However, real estate has been inadequately examined, borrowers were  not been adequately vetted as to income and other debt obligations, real estate became overpriced and overbuilt, borrowers stopped making payments, and financial institutions found themselves with properties that could not be sold.

 

The problem was exacerbated by the securitization of loan packages, pieces of which were wrapped into securities and then sold and re-sold. (“Securitization” involves bundling a pool of loans into debt securities with various maturities and credit ratings that could be sold to investors.) This process is so complex that it is impossible to know the worth of these securities, and so, in the current atmosphere of ultraconservative short-term trading, there is no market for them.

 

The current financial crisis has shocked all of the parties who normally are quite willing to be counterparties (buyers or sellers), and fear has put a hold on what previously were commonplace transactions. Normal business and consumer lending cannot resume until the government intervenes to clear the market through bankruptcies (e.g., Lehman), liquidity guarantees (e.g., AIG), forced mergers (e.g., Merrill Lynch with Bank of America), and government purchases of troubled investments (e.g., the $700 billion package that was requested by Secretary Paulson to buy troubled bank loans).

The freezing up of the financial system occurred because counterparties could no longer trust in the value of the assets being offered for purchase and sale. One of the problems is the concept of getting to a market price that will clear the market. In the next blog I will talk about valuation and the failed concept of marketed-to-market accounting.

Which Candidate Can Save Your Job?

Is U.S. Business Overregulated?

Senators Clinton, McCain and Obama seem to have three types of responses to the current business climate in their Presidential campaigns:

1.      throw money at the economy
2.      bash global business, or
3.      claim economic ignorance.

Here are some examples from early 2008 speeches and interviews:

#1. Clinton wants to renegotiate NAFTA and take other actions to protect U.S. jobs, including spending $2.5 billion a year to retrain workers for new jobs. Bashing global business may win some votes, but this really is populist claptrap and a terrible idea.  America is a part of the world, and ignoring global competition does not change the fact that we compete in the world. To fan the blames, she recently stated that “… we might be drifting into a Japanese-like situation,” meaning a prolonged recession.

#2. McCain has stated that “the issue of economics is not something I’ve understood as well as I should.” However, he is an economic conservative and a free trader, and opposes economic intervention in the credit and housing markets as a doomed attempt by the state to interfere in the market economy. McCain’s ignoring current problems is reminiscent of President Hoover’s refusal to allow the federal government to assist starving Americans after the 1929 stock market crash.

#3. Obama wants to spend $210 billion to create jobs in construction and environmental industries over the next 10 years. The money would come from ending the war in Iraq, cutting tax breaks for corporations, increasing taxes on high income earners and taxing carbon pollution. The problems with this proposal are that there is no automatic peace dividend, that Obama has never explained how we’d exit Iraq, that we now have the second highest corporate tax rate in the world, and that, as a country, we’re nearly $10 trillion in debt. Oh by the way, he denounces NAFTA.

What does the rest of the world see? Just look at the plunge of the U.S. dollar vs. every other important currency over the past eight years or so. So what should we do? In the U.S., we’ve underregulated the financial markets and overregulated the industrial markets. We need to create consolidated regulation for the financial services industry so that the newer participants do not fall through the cracks, and that financial firms that get into commercial banking are subject to the same standards as the banks (think Bear Stearns). We need to eliminate regulation that strangles U.S. business, like antitrust, the Sarbanes-Oxley Act (corporate governance), and archaic laws that stifle specific industries (such as airlines and communications).

Which candidate may get us there? We need restraint on spending, fewer restrictive economic laws, and an end to the bashing of global business. So far, none of the three candidates come close to meeting these requirements.

Microsoft Ends 9-Year Fight

Is U.S. Business Overregulated?It was no great surprise that Microsoft recently agreed to end its 9-year fight against the European Union’s antitrust regulators; see The New York Times, Oct. 23, 2007, 1st business page. The company simply got tired of fighting a system that claims to support competition without consideration for the realities of the marketplace. Will freer competition and better customer service result? There may be little actually gained because of previous Microsoft agreements with other computer companies for cross-licensing and the sharing of technology.

 

The U.S. version of the case began in 1998 and ended with relatively minor penalties assessed against Microsoft in 2002. Our government had alleged that Microsoft illegally tied its Web browser to the Windows operating system despite the fact that injury to consumers was never proven. The Microsoft case illustrates the challenges facing 21st century courts attempting to reconcile innovation, the financial requirements of an industry heavily invested in research and development, and antitrust law that was enacted more than 115 years ago. At the time of the first law protecting competition – the Sherman Act of 1890 – America was evolving from agriculture to manufacturing, and there was limited foreign competition.

 

The concept of antitrust made sense when consumers had no choice in their sources of supply as small businessmen and farmers discovered in the late 19th century. That situation has clearly changed, and America is now scrambling to compete in global markets with international competitors from China, India and other fast growing economies who are not looking over their shoulders at antitrust regulators. Numerous legal cases have similar histories to Microsoft as the judicial process slowly wends its way through fact finding, analysis, discovery, motions, and trials. Markets move faster than antitrust, and a shrewd litigation team can drag out the process for a much longer time than the life or death of a competitor.

Response to John Carroll

Of course these are European decisions — but aren’t we free to criticize any restrictions on global free trade? Furthermore, there is absolutely no evidence that consumers have been adversely affected by the business policies of Microsoft. If anything, the company has been a great corporate citizen. I explain of of this in my forthcoming book.

J. Sagner

And We Were Naive Enough to Think That Europeans Supported Free Trade!

It was no great surprise that Microsoft recently agreed to end its 9-year fight against the European Union’s antitrust regulators; see The New York Times, Oct. 23, 2007, 1st business page. The company simply got tired of fighting a system that claims to support competition without consideration for the realities of the marketplace. Will freer competition and better customer service result? There may be little actually gained because of previous Microsoft agreements with other computer companies for cross-licensing and the sharing of technology.

 

The U.S. version of the case began in 1998 and ended with relatively minor penalties assessed against Microsoft in 2002. Our government had alleged that Microsoft illegally tied its Web browser to the Windows operating system despite the fact that injury to consumers was never proven. The Microsoft case illustrates the challenges facing 21st century courts attempting to reconcile innovation, the financial requirements of an industry heavily invested in research and development, and antitrust law that was enacted more than 115 years ago. At the time of the first law protecting competition – the Sherman Act of 1890 – America was evolving from agriculture to manufacturing, and there was limited foreign competition.

 

The concept of antitrust made sense when consumers had no choice in their sources of supply as small businessmen and farmers discovered in the late 19th century. That situation has clearly changed, and America is now scrambling to compete in global markets with international competitors from China, India and other fast growing economies who are not looking over their shoulders at antitrust regulators. Numerous legal cases have similar histories to Microsoft as the judicial process slowly wends its way through fact finding, analysis, discovery, motions, and trials. Markets move faster than antitrust, and a shrewd litigation team can drag out the process for a much longer time than the life or death of a competitor.

 

It is difficult to argue that the U.S. economic system would not proceed in a civil and orderly fashion in the absence of an antitrust shield. The most recent landmark decision on antitrust – other than Microsoft – was possibly the case of AT&T. However, in that situation the government had allowed a monopoly to continue for much of the 20th century as an expedient to provide communications services to U.S. customers, and there is certainly no likelihood of a return to the control of that industry or any other industry in the sense of anticompetitive behavior.

 

In the U.S., Republicans haven’t generally enforced antitrust, while the Democrats did during their time in the White House and probably will again. This inconsistency of enforcement is patently unfair to society and against the intent of Congress when it passes legislation. The antitrust laws cannot be made sufficiently specific to allow fair and consistent application, and, in any event, should not impede U.S. companies from developing strategies to allow them to compete in global markets. The time may have come to consider repealing the antitrust laws. In situations of business regulation, let America be more realistic than the Europeans and encourage U.S. companies to freely compete in the global economy.