OK, we can have our disagreements over what is fair value accounting. But since its been passed and will come into effect as soon as the second quarter, lets look at the real effects on companies and markets. The first area is to look at the Credit Default Swaps for the affected banks. CDSs are basically insurance one can buy to insure against a certain company going bust. Hence if I bought Bear Stearns, and it went bust, the writer/issuer will be paying me the full sum I insured/hedged.
Now, with the new FASB ruling, the CDSs of the banks will reflect whether there was real effect or just a cosmetic effect on these banks' risk of failing following the new rules.- Citi is in about 40 bps but is just back to where it was on Tuesday
- Bank of America is lower by 50 bps
- Wells Fargo is lower by 30 bps
- JP Morgan is lower by 15 bps, all back to one week lows
-Morgan Stanley and Goldman Sachs are each in about 30 bps
Well, the effect is only minimal at best. The ones in real danger would be Citi and Bank of America, hence the narrowing of risk would be more pronounced there. Other banks which may have a lot less toxic assets in their books, would only see a very marginal reduction in risk. That means that the new rules DOES NOT really help to put the shaky banks out of the risk of possibly going bankrupt. It was the same level of riskiness as things were a few weeks ago.
That would be a correct consequence because the treatment of the "impairment" may be changed but the substance of the impairment is still in the books - hence the risk of failing should be the same or nearly the same as before.
The difference, the really big difference as I have mentioned yesterday is in the capital adequacy side. They will not need to hold so much capital or raise much new capital. That lightens the bank's dilution danger, and eliminates the big danger of failing badly should they fail to get a truckload of new funding over the near term. The supposed new capital is to plug the hole in the toxic assets write downs, and will not actually help to fund business activities going forward. If they do not sell the toxic assets, they will not be taking the loss in effect - hence I like the amortisation rule of the losses. Thus the reduced need to raise new capital will NOT affect existing operations going forward.
Its not like the new capital will be used for expansion, it was dead money to plus a hole in the balance sheet. Another consequence will be that many of the banks that received the TARP money will be looking to repay the sums back much quicker. Again, a confidence issue will work its way to boost optimism in the eyes of investors. You cannot imagine how much liquidity still resides on the bylines. Its a confidence issue and moving market back up by 10%-20% over a few weeks is not that strange in extreme market conditions.
Will the markets rally be shortlived? I think this one's got some legs. This bear market crisis was predicated on a significant loss of confidence in the entire financial system. What has come out of the G-20 and the new FASB ruling showed a more sobering and concerted view to address the issues. We are not out of the woods in terms of real economic activity, jobs will still be lost.
However, stock markets are forward discounting models, hence in the eyes of investors, the real economy are looking brighter 1Q2010 and 2Q2010, it is with that foresight that that the Dow Jones could scale above 9,000 and try to consolidate there over the next few weeks. Will we revist the lows??? ... pretty unlikely.p/s photo: Pace Wu Pei Ci
I was an accounting and finance major, heck I even did honours in the driest subject ever created, accounting in my 4th year. Accounting is a made up subject. You just have somebody a hundred years ago devising a way of recording assets and liabilities by dividing a page into two columns. What started as a convenient way recording assets and liabilities morphed into this thing called accounting.
Accounting is very much like fung shui (there I go offending 90% of my readers again), its made up as you go along.
Now the market seems to be favouring the fact that there will be some accounting rule change tonight in the US which may actually add legs to the current rally. It centers on approving changes to "mark-to-market" accounting. I spoke to a very very rich man 3 months back and told him that one of the likely market catalysts will be changes to mark-to-market accounting. He was taken aback, and just like the MAJORITY of investors and readers, including the CFA association - almost everyone is condemning or has condemned changes to mark-to market accounting as stupid, silly cosmetic and ineffective.
I am in the minority I guess. I have been around accounting figures long enough to know that accounting numbers DO NOT fully represent what the truth is. Accounting is just an approximation to the truth. If accounting rules are the best approximations to the truth, then by all means we need to maintain the boundaries and stick to the accounting rules - so that things can be appraised fairly and consistently.
What I don't get is how so many hold onto accounting rules even stronger than the tenets in the bible. Change some accounting rule, its worse than blasphemy!!! Gee, its just accounting.
I fully appreciate why most would not want mark to market to be tweaked as that may be largely cosmetic and is seen as a move pressured by the banks and government on the Financial Accounting Standards Board. Why change now,... if the fundamental argument is sound to change mark to market, why not change it years ago??? Aha!!!
First, let's look at the proposed changes that are likely to be passed. Banks may not need to undertake impairment charges if the banks say that 1) they do not intend to sell the affected asset, and that 2) they probably won't be forced to sell before it recovers. The banks will only record the losses upon maturity of the investment (assuming they are paper assets / bonds / contracts / derivatives). Thats all fine and dandy, but the key phrase is the second part which says that the banks WON'T BE FORCED TO SELL before it recovers.
For a bank not to be forced to sell, the bank will have to show safe asset-liabilities ratios and decent tangible common equity. Values of an asset may be destroyed temporarily and unfairly by:
a) a lack of liquidity
b) a temporary confidence crisis
Is this all cosmetic? No. Should the above rule be passed by FASB? Yes. My reasoning: If a bank were to hold a group of assets, and they all lost value, why the need to write off the impairment charges all in ONE YEAR??? These are assets which, if they do not sell, will be part and parcel of the company for 5, 10 or 20 years. I see them as being equated to buying an office building or installing a manufacturing line - good or bad, you don't ask the company to write down the entire cost of the building or manufacturing in the one year!!?? You AMORTISE it over the life of the asset.
In the same vein of thinking, while I am in agreement that there should be changes to the mark to market rule, I do think there is a better way. If the bank holds a $1bn contract but its low liquidity over the past few months makes it trade at just 40 cents to the dollar, and the contract expires in 5 years - the current rule would force the bank to write down $600m in losses. This is severe as it whacks at the capital adequacy ratios immediately.
A fairer way is to look at the impairment charges over the life of the contract and amortise the known losses over that period. Hence the bank will only need to write down 600/5 = $120m of impairment charges this year, and remember to footnote how/why you did it in the reports. If the market improves the next year and the asset now trades at 60 cents to the dollar, then you do the necessary write back over the remaining life. Tell me if this is not a fairer way of reflecting reality.
A complete and sudden whack of impairment losses is not just a temporary accounting entry. Some may argue that they can writeback the gains when markets improve in the 3rd or 4th year - thats fine if the writedowns do not have a significant bearing on capital adequacy ratios. If you CAR drops from 11% to 1% because of a huge writedowns on assets (which you do not intend to sell until maturity), that bank will have to claw a huge amount of capital from somewhere else, raising new funds via placements or rights issue to satisfy the regulators. Two years on, the market improves and then they have excess capital now thanks to the writebacks. But raising $1bn in difficult times, and giving back $1bn in good times ARE TWO ENTIRELY DIFFERENT THINGS to the company and investors, they do not equalise each other out.
The yo-yo volatility effect on shareholders interest, especially dilution of minority interest, and more importantly, the way management is forced to run the bank with such extreme volatility NEEDS a complete rethink.
Hence its not a travesty to make changes to mark to market accounting. The thing is mark to market and the whole shebang known as fair value accounting is still a "work in progress". The current extreme crisis has basically showed its flaws and inadequacies. Fair value accounting today is inadequate and sub-standard, stop defending it as if its cast in stone and brought down by Moses.
Approval of changes by FASB will move the markets higher and add legs to the rally. Its really not just cosmetic or artificial as it will have a realistic effect on affected banks - they can delay raising capital in such difficult circumstances. I think I will send this as a premise for my Phd in accounting ...lol.p/s photo: Deborah Priya Henry
