NoraLyn Blogs Norm's Financial and Business Thoughts: June 2009

Summary

I endorse the view that our current "economic crisis" is actually, primarily, an accounting crisis. Apparently over the last year or so, a distorted view of market value calculations for the entire gamut of securitized investment financial assets has led to drastic writedowns of such assets by banks, insurers and other financial institutions While currently illiquid, the great majority of these assets were still performing.

The pronouncement that seems to have caused this debacle was a little-publicized Emerging Issues Task Force (EITF) Issue No. 99-20, prepared by the Financial Accounting Standards Board (FASB). Although the present value of cash flows was still officially the primary method for determining market values, for the above invested assets, management judgment could not be used in measuring market values. Instead, trading values from "market participants" had to govern as defacto present values. However, the key SMOKING GUN was the implication was that if trades had tried up, and market participants were not available, fire sale values, that is, the lowest emergency sale prices obtainable, had to represent market values.

This has led to drastic writedowns of securitized mortgage assets and related types. Audit firms have apparently applied Issue 99-20 as gospel and have relentlessly required this interpretation of market values. After the Lehman bankruptcy, AIG and Citigroup, for example, had to receive massive government aid to stay afloat. No one claimed that massive defaults were occurring or imminent in their asset portfolios, but prevailing illiquidity had now decimated their balance sheets and surplus positions.

Last September 30, the Securities and Exchange Commission (SEC) issued Release 2008-234, which seemed to overturn this EITF. However, no explicit required change was made. Now, the FASB has proposed a new "FASB Staff Position" which would remove the "market participant" requirement from Issue 99-20 and allow once again the use of management judgment in determining present values.

Based on a provision of the massive bailout Bill, the SEC is studying the entire question of market values. It is supposed to issue a draft report by January 2, 2009, at about the same time that FASB may issue a final version of the FASB Staff Position that amends Issue 99-20 in a more reasonable manner.

Unfortunately, the damage done so far seems to be incredible and perhaps incalculable. If a commission is formed to investigate who and what caused our financial crisis, hopefully, the above accounting cause will be highlighted in great detail.

Background

Several years ago, I noted the appointment of a new Chief Accountant at the SEC, a retired partner from an accounting firm where I had also been a partner. His opening quote emphasized how enamored he was of market values. Soon after, he rigorously imposed a mark to market requirement for invested assets of banks and insurers such as bonds and mortgages.

This approach had an immediate impact on balance sheets of these financial institutions. Until now, life insurers at least had stated that they sold long term contracts. Therefore, their holding values had been amortized cost for these types of performing assets. The new market value requirement still allowed the amortized cost approach for insurers who documented that they had the intent and ability to hold these assets to maturity. However, if a company traded or disposed of such assets prematurely, there were significant penalties. Whether national audit firms deferred to one of their own as the SEC's Chief Accountant or not, they seemed to recommend strongly against even thinking about the exemption to retain amortized cost.

Until recently, there was little controversy as to HOW to compute market values. Prevailing trades were often available with published market values. If not, the present value of cash flows, using a prevailing discount rate, could be used, since this, at least implicitly, was the basis of traded values.

One corruption of this approach was uncovered in the Enron bankruptcy. For exotic energy futures, no published market values were available and patterns of future cash flows were basically unknown. Apparently, the company made up its own cash flow patterns and resulting "market values" each quarter, using blatantly obvious balancing item approaches for earnings objectives, rather than any objective attempts at cash flow estimation.

Also, at least one of the largest banks had apparently transferred much of its securitized asset portfolio to related entities that somehow were never included in its consolidated financial statements. Therefore, the question of proper market values did not arise for such assets.

Current Turmoil and Search for Causes

Today, the basic question is, what is fair value of invested assets, when trades have dried up and assets that are still performing are illiquid? The SEC’s release from its Chief Accountant office, 2008-234, of 9-30-08 (aided by the FASB staff) stated that the present value of cash flows was acceptable as fair value, even in the absence of recent trades. Shortly after the release, I reviewed FASB Statements dealing with market values, including No. 115, 144, 157 and Statement of Concepts #7. They all seemed to say the same thing, that fair value or market value was the present value of cash flows for still-performing assets.

Yet, in several articles, I read bitter complaints that banks, AIG, and other financial institutions (not mentioning other insurers) were being forced to apply fire sale values to these types of still-performing but illiquid assets. These articles included:

"Mark to Mayhem," by Holman Jenkins, WSJ, c. 10-1-08, in which he says, "Under current interpretation of accounting rules, banks can be obliged to value loan holdings based on their liquidation or fire sale value, even if (as now) the fire sale values are lower than might be suggested by the cash flow and payoff prospects of the underlying assets."

"How to Cure This Sick System," by Steve Forbes, Forbes, 10-6-08, "Think of the mark to market madness this way: You buy a house for $350,000 and take out a $250,000 30 year fixed mortgage. Your income is more than adequate to make the monthly payments. But under mark to market rules, the bank could call up and say that if your house had to be sold immediately, it would fetch maybe $200,000... The bank would then tell you that you owe $250,000 on a house worth only $200,000 and to please fork over the $50,000 immediately or else lose the house."

All these articles seemed to say that the fair value approaches in the above mentioned FASB Statements were not being followed. In related regulatory correspondence with the National Association of Insurance Commissioners, two different interpretations from audit firms seemed to require fire sale accounting for fair value. One of the two statements seemed to say that this was the current status quo for GAAP fair value.

I found one quote from a practitioner that seemed significant. In an 11 24 roundtable discussion on market value accounting, Jay Hanson, director of accounting at McGladrey & Pullen, described the difficulty of looking into the future based on past value. "That’s hard to do when a CPA is being criticized by the PCAOB...You go to the lowest number and be fairly conservative because that’s what Congress has asked us to do."

Given this statement, I wondered whether the SEC and/or PCAOB previously mandated this more stringent approach to market values. If so, were there earlier releases from these two bodies that mandated it, or were there instances of "desk drawer" bureaucratic bullying on case by case bases? So far, I have found no direct evidence of either.

Alternatively, given the indictment of two large audit firms, Andersen and KPMG (albeit for tax issues), and the abuse of the market value concept by Enron, are auditors so panicked that they automatically require the most onerous answer in the absence of specific regulatory permission to apply judgment?

Contentious Comments Without Resolution

In a 12-19-08 Wall Street Journal article, "Going on Offense with Mark to Market," the FASB vigorously defended mark to market accounting. The organization announced it was making a detailed study of this accounting and implied an actual push to expand market value accounting to include bank loans. It further implied that the current approach of original cost less a reserve for losses may be inadequate to cope with poor bank lending practices.

I noted a few assertions that our current economic crisis was actually an accounting crisis. However, this usually led to passionate attacks on mark to market accounting as such. Usually, this was followed by equally passionate defenses of the fair value accounting approach.

I realized that there were other causes of the present economic crisis. To name a few, faulty loan underwriting by banks, required issuance of subprime mortgage loans under the Community Reinvestment Act, over-concentration by financial institutions in risky loans, availability of Fannie and Freddie to absorb risky loans until even their financial capacity dried up and issuance of exotic assets such as credit default swaps that were not completely understood by issuers, have all played a part.

In a 12-22-08 New York Times article, as reported by Fox News, the writer explicitly blamed the Bush administration for the "mortgage meltdown." There were related controversies in response, as to which administration, Bush or Clinton, had done the most to encourage lenders to expand mortgage availability irresponsibly. But here, the main unanswered question was "what meltdown?"Mortgage values on lenders' balance sheets were down significantly, perhaps drastically, but were actual defaults and foreclosures so much higher as to constitute "meltdown?"

Unfortunately, there seemed to be a wholesale lack of zeroing in on the critical question - if FASB Statements called for the present value of cash flows as fair value, how did fire sale value apparently come to be applied so extensively and even defended by audit firms? No mention was made as to why the present value of cash flows, reasonably performed, should not be the market value approach to test against original cost. More to the point, no mention was made about whether fire sale valuations representing market values caused problems in the first place. Illiquidity of balance sheets was still a problem that deserved disclosure to investors and regulators. But wouldn't the traditional approach to market values have allowed for a form of "soft landing" and gradual corrections to balance sheet values instead of unnecessary panics and drastic writedowns?

The Real Culprit and What to Do About It

After all the uncertainty, few days ago, I read articles about the FASB's proposed revisions to EITF Issue 99-20. Now, under a revised FASB Staff Position, this revision will rank higher in the FASB’s hierarchy, alongside its Statements. Finally, the real culprit, an FASB Task Force pronouncement that did not even have the highest ranking within that body's hierarchy, seemed to have been uncovered.

If management judgment will again be allowed in determining market values for the above assets, will this cause a very significant improvement in financial positions of banks and other institutions? If many of these assets (as much as $350 billion, about 50% of the bailout amount) have been transferred to the government or somehow disposed by Paulson, can an accurate, meaningful reading ever be made?

In an explosive situation like this, the tendency to cover up past mistakes is always present. If the accounting profession overreacted and required widespread distortions to market value, it can be understood to some extent. Since they are now subject to PCAOB as well as SEC oversight and second guessing, not to mention vast lawsuits, they may well be terrified of use of judgment instead of prescribed rules, such as for market values.

The Community Reinvestment Act and other government pressures from numerous agencies were clearly the cause of the mortgage overexpansion. The accounting profession's fear of the PCAOB and SEC may well have been cause of pronouncements such as 99-20. If distorted accounting rules and requirements for market values were the primary causes of our economic downturn, they should be highlighted. But underlying government pressures on the profession should also be disclosed.

Today, the main task is to make sure that all causes are properly identified AND ranked, so as to minimize chances of future repetition.

The above views are my own and are not necessarily those of any professional organization.

Norman E. Hill, FSA, MAAA, Member AICPA, ASCPA

Norm's Thoughts

Books by Hills
Winner and Final Chairman

All these pockets of instability, combined with unprecedented economic and stock price growth in the U.S., meant that some corrections had to take place.

Accounting Haymaker

The above conditions meant that corrections were needed. However, the additional "fly in the ointment," the "last straw," or whatever term, was arguably a key accounting rule. Market value requirements for most invested assets of banks and other financial institutions had been in place for some time. Now, a subtle change in the rules had taken place. Along the way, the definition of market value had changed.

A little noticed Accounting pronouncement, EITF 99-20, stated that, in computing the present values of cash flows for securitized assets, the basic determinant of market values, management estimates, could not be used. Instead, "market participants" could be the only determiners of market values. By implication, at least, if there were no market participants, only net current realizable value (realizable immediately) had to serve as market value.

At the same time, due to related economic conditions, availability of the elusive market participants was drying up. Cash flows thrown off from these securities were showing some strain, but were by no means falling apart. Some noticeable reductions in market values would surely have occurred, if objective management-determined present values of cash flows could have prevailed. Instead, net realizable values at that point in time, drastically reduced fire sale values, were required by auditors as balance sheet market values.

Balance sheets included, of course, surplus. Both were hit in dire fashion by reduced asset values. Often, required surplus or capital values for banks and required values for loan collateral became violated by the sudden, unprecedented strain on asset and surplus amounts.

Very likely, sharply reduced realizable values deserved disclosure in financial statements. Investors could make their own decisions about the viability of financial institutions. But, this would have been a big difference from balance sheet hits themselves.

Widespread bitter complaints about fire sale accounting were made in journals, by respected columnists. If the government had listened to them, it could have mandated to the SEC and FASB that sensible accounting and valuation practices had to be followed. There were still no reports of widespread collapses of riskier assets, even of credit derivative swaps. Return to management determinants of present values of cash flows might well have kept the situation in hand.

Current Time Tumult

Massive government bailouts of banks, AIG and other financial institutions have not eased market uneasiness or, apparently, the financial conditions of these organizations themselves. Even though the SEC and the FASB have apparently backed off on the above draconian definitions of market values, there are no indications from banks and others that they are taking advantage of liberalizations. Instead, there is a continued call for more bailouts.

A newly proposed variation of bailouts is government purchase of "troubled" assets from banks and other financial institutions. These assets are sometimes called "toxic" or "risky," but the flat out description "in default status" has not been used as yet (with the exception of direct bondholders or stockholders in Lehman).

Other segments of the economy, such as the Big 3 automakers, have also lined up at the federal trough for bailouts. These companies were clobbered by the summer gasoline surge, which greatly lessened sales of their highly profitable SUVs. Now, with prices back to normal, they have apparently not gone back to past manufacturing output of SUVs. With their uncompetitive UAW contracts and benefits, they cannot compete with foreign automakers, on any basis short of past SUV output and sales.

The Big 3 (that is, two of the three) certainly should not have received such bailout. If the government had stepped in with aggressive investigation of causes of summer gas spikes, it might have been able to thwart some of the economic pain for them, airlines, and others.

Conclusions

In summary, several government actions in the summer and fall of 2008 could have mitigated the economic panic. Instead, massive bailouts and government intervention have made matters worse. There is no admission whatsoever that all the above Big 10 (Infamous 10) government actions initiated the treadmill of instability in the first place.

Worst of all, both the SEC and FASB are passionately defending market value accounting, without ever admitting to the fire sale corruption of market value that, at least for a while, had been mandated. This means that there is a widespread blank out of the possibility that continuation of prior accounting rules could have allowed a soft landing, instead of serving as the economic last straw.

For the long term, the solution is to remove all the government controls and programs that promote this inherent instability. This cannot happen in just one generation. In the shorter run, I believe the only course is to buy time--buy time for as much stability as possible, in the hope for eventual removal of controls. Avoiding knee jerk impositions of new programs and regulations, whether from governments or accounting rule-makers, that demolish uneasy stability is one absolutely essential ingredient.

To an extent, it can serve as a trap to dwell on what could have been. But often this is the only way to have a chance to avoid the same mistakes in the future.

The above views are my own and are not necessarily those of any professional organization.

Norman E. Hill, FSA, MAAA, Member AICPA, ASCPA
Norm's Thoughts
Books by Hills
Winner and Final Chairman