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

Several years ago, I noted a press release about the appointment of a new Chief Accountant at the SEC. He was a retired partner from an accounting firm where I had also been a partner. At first, I thought this was a positive development. A top-flight accountant should ensure sensible accounting policies at the top GAAP regulatory agency. The first quote I saw from the new Accountant dissuaded me from this view. "I'm just a little old country boy who likes market values," came out of his mouth. I wasn't sure just what he meant. In the past, whenever I heard the phrase, "...Little ole'country boy," I automatically reached for my wallet. I, along with all publicly traded companies, soon found out exactly what he meant. He rigorously imposed the mark to market rule for invested assets such as bonds and mortgages. This approach had an immediate impact on balance sheets of banks, insurance companies, and other financial institutions. Until now, life insurance companies especially stated publicly that they sold long term contracts.

Therefore, on balance sheets, they had always carried the above types of invested assets at amortized value. The exceptions for insurers had been for: 1. The above assets deemed to suffer from permanent impairment. 2. Separate accounts tied to variable annuities and similar products, where matching assets had mostly been common stocks and where other types had also been carried at market values. The Chief Accountant touted the market value approach with a near-fanaticism. One exception was allowed, for an insurer that committed to having both the intent and ability to carry the above assets to maturity. However, if a company traded or disposed of such assets prematurely, there were significant penalties. These penalties seemed to spook the national audit firms. Whether it was deference to one of their own as the SEC's Chief Accountant, or actual fear of him, they seemed to recommend strongly against even thinking about the exemption to keep amortized cost. In the meantime, statutory accounting for insurance companies continued to stress amortized cost. Of six investment grade categories for the above assets, the lowest one was for those with permanent or very significant impairments. The latter would be carried at market value, but the great majority of such assets continued with amortized cost on balance sheets. 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 for traded values. One corruption of this approach was uncovered in the Enron bankruptcy. For exotic energy futures, no published market values were available. The pattern of future cash flows was basically unknown. Apparently, the company made up its own cash flow patterns and "market values" each quarter, using blatantly obvious balancing item approaches, rather than any objective attempts at cash flow estimation.

Redefined Mark to Market and Economic Turmoil Recent so-called economic turmoil really stems from accounting distortions. For many securities, recent trades have disappeared. Many securities, even though still performing, became temporarily illiquid. However, instead of relying on the present value of cash flows, a new interpretation of "market value," namely, liquidation or fire sale value, has been uniformly followed. Apparently, this has been an SEC interpretation of market value. The result has been that temporarily illiquid securities of banks and some other financial institutions were immediately subjected to drastic balance sheet writedowns. These carried over, of course, to retained earnings. Banks, brokerage houses, investment banks, and even insurance giants like AIG teetered on the edge of bankruptcy. Ratings were also impacted very negatively, due to these severe reductions in retained earnings and other measures of financial soundness. Mergers, government-enforced mergers, or government loans ("bailouts") have become the order of the day. In the words of Holman Jenkins, from a recent Wall Street Journal article, "Mark to Mayhem," "Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on a accounting writedown." With forced asset writedowns triggering much lower retained capital, this is exactly what has happened. Two other articles that also point the finger at bad accounting for the recent crisis are "Mark to Nonsense," by Steve Forbes in the 9 15 08 Forbes and "How to Save the Financial System" by William Isaac, in a recent Wall Street Journal issue. Some have said that investors, rating agencies and others deserve to know the current status of asset portfolios. In other words, they deserve to know what current "fire sale" values of securities are. One approach would be to disclose such values, together with management statements that these values are only temporary (assuming no permanent impairment) and do not reflect any intentions or need on their part to sell currently. On September 30, 2008, the SEC's current Chief Accountant issued Statement 2008-234. It stated that, in determining market value, the use of discounted cash flows was acceptable, even in the absence of recent trades. This extraordinary statement could be construed as a regulatory admission that its previous pronouncements in this area were dead wrong. In any event, it could have an extremely favorable effect on balance sheet and retained earnings values. Third quarter GAAP financials could show drastic improvements in results, due to revised market values, and institutions teetering on the brink of insolvency before could now how a restoration to health. The sad aspect of this could well be that such institutions were never teetering in the first place, but were victimized by bad accounting.

Current Developments A few days ago, Wells Fargo Bank put in a bid for Wachovia assets that was much higher than Citigroup's. The latter bid came before the abovementioned SEC announcement, restoring historical methods for determining market value. It could be very interesting to see if there is a link between the new Wells Fargo bid and a likely very significant, positive accounting change. Momentum for a government bailout of financial institutions started before the 9-30 SEC announcement. Most unfortunately, after one failure, a revised Bill was passed by the House on 10 3 08 (after Senate passage on 10 1 08). The total cost of the Bill is stated as a staggering $700 billion. Possibly, $350 billion of this is earmarked to Secretary Poulson for his purchases of "troubled" assets (at prices he apparently sets). IF market values rocket upward, after more reasonable accounting prevails, perhaps Poulson won't find many attractively priced assets. Those with permanent impairments would be covered by this Bill, to be sure. However, the likely government strings that would go with any purchase may make such transactions unattractive. One can always hope!

Summary The current "economic crisis," to be sure, includes an increase in permanently impaired assets. Mortgage defaults and other non-performing assets are noticeably higher than in recent years. However, the great bulk of the crisis is really due to bad accounting. In other words, it is an artificially induced crisis from regulatory impositions of fire sale interpretations of "market value," instead of the more rational one of present value of future cash flows. Financial institutions should be able to use the latter market values for balance sheet presentation of performing assets. Due to misuse of market value and recently prevailing fire sale values, these should also be disclosed in financial statements. Hopefully, rather than any "bailout," this approach to market values can restore investor confidence and ensure that our economy can ride out this scary setback.

Norman E. Hill, FSA, MAAA, CPA

Books By Hills

"Winner and Final Chairman"

What State Legislators Can Do About Our Nationwide Crisis

First, I realize there are many contributing causes of our problems:

These all served to make our economy unstable and volatile. Nonetheless, the one underlying cause was accounting, which makes this primarily an ACCOUNTING CRISIS. Fair market values for financial institution assets have been around since the 90s. However, sometime in 2007, the definition of market value, at least for collateralized assets, got corrupted to fire sale value. Management's judgment in computing the present value of cash flows could no longer be used to fair value assets - only valuations of "market participants." When trades of assets dried up, the only option left was use of fire sale value.

At the same time, the leading bank and probably other banks had been holding riskier assets off the balance sheet and not consolidating. Similar practices were followed by Enron, which all had the ultimate result of hiding true financial conditions from investors. Sometime in late 2007, this apparently changed and these assets had to be re-consolidated.

Accounting matches applied to an unstable tinder box set off the September, 2008 panic.

Arguably, some correction due to the above contributing causes had to take place. However, there are numerous fallbacks in place that would have provided considerable chance for a "proverbial soft landing" of the economy. With accounting changes as the last straw, this became impossible.

At the same time, and connected to the crisis, because of AIG's problems with non insurance subsidiaries, we have the fresh momentum for OFC.

Given all this, what can state legislators do?

Bring pressure to bear on your state accountancy boards. These control CPA licenses, even though we know the SEC and PCAOB agencies also exert great power. Demand that Boards in turn petition these two agencies and FASB:

Other demands are more well known, that basically involve your petitioning Congress or petitioning your own voters to petition Congress:

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