Criticism of FASB Proposal Unfounded
The FASB released two proposed staff positions (FSPs) on Tuesday as expected to provide application guidance on determining fair value in inactive markets and on accounting for securities that are other than temporarily impaired. The FASB is seeking comments through April 1st on both proposals with the goal of finalizing at an April 2nd board meeting.
Information from the FASB and the FSP’s on the process can be found here:
http://www.fasb.org/news/nr031709.shtml
The two proposals can be found here:
http://www.fasb.org/fasb_staff_positions/prop_fsp_fas115-a_fas124-a_and_eitf99-20-b.pdf
http://www.fasb.org/fasb_staff_positions/prop_fsp_fas157-e.pdf
Jonathon Weil wrote a commentary for Bloomberg on March 18th titled “Accounting Brothel Opens Door for Banker Fiesta” where he calls the new FSP’s the dumbest, most bankrupt proposal of the “Fraudulent Accounting Standards Board’s” 36 year history. However, the basis for his conclusion is based on a misinterpretation of the proposals. Weil writes, “So, if these rules had been in place last year, a company that still owned shares of AIG or Fannie Mae, for instance could exclude those stocks’ price declines from net income entirely. It would make no difference that the companies were seized by the government last year, or they are both penny stocks. The loss would get buried away from the income statement, in a balance sheet-sheet line called “accumulated other comprehensive income.”
This is wrong. Actually, any loss related to an other than temporary impairment (OTTI) stays right on the income statement in the new proposal. In fact, the new proposal provides more transparency as the components of the loss are broken out between credit and non-credit components. Any investor would certainly find that information more meaningful.
Weil also suggests that under these rules, banks that hold shares of Fannie Mae would not be required to write those shares down to net income. This would only be true if they believed they were going to get all their contractual cash flows of the security back. Given that the accounting industry has banned Bernie Madoff’s accountant, David Friehling, from auditing, I don’t think you would find an accountant that would that accept that assertion.
In summary, the proposals will not change the carrying value of the security, the loss disclosed on other securities that are OTTI on the income statement, OR the reported capital on the balance sheet. It also doesn’t change significantly the way a security is determined to be OTTI. The only thing that changes is the amount of Tier 1 capital for regulatory purposes if you have a security that is OTTI. The loss related to non credit reasons is excluded from the Tier 1 capital calculation and thus, would increase the lending capacity of a bank.
“Mark to market” is the mainstream term for the accounting issues facing financial institutions today but the issues are a little more complicated than the mainstream debate which centers on “the new rule that requires all banks to write their loans and securities to market”. Many bankers have joked that during this last year they have all been forced to become accountants to better understand the issues. Journalists are trying to do the same and catch up in 6 months with the 5 board members of the FASB who have probably over 100 years combined dealing with these issues. If you listen to the board members debate over the proposals (which you can here )http://craig.teamline.cc/fasb_archive3 , you will walk away impressed with not only their grasp of the issues but how they debate them.
The “mark to market” issues are less about accounting and more about the interrelation between credit rating, accounting, and regulatory policies. Many residential mortgage-backed securities have real credit issues but the policies have created so many obstacles that virtually all buyers have been eliminated accelerating the pricing pressure on the securities. A trillion dollar + market has been orphaned and consequently many securities are trading far below intrinsic values. Until these issues are fixed, the securitization market will remain stalled. The FASB’s proposals are one positive step in this process.
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Subject: Mark To Market: The Market Price Is Wrong!
Financial crises are caused by wrong market price and the mark-to-market accounting method should be replaced by a correct solution of value, which determines what the price should be based on the expected future income, and not blindly follows the past data, even when the market has crashed.
The financial crisis occurs because the market price is wrong. Market participants using incorrect method of valuation will produce an incorrect market price. The market price will be correct when all the market participants, including, particularly, the government use the correct solution of value. However, the current market price is determined by incorrect solution of value.
The most common incorrect solution of value is the market comparison approach. It role in the financial crisis can be explained by the parable that “The blind follows the blind, until everyone falls off a cliff.” In theory, the price depends on the future expectation, not the past market price, which can be used only when future expectation has not changed, but future expectation will continually to change to infinity in time.
The correct solution of value uses an income approach where the inputs to the valuation system are obtained from market comparison. Only the price should not be compared to past prices; the price depends on the future income. The mathematically rigorous solution of value is disclosed in the patent “Quantitative Supply And Demand Model Based On Infinite Spreadsheet” (Pat. No. 6,078,901).
The calculated price based on the solution of value is generally different from the market price, which oscillates around the calculated price. The solution of value predicted the Savings and Loan Crisis publicly as early as 1984 when the market price became over-valued where the market price was appreciably greater than the calculated price. It predicted the Subprime Woe and warned the Federal Reserve in June of 2006 that the rising interest was approaching the decreasing, due to the increasing interest rate, investment rate of return, which should be greater than the interest rate in order for investors to borrow.
Even being wrong, the market price is the main hindrance to the public acceptance of the correct solution of value. The textbook definition of the market price that the price is what a buyer is willing to pay is only correct if the buyer is using a correct solution of value. During the Savings and Loan Crisis, nearly all the real estate appraisal authorities endorsed the correct solution of value and abandoned the three traditional approaches to appraisal, but the Crisis was solved politically with over $100 billion of money from the taxpayer.
Being mathematically rigorous, the solution of value is a non-violable law of nature in social science. Only mathematics can expose our blind faith in the market price. Nature is trying to teach us the non-violable law of nature, namely, the solution of value by punishing us with repeated financial crises. If we still refuse to replace the mark-to-market standard of accounting with the solution of value, admittedly a revolutionary change, we would again suffered in vain in the current financial crisis. 3/23/2009
Hey guys! I pretty much disagree with everything you have to say, and pretty much agree with Weil (but not entirely), but I think you’re very fair-minded and well-informed, and gave you a plug in my take on the issue.
In a nutshell, I would agree with you rather than Weil if and only if The-Too-Big-Too-Fail Boys could be trusted with the instrument you propose. They can’t. They’ve proven they can’t be trusted. End of story.
More:
Correctly Political Action Alert: Can We Stop The Deepening Fraud of “Unobservable Inputs”?!?