Quantitative Easing and Mark-to-Market a Concern for Economists
In a recent New York conference, Nobel Laureate Robert Mundell, widely regarded as the “monetary guru” of conservative economists, spoke about quantitative easing and the recovery from the global financial crisis. Mundell surprised many when he said that deflation, not inflation, should be the greatest concern to the United States economy.
His comments relate to a discussion on the Fed’s reaction to the financial slump. Mr. Mundell said that the Federal Reserve’s decision to implement mark-to-market accounting in the midst of the subprime mortgage crisis is “one of the worst mistakes in its history.” Mark-to-market forced financial firms to cover short-term losses, a key component in the overall health of the bank. Mundell says this implementation exacerbated the problem, rather than eradicated it. The first bout of quantitative easing, which lowered the dollar against the euro, gave the economy it’s first sign of recovery, he said. But QE2, which lowered the value of the dollar and allowed the second leg of recovery to begin, was the wrong solution, he says.
IASB Notes Further Specification on Fair Value Standard
The International Accounting Standards Board (IASB) recently clarified its tweaks to the fair value measurement. In IFRS (International Financial Reporting Standards) 13, an update on the “Fair Value Measurement” rules, international and United States accounting policies took another step at converging to a single accounting standard. Though it does not mandate the use of fair value accounting, as many had fought against, it does lay out guidance on when and how the standard should be applied to IFRS-adopted companies.
The IASB called the standards update a “five-year consolidation project” that solidified the existing rules around mark-to-market, or fair value, accounting. “This is a standard that applies to any asset or liability that requires you to make a valuation,” said IASB board member Warren McGregor. The focus remained tightly trained on financial instruments, mostly due to the global economic slump. But it’s much wider than that, said McGregor.
Budget Office: Fair Value Increases FHA Cost
The Congressional Budget Office (CBO) compiled a report showing that if fair value accounting was applied to the Federal Housing Administration’s (FHA) 2012 budget, it would result in a $3.5 billion cost, rather than the $4.4 billion savings the program promised. The CBO began the report when Representative Paul Ryan (R-WI) asked for a fair value estimate and measurement of the FHA’s budget.
The current accounting method dates back to the 1990 Federal Credit Reform Act (FCRA). The CBO said its current method’s purpose is to “make the budgetary cost of credit programs equivalent to that of other federal spending.” But the CBO acknowledged that FCRA estimates have not always met their stated goals.
The CBO says the difference in methods comes down to the fair value calculation’s inclusion of a market-based risk premium. The CBO says fair value estimates recognize “the financial risk that the government assumes when issuing credit guarantees is more costly to taxpayers than FCRA-based estimates suggest.”
There is no word yet on whether or not the budget will be adopted or revised.
Economic Recovery at Two Years Running
It has been over two years since the United States financial market bottomed out on March 9th, 2009. Financial publication The Street reported on the financial regulation and gains that have led to this recovery.
The very first catalyst noted by The Street is the repeal of mark-to-market accounting rules. As banks lend based on the value of their reserves, lending was difficult as debt prices plummeted. Though often criticized for allowing banks, not the market, to determine the financial worth of their debt reserves, mark-to-market’s repeal has been noted as a key factor to the recovery, as banks could now lend freely.
Though mark-to-market’s repeal was only part of the recovery, as bank balance sheets were still struggling a year after the bottom-out. Federal Reserve Chairman Ben Bernanke’s Quantitative Easing programs, where the Fed would purchase Treasury bonds to pump more money into the economy, is the key follow-up to the recovery noted by The Street.
Regulators, Politicians Battle for Economic Recovery Credit
With a political shift in Congress and the economic recovery beginning, many have now tried to seize political points by claiming responsibility for the United States’ current financial upswing. A Seeking Alpha editorial by Brian Wesbury profiles this debate, saying that while certain elements of the recovery can be attributed to different areas, it has been entrepreneurs that provided the backbone to the recovery.
Wesbury criticizes Federal Reserve Chairman Ben Bernanke for his politicizing. Bernanke pointed to Quantitative Easing on the part of the Federal Reserve as a key factor in the recent recovery. Wesbury notes that the first round of Quantitative Easing began in September 2008, well before the market bottomed. “When mark-to-market accounting was changed to allow cash flow, instead of illiquid market prices to be used to value assets, the equity market bottomed. Once the accounting rule was ‘fixed,’ any risk of a Depression vanished and the economy started to recover,” says Wesbury. He continues to note that the 2004 interest rate drop (to 1%) exacerbated the over-investment in housing, which “never would have created a financial crisis if mark-to-market accounting had not been instituted in November 2007.”
Overall, Wesbury argues, it was political dealings that helped cause the crisis, but the American entrepreneur who really deserves credit for the recovery.
In Wake of Fair Value Assessment, Auditors Play Detectives
With financial reporting methods constantly in a state of flux, especially in global markets, financial auditors are kept on their toes. A recent Financial Timeseditorial by Adam Jones profiles auditor Ian Powell and his experience not just reviewing financial reports, but deeply assessing the overall health of a business to get a clearer picture of the numbers in the financial report. Powell disagrees with the notion that the “malleability” of auditors and subsequent oversight of unhealthy companies with impossibly healthy financial books signals an issue with the overall system. Rather, it comes down to basic reporting standards.
“Accountants also suggest that the evolution of financial reporting might have muddied the waters. There is now more subjective assessment by management of a company’s accounts, making verification less of a black-and-white issue,” says Jones. Areas like fair value assessment often yield vague or multiple answers that auditors are looking for. Auditors, now faced with increasingly robust but often subjective financial statements, are more apt to be skeptical in the interest of better performance. “On tricky areas, such as fair value assessments, there could be more of an onus on the auditor to push a company to disclose how it arrived at its figure,” says Jones.
Fair Value Looms as a Top 2010 Reporting Change
For 2010 year-end financial reporting, new fair value disclosures top the list of reporting changes to be mindful of, according to SmartPros, a business and legal information house. Although the Financial Accounting Standards Board (FASB) did not continue to press for its proposal that would require banks to list loans and most other financial instruments at fair value, there are still some fair value concerns and changes for 2010.
In 2010 reports, companies are now required to provide additional disclosures for items measured at fair value. Specifically, “significant transfers in and out of Level 1(quoted market price) and Level 2 (valuation based on observable markets) must be disclosed separately, along with the reasons for the changes.” Level 3 items (valuations based on internal information) also requires additional disclosure on purchases and sales. The FASB recently ruled not to exempt private companies from these new rules, a potentially time-consuming task for companies but an additional insight for investors.
FASB and International Accounting Standards Board (IASB) convergence rounds out the “Developments to Watch in 2011” list. Fair value measurement has been the largest sticking point in the two standards boards reconciliation of respective accounting rules.
Bernanke Defends Policies on Inflation, Mark-to-Market
the central bank’s purchasing of bonds to help aid the United States’ economic recovery. In a House Financial Services Committee hearing, Bernanke backed up his additional decision for “quantitative easing.” “What we’d like to see is a sustainable recovery. We don’t want to see the economy falling back into a double dip or to a stall-out,” he said.
Seeking Alpha writer Pater Tenebrarum recently shared an interview between Bernanke and Westwood Capital manager Dan Alpert at Bloomberg. In the interview, Alpert grills Bernanke on the nearly $3 trillion on mortgage loans that remain on the books of the United States banking industry. With many of these mortgages “under water,” Tenebrarum and others express concern that the suspension of mark-to-market rules in 2009 serves only as a patch until theseunderwater loans get better. Tenebrarum notes that this is the same strategy used in the past two decades by Japan, which has produced the “well-known results of never-ending economic stagnation and a fiscal debt that has grown to the sky.”
Bernanke remains committed, however, to more than $600 billion in treasury purchases.
Hussman Rips FASB on Mark-to-Market Decision
In his “Open Letter to the Financial Accounting Standards Board (FASB),” financial analyst and mutual fund owner John Hussman criticized the FASB’s decision to back off of its proposal that would have applied mark-to-market accounting to a broad range of financial instruments. Hussman, who is known as one of the few analysts who warned of an economic collapse well before the financial crisis, has frequently spoken out against the board.
Hussman rails against the move back to amortized cost in the letter, saying that the board ignored a procedure that would require and produce an adequate valuation due to banking industry pressure. “The FASB is a standards board. You are not running a popularity contest,” he says. The letter claims the FASB has shifted its focus to serving the banking industry insiders, and not the general public and investment community who rely on the board to apply fair standards.
The letter can be reviewed here: http://www.hussmanfunds.com/wmc/wmc110228.htm
Former FASB Chair Herz Steps Into Private Sector
(FASB) has stepped into the private sector as senior advisor at WebFilings, a company that provides technology for SEC financial filings. The technology startup, based in Palo Alto, CA and Ames, IA, also lists Eugene S. Katz, a retired partner and board member at Herz’s old firm PricewaterhouseCoopers, as a member of its senior advisory board.
Herz, who abruptly retired last autumn two years before the end of his term at the FASB, is best known for controversial proposals to accounting standards, most notably his proposal to require that financial instruments such as bank loans be reported at fair value. The FASB, now chaired by Leslie Seidman, has taken a more accommodating approach due to significant public comment against Herz’s proposal.
Even in the private sector, Herz remains very interested in accounting policy. His desire to streamline the process using technology is well noted. “I’ve long been an advocate of making better use of technology in the financial reporting process,” Herz said in a statement. He continued, “The WebFilings collaborative solution is a huge leap forward for financial reporting — a pioneering technology platform that takes a holistic approach to streamlining financial reporting.”
