In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Saturday, August 30, 2008

SFAS 157, Fair Value and Other Fairy Tales

by lama on 8/30/2008 07:39:00 AM

Every so often, the general public gets its pocket picked by some company or industry manipulating the rule of law. Enter the FASB. Sometimes they get it right the first time. Most times the FASB might rush a bit or underestimate the dark side of human nature a bit. So, we get a series of pronouncements. Sometimes they all mesh together well, mostly not. Different pronouncements often contradict each other and we (or I) end up in negotiations as to which pronouncement(s) are more relevant to a particular situation.
There’s been much discussion on various blogs about Fair Value Accounting. Proponents make an excellent point in that, what difference does it make what you paid for something? If you’re telling me, an investor, that you have a certain amount of assets on your books, prove to me what they’re worth. Not exactly a revolutionary thought to have. The fact is, this is what balance sheets have supposed to be reflecting all along. “Lower of Cost or Market” they called it back in school over the sounds of clicking abaci.
What really changed recently with SFAS 157 are the number of assets under fair value rules and the additional required disclosures, mostly footnotes, for Fair Value accounting for various instruments.
What types of assets should be subject to fair value accounting? Should a company revalue its land and equipment each year? Seems like a lot of work and expense. Corporations already keep two sets of books, GAAP and Tax. To be fair, the underlying transactions are the same for both, but the more in-depth analysis is performed by two separate groups of well paid employees, the Reporting Group and Tax Department. Fair value will involve hiring another group of accountants; perhaps not as large, but more expense.
What is the benefit? Fair Value isn’t going to mean much for internal operations. Some of the biggest opponents are US based manufacturers, headed by automakers. Does it matter what your plant’s equipment is worth? Not for internal purposes. It won’t help you analyze your business. In the case of Plant Equipment, not even the investors benefit much from fair value.
What types of assets should be valued at fair value? Most of us agree that securities are at the center. We’re now in the process of sorting out the values of nicely packaged garbage on banks’ books. Basic Economics and Accounting theory posits that assets should be valued at discounted future cash flows. Cash is the exit strategy for all assets. Nowhere is this more evident than valuing securities. With securities, we need to look at the intent of the owner; the exit strategy to convert to cash. So, the exit strategy defines the valuation method. For securities, this brings us to the three categories of investments; Levels 1, 2 and 3. Here are guidelines:
Current Name; Level 1
Prior Name; Trading Securities
English Translation; We're selling now
Valuation (exit); Market value, probably on an exchange
Current Name; Level 2
Prior Name; Available for Sale
English Translation; We’re selling if the price is right
Valuation; Market value, preferably on an exchange
Current Name; Level 3
Prior Name; Held to Maturity
English Translation; We’re not selling
Valuation; Cost, unless the loss is “other than temporary”.

The levels indicate how obvious or concrete the market comparisons, with L1 the highest. Do you see a trend in valuations? It’s ALL exit value. It’s all based on intent. The reason we don’t time value discount Level 1 and 2 securities is because the cash conversion is projected to happen now (or soon enough).
A bank is free to change its intent for any of these assets, and therefore is free to re-categorize any security for which it has changed its intent. If the bank doesn’t like the current market price, it doesn’t have to sell. Market Value/Fair Value doesn’t force the bank to take a fire sale price. Fire sales usually aren’t fair to the seller. Fair value is determined in an orderly market. Did we have a disorderly market earlier this year? It sure looked like one. So, we had a combination of banks taking hits in fire sales and moving securities to Level 3. These are the securities they thought they had passed off or would pass off to investors. There’s some karma in there somewhere, but that’s not my focus.
Side note: Temporary L2 asset losses are found further down on the Income Statement under Other Comprehensive Income (sort of purgatory place) where they do not get factored into P/E ratios.
Can banks now move these former L1 and L2 assets in L3? They sure can. SFAS 157 allows for the lack of a market for Level 3 assets and replaces the market with the inputs into measurement…good luck. The down market is surely going to be prolonged and the only rational valuation in the absence of a market is the future cash flows. What are those going to be? No one knows. Everyone has an opinion. For some grimacing TV hosts, that would be a small haircut from the terms and conditions of the underlying mortgages. Some of my esteemed fellow commentators would guess far south of that. Wall Street attempted to calculate the risk using an initially random, but reactive to trends, calculation system called “Monte Carlo Calculations”. The problem is, unlike Monte Carlo and decks of cards, the rules change when the inputs are unknowable and differ profoundly from historical inputs. ARMs were supposed to act as they always did when the borrowers’ information was reliable. My guess is at the retail banking level there are probably some neat and thoughtfully constructed Excel spreadsheets calculating with assumptions that could have just as well come from the phone book. It all involves unknown data (read SISA) and the projected behavior of millions of people with unique life’s situations. So, the values were unknowable. The values are only now becoming estimable through the painful discoveries we’ve made. Bear in mind that SFASs (including 157) function to shine a light on some dark places and make broad guidelines. It will not fix a broken market or a broken model.
I’ll tell you one thing I can’t quite figure out is why all these financial institutions have not been forced to restate earnings. If you made a zero down $500,000 loan to someone without checking his income or assets, can you now act surprised you didn’t get paid? Sarbanes Section 404 requires that management pay back their bonuses if they have to restate income negatively. It certainly has paid-off so far to look surprised. This does not bode well for SOX compliance by management in other industries.
Side note #2: SOX is mostly documenting procedures and identifying risks related to accounting procedures. It's similar to ISO.
If you made it this far without falling back to sleep, here’s a funny one. There was a rumor (published in a Finance trade magazine) about why FAS 157 was delayed. We all know that if Bank C owes Bank A some money, but cannot pay, Bank A will have to take a hit to earnings. Well, guess what? Bank C came up with the idea that this meant Bank C should record a gain for being a deadbeat. In fact there were several deadbeats cueing up to take their gains. Apparently the FASB put the kibosh on that. Who said bean-counting wasn’t fun?