THE BEAR'S LAIR The degradation of accounting
By Martin Hutchinson
Fair value accounting, by which debt and equity securities on a company's
balance sheet are "marked to market" - written up or down to their market price
- has been hyped by accountants and regulators as the epitome of modern
financial reporting, enabling investors to gain a completely true picture of
their investment's financial position.
Indeed, Gerald White of the Chartered Financial Analyst Institute, speaking at
an American Enterprise Institute conference on Tuesday, believes it should be
applied to all items on the balance sheet, not just financial instruments.
There is just one problem: in the turbulence of the past nine months, it has
completely failed to
work and has indeed shown itself to be pro-cyclical, encouraging economically
foolish behavior in both up and down cycles.
As someone who only thinks about accounting once a decade or so, I wasn't
really aware that much had changed from my business school days in the early
1970s. At that time, the values of assets on the balance sheet didn't move
much. Everything the company owned was dumped on the balance sheet at cost
price and stayed there for decades while the world turned. The only exception
was when the company held bonds or shares that had declined catastrophically in
value (the occasional wobble was ignored) in which case they were declared
"impaired" and their value written down.
The fun for analysts was in finding companies whose downtown real estate was
still held on the books at its value of 1926, when it had been bought, since
there just could be a little teensy-weensy asset profit that might be unlocked
from the company if one could figure out how.
This attitude to values was maintained through the inflation-accounting period
of the late 1970s and early 1980s. Assets were assumed to be held for the long
term, so buildings were written up by the movement in the consumer price index
between the asset's purchase date and the balance sheet date. US and British
accounts differed in their approach to inflation accounting, which may have
been one reason why it was abandoned fairly quickly once inflation returned to
single digits, but neither system attempted to "mark to market".
The mark-to-market approach had been used since 1940 by US investment banks,
holders of large numbers of tradable securities, that needed to convince their
regulators that their capital was adequate. It was not however used by British
merchant banks, equally holders of substantial amounts of tradable securities.
Only a small portion of merchant bank assets was held in a "trading account".
The remainder was held on a "back book" investment account and valued at cost.
In this way, merchant banks were able to manage earnings very effectively;
generally they built up large "hidden reserves" in good years which were
amortized into earnings in years of unexpected dearth, so that the overall
picture was smoothened. The result was to increase the confidence of the market
in each merchant bank; people assumed that 200-year-old institutions had
accumulated enough "hidden reserves" and undervalued real estate to smooth out
any problems that might arise.
Mark-to-market accounting spread beyond the traditional investment banks around
the late 1980s. Its great advantage, to executives who were for the first time
paid a large portion of their remuneration based on profits, was that values
could be marked up as well as down. No longer did you have to sell that
illiquid investment in order to realize a profit on it and be paid a bonus; you
could now recognize its increase in value on an annual basis. Conventional book
value accounting was derided as being old-fashioned and the original
acquisition cost of a position scorned as being hopelessly irrelevant to an
up-to-the-minute valuation.
The new accounting standard FAS157, propounded in September 2006 and coming
into effect for fiscal years beginning in 2008, codifies this trend but does
not materially alter it. Its most startling feature for a layman is that it
allows companies to mark-to-market assets for which there is no market.
Financial assets are divided into three "levels" according to their degree of
marketability. Level 1 assets are those for which a ready market exists, Level
2 assets are those for which a market exists for comparable securities and
Level 3 assets are those for which no market exists, which are to be valued by
use of mathematical models.
Artificial increase of 'market' values
In the use of this new standard by the investment banks, two problems have
appeared. First the Level 3 designation has given rise to all kinds of
model-building creativity, by which "market" values can be artificially
increased. Such is the ethical standard of Wall Street that this was done in a
number of investment banks during the bull market years before 2007, with the
resulting increases in value being taken into earnings and large bonuses paid
to executives in actual cash based on the imaginary increases in value. This
technique was particularly useful for private equity holdings, where the normal
procedure of holding the position until it could be realized and booking the
profit only then proved irredeemably boring to the impatient titans of Wall
Street finance.
The second problem that has now emerged runs in the opposite direction. "Level
2" valuation techniques allow the institution to ignore prices received in a
"distress sale". However, in a bear market almost all sales are distress sales;
the asset holder is distressed that his asset has declined in value and is only
selling it because he needs the cash.
Since the values of ABX indices on subprime mortgages have declined to a modest
fraction of par, holders of this rubbish have decided that they do not
represent the true market.
Consequently, in their view, there is no true market; consequently the assets
are Level 3. It is notable for example that Goldman Sachs' Level 3 assets
increased in the last quarter to $82.3 billion from $54.7 billion. Since it
seems most unlikely that Goldman, a smart operator if ever there was one, has
been deliberately loading up on $26.6 billion worth of illiquid rubbish, the
change must result largely from strategic reclassification from Level 2 to
Level 3. Indeed, Goldman's Level 3 asset-backed securities doubled during the
quarter to $25 billion, presumably for precisely the reason that Goldman found
unattractive the market prices prevailing for those securities.
At $82.3 billion, Goldman Sachs Level 3 assets are more than twice its capital.
This is not therefore a peripheral problem, which can be allowed to remain
hidden within the arcana of accounting conferences. The reality is that, as was
demonstrated in the true recessions of 1973-74 and 1980-82 but not in the mere
dips of 1990-92 and 2001-02, the value of highly illiquid Level 3 assets taken
on at the peak of a bull market is pretty well a big fat zero.
Insolvency down the track
Since the Michigan Consumer Sentiment Index is now at its lowest level in 26
years, it is beginning to become clear even to investment bankers that the US
and probably the world are in the early stages of a "proper" recession of the
1973-74 and 1980-82 pattern, albeit a recession with a considerable inflation
problem attached. In that event, the Level 3 assets on the balance sheets of
Goldman Sachs and other financial institutions are worth only a small fraction
of their nominal book value, and the institutions themselves will eventually be
demonstrated to be insolvent. So much for the supposed greater transparency of
"fair value accounting".
The shaky state of the world's major financial institutions is a matter of
history; their shareholders and creditors have been deluded by the fictions of
fair value accounting and the excitement and profitability of a prolonged asset
bubble. Repeated bankruptcies are probably the only fair way out; in practice
however most such institutions will be deemed "too big to fail" and the cost of
their rescue will fall on the world's long-suffering taxpayers.
At that point, the taxpayers should have something to say about the accounting
practices that made financial institution balance sheets and income statements
so illusory. Fair value accounting must go and be replaced by the much sounder
principle that pertained previously, that assets can and should be written
down, but must never be written up until they are sold.
If banks and investment banks wish to make a memorandum account of the fair
value of their investment positions, they should certainly be free to do so,
but increases in that fair value should not be brought through the income
statement until they are sold, and bonuses should not be paid on the basis of
such increases.
Accounting was invented in 15th century Florence (well, actually in Dubrovnik,
a dependency of Florence at that time). Another Florentine of that period,
Niccolo Macchiavelli, would instantly have recognized the attractions of fair
value accounting, enabling investment bankers to maximize their short-term
returns while leaving the long-term problems of an illiquid and clogged balance
sheet to be sorted out by regulators at the expense of the public. In the long
run, institutions that are "too big to fail" are also too big to take large
risks at public expense, and both their operations and their accounting should
be scaled back to the most conservative basis.
Their place will be taken by smaller institutions, not subject to bailouts by
the general public, and which will remain relatively unrestricted and will be
able to assume risks in order to innovate, albeit only on a modest scale as
befitting their smaller balance sheet.
In other words, the structure of finance, like the principles of accounting,
needs to revert at least 40 years; probably, in the United States, 80 years.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from
PrudentBear.com. Copyright 2005-07 David W Tice & Associates.)
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