IMHO, the move toward mark-to-market accounting, a gradual process through much of the 1990s and into this century, was a good idea, driven by business realities and, in its final stages, by a sensible reaction to the ludicrous bookkeeping of the late Enron Corp.
If a management's valuation model relates to reality it ought to be possible to get quotes backing that up. If it is not possible, then it is very likely management is either trying to pull something at the expense of somebody or has deluded itself, and neither possibility sounds like a sound basis for accounting rules.
"Oh, but some assets can't be sold right away except at fire sale prices!"
Market-based valuation doesn't require immediate sale. It is my understanding that conversations between corporate folk (CF) and auditors looking for GAAP compliance often go something like this.
CF: We can't mark these assets to market.
A: Why not?
CF: Nobody's buying them. So there's no market except a fire sale one.
A. How long do you think it might take you to get a non-fire sale price?
CF: Maybe six months.
A: So how much do you think you might be getting if you had started asking around for quotes six months ago?
That dialog comes (adapted by yours truly) from Einhorn's recent book.
With this, I leave the issue of mark-to-market accounting, and I'll try to get back to the chronicling of proxy fights next week.
Showing posts with label FASB. Show all posts
Showing posts with label FASB. Show all posts
Wednesday, April 29, 2009
Tuesday, April 28, 2009
Mark-to-market accounting III
Continuing.
On April 9 the FASB issued its final staff positions "to improve guidance and disclosures on fair value measurements and impairments," i.e. the modifications to mark-to-market.
You can see the relevant press release here.
Effects were felt immediately. Indeed, the changes were beginning to have an impact before they were finalized. I was at the Manhattan office of Kaye Scholer on April 2, the day the prelimary draft was under discussion by the FASB.
Kaye Scholer, a law firm prominent in the alt-invest world, was hosting a seminar on
“Using Private Equity and Hedge Fund Structures and Strategies to Invest in Distressed Assets.”
The consensus at the seminar was that the government, by pressuring the FASB in this direction, had cut off its nose to spite its face. For the same government was trying -- still is trying -- the get private party participation in what it calls the PPIP (public-private investment program), in which a government-organized consortium is supposed to buy 'toxic assets' from banks in order to hold them until their toxicity wears off ans re-sell them then at a profit.
In the meantime (so runs the theory) the sale of these assets by the banks will improve the balance sheets of said banks, making them more willing to make loans, and getting the wheels of commerce rolling again.
But for PPIP to work, mark-to-market accounting should still be in force. The significance of M2M is precisely that it gives banks an incentive to sell assets they aren't prepared to hold, and let somebody else, somebody more daring and speculative, perhaps a hedge fund, (or perhaps PPIP, a nineteenth century Brit lit figure in the form of a 21st century acronym) hold them instead.
The FASB decision, and other ongoing efforts by elected officials and regulators to relax mark-to-market accounting rules, would reduce banks’ incentives to sell distressed assets at prices that would make them attractive to private investor participants in the PPIP, and would thus undermining the viability of the program.
We haven't heard much from PPIP since. He's expecting a fortune from Miss Haversham but she no longer has any incentive to bestow it. (Okay, I've got the plot a bit wrong there, but I'm working with the 21st century template as best I can.)
Final thoughts on mark-to-market tomorrow.
On April 9 the FASB issued its final staff positions "to improve guidance and disclosures on fair value measurements and impairments," i.e. the modifications to mark-to-market.
You can see the relevant press release here.
Effects were felt immediately. Indeed, the changes were beginning to have an impact before they were finalized. I was at the Manhattan office of Kaye Scholer on April 2, the day the prelimary draft was under discussion by the FASB.
Kaye Scholer, a law firm prominent in the alt-invest world, was hosting a seminar on
“Using Private Equity and Hedge Fund Structures and Strategies to Invest in Distressed Assets.”
The consensus at the seminar was that the government, by pressuring the FASB in this direction, had cut off its nose to spite its face. For the same government was trying -- still is trying -- the get private party participation in what it calls the PPIP (public-private investment program), in which a government-organized consortium is supposed to buy 'toxic assets' from banks in order to hold them until their toxicity wears off ans re-sell them then at a profit.
In the meantime (so runs the theory) the sale of these assets by the banks will improve the balance sheets of said banks, making them more willing to make loans, and getting the wheels of commerce rolling again.
But for PPIP to work, mark-to-market accounting should still be in force. The significance of M2M is precisely that it gives banks an incentive to sell assets they aren't prepared to hold, and let somebody else, somebody more daring and speculative, perhaps a hedge fund, (or perhaps PPIP, a nineteenth century Brit lit figure in the form of a 21st century acronym) hold them instead.
The FASB decision, and other ongoing efforts by elected officials and regulators to relax mark-to-market accounting rules, would reduce banks’ incentives to sell distressed assets at prices that would make them attractive to private investor participants in the PPIP, and would thus undermining the viability of the program.
We haven't heard much from PPIP since. He's expecting a fortune from Miss Haversham but she no longer has any incentive to bestow it. (Okay, I've got the plot a bit wrong there, but I'm working with the 21st century template as best I can.)
Final thoughts on mark-to-market tomorrow.
Monday, April 27, 2009
Mark-to-market accounting II
On Thursday, April 2, the FASB met to discuss a new staff position, FSP, addressing the issue and in part modifying the system, addressing objections to M2M.
The FSP outlined how a reporting entity could determine whether a market is inactive and whether a transaction is not distressed in the sense pertinent to the application of SFAS 157. In terms of Angel’s metaphor, this is an effort to exorcise the ghost of Arthur Anderson from future auditor/reporting-entity interactions.
It established a two-step process. The first step involves the consideration of seven factors that would indicate the inactivity of a market. These factors are:
• Few recent transactions (based on volume and level of activity in the market)
• Price quotations are not based on current information
• Price quotations vary substantially either over time or among market makers (for example, some brokered markets)
• Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values
• Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared with reasonable estimates (using realistic assumptions) of credit and other nonperformance risk for the asset class
• Abnormally wide bid-ask spread or significant increases in the bid-ask spread
• Little information is released publicly (for example, a principal-to-principal market).
The proposed FSP said that the entity shall consider the significance and relevance of each factor, yet it cautions that the list is not all-inclusive; “other factors may also indicate that a market is not active.”
If the entity concludes after step 1 that the market is not active, it has created a rebuttable presumption that a quoted price is associated with a distressed transaction. Yet it must as step 2 consider evidence that would rebut that presumption. This would be evidence that (a) there was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset and (b) there were multiple bidders for the asset. If both of those factors are present, then the presumption of distress is defeated.
In the absence of one or the other of those defeating factors, the presumption of distress prevails. “When that is the case, the reporting entity must use a valuation technique other than one that uses the quoted prices without significant adjustment.
The board told its staff, "you're doing good work, but you need to go back to the drawing board and modify this a bit." That's actually my paraphrase.
Specifically, the board said the staff should “eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise.” The final FSP should also require an entity to disclose a change in valuation technique, and the related inputs, resulting from the application of this FSP and to quantity the effects of that change if practicable.
The FSP outlined how a reporting entity could determine whether a market is inactive and whether a transaction is not distressed in the sense pertinent to the application of SFAS 157. In terms of Angel’s metaphor, this is an effort to exorcise the ghost of Arthur Anderson from future auditor/reporting-entity interactions.
It established a two-step process. The first step involves the consideration of seven factors that would indicate the inactivity of a market. These factors are:
• Few recent transactions (based on volume and level of activity in the market)
• Price quotations are not based on current information
• Price quotations vary substantially either over time or among market makers (for example, some brokered markets)
• Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values
• Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared with reasonable estimates (using realistic assumptions) of credit and other nonperformance risk for the asset class
• Abnormally wide bid-ask spread or significant increases in the bid-ask spread
• Little information is released publicly (for example, a principal-to-principal market).
The proposed FSP said that the entity shall consider the significance and relevance of each factor, yet it cautions that the list is not all-inclusive; “other factors may also indicate that a market is not active.”
If the entity concludes after step 1 that the market is not active, it has created a rebuttable presumption that a quoted price is associated with a distressed transaction. Yet it must as step 2 consider evidence that would rebut that presumption. This would be evidence that (a) there was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset and (b) there were multiple bidders for the asset. If both of those factors are present, then the presumption of distress is defeated.
In the absence of one or the other of those defeating factors, the presumption of distress prevails. “When that is the case, the reporting entity must use a valuation technique other than one that uses the quoted prices without significant adjustment.
The board told its staff, "you're doing good work, but you need to go back to the drawing board and modify this a bit." That's actually my paraphrase.
Specifically, the board said the staff should “eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise.” The final FSP should also require an entity to disclose a change in valuation technique, and the related inputs, resulting from the application of this FSP and to quantity the effects of that change if practicable.
Sunday, April 26, 2009
Mark-to-market accounting I
SFAS 157, issued by the FASB in 2006, became effective for financial assets and liabilities issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. It defined fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition applies to assets that are held for trading – not to assets held for investment or to maturity.
From this definition of fair value follows a three-level hierarchy of valuation based upon the type of inputs available:
• Level One inputs include directly observable market data, such as quoted prices in an active and unimpaired market;
• Level Two is applied when a market is impaired (such as the market for bonds at mid maturity), and value is derived indirectly from the prices of Level 1 assets;
• Level Three is applied when the market is inactive (such as the market for mortgage-backed securities in recent months) and value can be derived from management projections and modeling.
For a more complete account, see “Mark-to-Market Accounting in the Absence of Marks,” The Hedge Fund Law Report, Vol. 2, No. 1 (January 8, 2009).
Many institutions have complained that this system, combined with the incentives of auditors, is far too niggardly in allowing managements to move down the hierarchy from one to two, and from two to three.
They found academic support too, for instance from James Angel, Associate Professor of Finance, McDonough School of Business, Georgetown University.
I spoke to Mr. Angel not long ago, and he asked me to consider a hypothetical asset that a bank or hedge fund has purchased for a dollar.
“The management believes in its heart of hearts that its present value is $0.75. But nobody is buying that sort of asset right now, except for a bottom-fisher who offers them a nickel. Under mark-to-market strictly applied, it is worth a nickel.”
But, Angel continued, the fact that management chooses to hold on to it is evidence that it is in fact worth more than a nickel. “Its value is somewhere between 5 and 75 cents. I believe in a mark-to-management approach that would explicitly take account of management’s own view of asset value.”
More tomorrow.
From this definition of fair value follows a three-level hierarchy of valuation based upon the type of inputs available:
• Level One inputs include directly observable market data, such as quoted prices in an active and unimpaired market;
• Level Two is applied when a market is impaired (such as the market for bonds at mid maturity), and value is derived indirectly from the prices of Level 1 assets;
• Level Three is applied when the market is inactive (such as the market for mortgage-backed securities in recent months) and value can be derived from management projections and modeling.
For a more complete account, see “Mark-to-Market Accounting in the Absence of Marks,” The Hedge Fund Law Report, Vol. 2, No. 1 (January 8, 2009).
Many institutions have complained that this system, combined with the incentives of auditors, is far too niggardly in allowing managements to move down the hierarchy from one to two, and from two to three.
They found academic support too, for instance from James Angel, Associate Professor of Finance, McDonough School of Business, Georgetown University.
I spoke to Mr. Angel not long ago, and he asked me to consider a hypothetical asset that a bank or hedge fund has purchased for a dollar.
“The management believes in its heart of hearts that its present value is $0.75. But nobody is buying that sort of asset right now, except for a bottom-fisher who offers them a nickel. Under mark-to-market strictly applied, it is worth a nickel.”
But, Angel continued, the fact that management chooses to hold on to it is evidence that it is in fact worth more than a nickel. “Its value is somewhere between 5 and 75 cents. I believe in a mark-to-management approach that would explicitly take account of management’s own view of asset value.”
More tomorrow.
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