Regulate Derivatives? Start with Better Accounting!

I can usually find enough time to write only one post each week. Consequently, much of what I considered to be high-quality fodder is washed away by the exigencies of my real work. This week, however, had too many interesting news items, and I can't let them go without at least something said about each of them:

• The FASB's own Investors Technical Advisory Committee (ITAC) wrote a strongly-worded letter to the Financial Accounting Foundation decrying that current events have eroded the FASB's independence. Independence indeschmendence — the most telling aspect of the ITAC letter for me is the reference to the weakening of accounting standards that were "already inadequate." I'd say that taken as a whole, they are woefully inadequate.  That's because the FASB has never acted in an independent manner.  When pressed, it folds like a cheap suit.

• Joseph Nocera and Gretchen Morgenson, both of the New York Times, wrote separate stories (here and here) decrying glaring shortcomings of SEC enforcement activities. Nocera reports that the SEC staff has been measuring itself for far too long by the sheer volume of the number of cases it settles. Over a year ago, I wrote about that here, but I hope to revisit the issue soon again.

• Bob Herz, chairman of the FASB, addressed a broad range of issues in a speech to the National Press Club. Compare his remarks to that ITAC letter, and it should be pretty obvious why they don't appear to agree on very much. (I'm with ITAC.)

Floyd Norris, also of NYT, wrote of the issues facing policymakers ("Derivatives Tug of War Takes Shape") as they struggle to create new regulations and mechanisms for trading derivatives. That's my topic for this week.

Derivatives are Like Butchers' Knives

My father used to say that just because a butcher's knife could be used as a lethal weapon, that doesn't mean butchers should be required to have a license to use them. (Actually, I'm butchering his words slightly to make my point — sorry, Dad.)

The butcher's knife view of derivatives is that they are primarily used as 'hedging' instruments; and the opportunity to hedge risks promotes investment. But, there is a growing recognition that they have been too frequently utilized as weapons of mass economic destruction; and, unlike butcher's knives, should be regulated. First, they have been used to transfer risks to others who may not have understood the risks, due to lack of sophistication and/or transparency. Second, and to my view the more fundamental problem, is the way that managers "game" the derivatives accounting rules to accomplish personal objectives at the expense of shareholders.

Recent events are rife with examples of management's games, but they can be so complex as to obscure the basic point I want to make. So, here's a case I encountered some years ago during the course of a consulting engagement, which more plainly illustrates my point.

My client, let's call it OilCo, produced and sold oil and gas. For years, OilCo did very well by selling its output at prevailing market prices; shareholder returns were consistently above average compared to its peers because OilCo personnel were good at their job: locating reserves and extracting them efficiently. But, shortly after oil prices reached a level that had not been seen for a number of years, management made the decision to invest in crude oil forward contracts, effectively selling the company's next year's worth of production at a fixed price. Alas, in the first quarter of the ensuing year, crude oil prices continued to rise. Consequently, the fair value of their forward contracts declined, and OilCo's stock price declined as the rest of the industry moved up.

The key remaining detail of the case is that 'special hedge accounting,' which OilCo and other large companies strenuously lobbied for, did its job for management, even while they were destroying shareholder value. Reported earnings (and any management bonuses tied to earnings) were essentially the same as the previous year, even though oil prices were lower at that time. 'Special hedge accounting' worked because it enabled OilCo to defer the losses on those forward contracts until they could be offset by the higher revenue from actual sales.

By entering into a forward sale of its production at a fixed price, was management of OilCo hedging against future adverse changes in oil prices, or were they speculating that oil prices would decline? However you might answer that question (methinks they were speculating), I take it as given that OilCo's management would never even have considered selling the year's production forward without favorable accounting treatment afforded by 'special hedge accounting.' This strongly suggests to me that fixing the accounting rules may well be a precondition for any additional regulation of derivatives to be effective.

Norris correctly observes that even though the Obama administration's heart might be in the right place, the devil will be in the details of any new derivatives regulations; and there will be intense pressure from special-interest groups to ensure they'll be able to make chicken salad from them.  Although I am strongly in favor of enhanced regulation of derivatives, some of those details will be impossible to get 'right.'  Some of the concepts pertaining to derivatives are pretty amorphous; as the OilCo case illustrates, what may seem on its face to be hedging, may in fact be shareholder-value-destroying speculation.

And even stickier issue is determining the scope of the regulations. What, for example, is the difference between 'insurance' and a 'derivative' (especially a call or a put option)? And what the heck is a 'derivative', anyway? For example, is there a derivative when a manufacturer negotiates a 'take or pay' arrangement with a supplier for the delivery in six months of copper wire that it will use to make its product? Answer: 'Yes.' Will such a contract be regulated? Answer: 'No.' 

My point is that there is no principled distinction between financial derivatives and everyday transactions that may have forward and option components embedded in them. I fear that a major result of new derivatives regulation would be the creation of a new 'financial service' to assist clients with engineering transactions solely for the purpose of circumventing the new regulations.

That's why I believe that derivatives regulation should begin with getting the accounting right. Throw away FASB Statement No. 133's hedge accounting provisions and require that all derivatives be fair valued (I prefer replacement cost to fair value, but that's another story) with gains and losses going to earnings. To be maximally effective, the accounting rules should require that all assets and liabilities, especially those arising from insurance contracts, be fair valued with gains and losses going to earnings.

I will readily admit that getting the accounting right will not be a panacea, but given the trouble the Obama administration is having building a consensus on regulation, the accounting is clearly the right place to start. And, it could turn out that little more is needed.  As the OilCo case illustrates, managers generally eschew transactions that place their accounting-based bonuses at risk. So, if taking a derivatives position doesn't promise to sweeten future earnings, then fuggedaboutit. Fewer derivatives transactions will require fewer regulations.