Peeling away financial reporting issues one layer at a time

Ten Reasons Against Mark-to-Market for Loans – and the Reasons Why They are Wrong (Part 2 of 2)

Continuing my previous post, here's reasons 6 – 10 with my responses.

6. There are also hedge accounting considerations. Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief. Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

Inflation is a real risk, and it is independent of management's free choice in their accounting for that investment. Ironically, the risk of greater-than-expected inflation is greatest in the presence of such a pledge to hold to maturity, yet through existing hedge accounting rules management is discouraged from entering into a hedge to reduce the risk of excess inflation on the purchasing power of its future cash inflows. This is because the gains and losses on the hedging instrument would actually increase the volatility of accounting earnings, while the effect of the hedge would be to reduce the volatility of economic earnings!

If all investments in debt instruments were marked-to-market, then management would choose the economic hedge that best fits the circumstances of the enterprise; they could choose to hedge default risk, inflation risk, prepayment risk, or whatever other risk that concerns them without worrying about silly rules regarding arcane accounting definitions for "macro hedging," "hedge effectiveness," documentation requirements and more. Management would also not feel a push one way or the other toward a particular brand of "hedging instrument."

7. The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory. Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem.

Actually, agency costs can occur because one party, usually the agent, is able to observe economic earnings (and take for itself an undeserved share of those earnings) because the principal cannot measure economic earnings as precisely and completely as the agent. Thus, accounting rules that deliberately distort economic earnings create agency costs, and not vice versa.

Exhibit A for the case that historical cost is the real purveyor of agency costs is the thankfully defunct SFAS 76 and related literature on accounting for an "in-substance defeasance" of debt. Basically, managers wanted to report gains upon early retirement of their bonds, which of course were measured at historic proceeds instead of being marked to market. (Obviously, the yield to maturity of those bonds had increased subsequent to issuance for whatever reason.) Those managers were prevented, either practically or contractually, in many circumstances, from retiring those bonds.

So, special interests did whatever they needed to do to get the FASB to permit in-substance defeasance accounting even if the bonds were not actually retired. The process was pretty straightforward: if enough dough were transferred into essentially riskless, irrevocable trusts whose funds could only be used to make payments to the bondholders, management could get their gain accounting upon funding the trust.

The economics, however, effectively transferred wealth from shareholders to bondholders for no other apparent reason, except to juice reported earnings. Essentially, the bondholders received a windfall gain, because their risky bonds on which they were earning a risk premium, all of a sudden were backed by a fully funded, risk-free trust account. In other words, they were still earning a risk premium without being exposed to any risk! Of course, after the FASB rescinded SFAS 76 et. al., the in-substance defeasance game became a lot less interesting.

My point is that agency costs are minimized when accounting reports economic income. Management can use the opportunity to report fictitious earnings to screw anyone they can: bondholders, employees, shareholders, whomever. Other examples include retiree healthcare costs (mentioned earlier) and compensation via stock options. In all of the cases I can think of when bad accounting became less bad, abuses lessened significantly.

8. We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.

It is quite possible that this "purchase contract" could become a derivative within the scope of FAS 133, and thus measured at fair value, if net cash settlement were required or permitted on each delivery date, instead of physical delivery of paper. In other words, it is currently required (and noncontroversial) to report "fiction" for complex derivatives, but not for other complex (and even less complex) debt instruments, or lease contracts, or purchase contracts, etc.

I am not proposing that we abandon FAS 133's requirements to measure complex derivatives at a current value, but rather to say that if we can tolerate "fiction" for derivatives, I'd like to know why we shouldn't tolerate it for other contracts.

Furthermore, I can only conjecture that the two parties to this transaction would not have entered into it, or at least modified it significantly if it actually did fall within the scope of FAS 133 or some other requirement to measure it at current values. Maybe, instead of Regis providing Dow Jones insurance that the price of paper won't go to high, a more appropriate arrangement would be made with a properly funded financial institution.

The only way to fix this sort of agency problem is to require current valuation of all legal obligations to make future deliveries of goods or services. I know it sounds drastic, but I believe it's necessary, and at least in the arena of lease contracts, the FASB is finally acknowledging that ignoring such contracts by calling them "operating leases" has benefitted only management and its "financial consultants."

9. Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted. One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.

Again, my response to the valuation problem of the debtor/obligor is to mirror the replacement cost measurement exercise of its counterparty.

10. Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees — that's the ultimate loss.

Actually, on an aggregate basis, I am not sure that clients are actually paying audit fees even today. Each year, the increase in the Big Four's liability exposure (including interest) may be outstripping the fees that they are supposedly earning with audits that do little more than provide legal cover for corporate executives to lay claim to as much of the shareholders' money as they can get away with. Shareholder suits are threatening to bankrupt every single one of the Big Four, and ironically, a more stable (albeit less lucrative) future for audit firms can be found in mark-to-market accounting. This may be a stretch, but I read a wonderful quote of Upton Sinclair (courtesy of Paul Krugman) just today: "It is difficult to get a man to understand something when his salary [or, Krugman adds, his campaign contributions] depends upon his not understanding it."

Even in the absence of a change in measurement attribute, the SEC needs to radically think about the kind of assurance services auditors should be providing on financial statements. As just one example, what is the quantum of investor protection that is added when an auditor documents in its workpapers that the management of Bank XYZ has made an estimate of its loan loss reserves that "appears reasonable"? In place of a rubber stamp from auditors who, despite what any law might provide, can be fired by management virtually at will, I would prefer to be furnished with an independent appraisal of the replacement cost of the loan portfolio, prepared without the involvement of management. Auditors should go back to what they most often do well: count cash: test calculations; confirm receivables, payables, debt amounts and inventory counts; and little else.

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That's all, folks. Here's hoping that whatever the outcome of the debate on loan valuation, it will consist of more than pure politics. As the anecdote from Clarence Sampson indicates, capital markets regulators have been pushing for improvements to bank accounting for ages, with improvements being grudgingly conceded in decades-spaced drips and drabs. Now, finally, the FASB is aiming higher. Let's see whether they can score a hit somewhere in the vicinity of the bulls eye.

1 Comment

  1. Reply Raza August 25, 2009

    Hi Tom – thank you for a yet again excellent magun opus)post from you, and also thank you for keeping us up to date on the developments as well. The debate – as you have alluded to -is part political and part technical. What I mean by this is that there are some who are well aware of the effect that inflation does and can play even if the loans are paid in full but for obvious reasons don’t want to take that route- and then there are those who simply don’t understant it (And hence Uton’s Quote here :)) because they are too used to counting cash : ) I would just join you in hoping that “whatever be the the outcome, just hope that it turns out to be more than pure politics.”

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