Can Auditors Help Save Spain’s Banks? Nuts!

Less than a day after posting my critique of the FASB and IASB loan loss allowance proposal, I happily learned that the FASB may be backtracking. According to a PwC In Brief:

"After considering the results of outreach efforts and constituent feedback, the board unanimously agreed with concerns that aspects of the "three bucket" impairment model are complex and difficult to understand. As a result, the FASB will not move forward with an exposure draft on the "three bucket" impairment model …

The FASB's decision to explore a revised approach could result in an impairment model that differs from the IASB's model. During today's discussion, certain IASB members indicated that they have heard much less concern about the "three bucket" impairment model and therefore, plan to move forward with that approach. ….

It is unclear at this time whether the IASB will move forward with an exposure draft in the near term, or whether the IASB will first consider any revised proposals from the FASB." [bold italics supplied]

Dare I now hope that the FASB will ultimately rediscover the wisdom of measuring loans at market-based values? I would be more optimistic that reason might prevail if the newest three board members hadn't been specially chosen by the powers that be at the Financial Accounting Foundation to be dependable opponents of market values for loans.

In an unrelated event, but telling nonetheless, the Wall Street Journal published a few days later a very perceptive and perspicuous article, by Gabriele Steinhauser, discussing the approaches the EU might take for bailing out Spanish banks. The gist of the article is that "a team of private auditors is rummaging through the books of the 14 largest Spanish banks to determine…" the amount of the loan losses. Nuts.

I recommend that you read the full article, but for the points about the auditors' role that I want to make, it is sufficient to know the following, which in any case is somewhat oversimplified:*

• The European Financial Stability Facility (the bailout fund that is backed by guarantees from the Eurozone member states) will lend €100 billion to Spain for a bank bailout.
• An uncertain amount of the investment, perhaps €25 billion, will be used to capitalize a 100%-owned "bad bank," which will purchase the junkiest of junk loans from the banks.
• The amount not invested in the bad bank will be contributed to those pretty-awful Spanish banks, probably in exchange for some form of TARP-like equity.
• "Each lender's needs will depend on how much it is likely to lose on its part of some €200 billion in loans the banks made to property developers and other boom-time real-estate investors." Presumably, the audits are supposed to help determine these amounts.

I Said "Nuts"

First, whether new capital comes from private or public sources, the valuation question pertaining to an investment should be the same. An investor should want to know how much one could pay for identical or similar assets if they were acquired some other way. Yet, the auditors it seems are not being asked to provide an answer to that question. Instead, they are tasked with estimating: (1) how much cash could be scavenged when (or if) the Spanish economy rebounds within a reasonable time period; and/or (2) the current sales value of the banks' portfolios of loans and abandoned development projects.

Some months ago, I was amused to watch Angela Merkel and Nicolas Sarkozy debating on TV an accounting question: the size of the balance sheet haircut that EU banks should take on their holdings of Greek bonds. Such discussions of paper losses or sale values for asset positions that won't be sold can make for interesting political theater, a play which seems to have been remounted in Spain.

Unfortunately, the real economics of the situation facing Spain and its fellow EU members is much less like theater and much more like surgery without anesthetic. Time marches on and risk is high; hence a simplistic cash-in-cash-out view of gains and losses is far from the transparency that taxpayers, or any other investor, need and deserve before committing one's money to a risky venture that is perilously close to a hopeless cause.

Second, whatever the measurement objective, auditors have no demonstrated competence to produce estimates that policymakers/investors can rely on. If you want a valuation, ask a valuation expert. If you want to understand future cash payment scenarios, then ask an economist. Very simply, and with absolutely no disrespect intended, auditors don't possess the depth of training in asset pricing methodologies or econometrics to do this critical job right – which if not done right could spell the end for the euro.

* * * * *

I see a pattern here. Both the ECB's bailout plan of Spanish banks and the IASB's three-bucket approach to measuring loan carrying values are misguided and inappropriately dependent on the competencies of auditors — who even with the best of intentions lack the requisite training to evaluate a market value much less an ineffable reserve estimate.

Maybe this is the case study that can convince the FASB that it should leave the IASB and the EU to its own devices when it comes to loan accounting.