Accounting is something that most writers avoid like the plague. However, sometimes, even a tiny change in the way accountants view an item on the balance sheet or income statement may have a huge impact. I believe one such rule, called FASB 157, is behind the 60% gain in banking stocks last month and may also have fueled much of the 26% gain in the stock market this year.
The Connecticut-based Financial Accounting Standards Board is the nation’s arbiter in all things accounting. This prestigious, private-sector organization establishes financial accounting and reporting standards for America’s businesses and has an important influence on accounting worldwide. Over the last several months, the Board has been under enormous pressure from Congress and the Federal Reserve to establish new guidance on how companies can value assets on their balance sheets. The politicians and industry lobbyists want the nation’s banks to be able to use “significant judgment” when valuing the price of some investments on their books. Specifically, they are talking about the trillions in toxic assets like mortgage-backed securities that the banks hold and no one wants to buy.
Up until now companies were forced to value these assets at fair value or, put another way, mark them down to whatever the market will pay for these securities. If there is no market, then companies are required to use a similar asset sale. A few months ago, Merrill Lynch was forced to sell off $30 billion of toxic assets at 20 cents on the dollar in a very distressed market. Since then most companies have been using that sale as a rough model to value their assets. Many argue that isn’t fair, that the assets are worth more than that just not right now.
There is a third approach, in the event there is no market at all, in that case companies can use some valuation model, such as a discounted cash flow, to come up with a guesstimate. Unfortunately, this requires some assumptions which might be considered a “judgment” call. Ever since the Enron accounting scandal and subsequent Sarbanes-Oxley Act of 2002, few companies are willing to use any judgment at all in analyzing or accounting for these securities.
As a result, as the prices in these toxic assets fell further and further, financial companies were forced to write down billions each quarter in capital. Their share prices plummeted and it looked like there was no bottom to this dark well. But back in early March, the American Bankers Association and 65 congressmen urged the FASB to suspend or relax the rules at least temporally.
“Actually, the Board is only providing further guidance on ‘how’ not ‘when’ to use FASB 157,” explains Gary Schieneman, an old friend and former member of the FASB.
Gary and I worked together for years on Wall Street. He recently retired here in the Berkshires where he paints and teaches skiing at Catamount ski slope. He believes that what the FASB is doing is clarifying what constitutes an active market for selling securities and exactly what a distressed sale really means.
“As far as I’m concerned, it’s really not an issue of changing what is fair value, it just brings into the valuation process some additional means other than just market price.”
He does believe it will be good for the banks where some companies may even be able to ‘write-back’ some of the losses they have already booked in prior quarters. Some analysts on Wall Street are claiming that it could mean a 20% increase in earnings for the banks. However, Schieneman warned that only marketable securities would be included in this change and not the bank’s loan portfolios. He also advised investors to be careful with earnings expectations since not all of these changes will affect the income statement.
As for what the real value of these toxic assets is no one knows. Schieneman believes that these securities were probably discounted too heavily in the past.
“Yet, I’m certain of one thing they aren’t worth 100 cents on the dollar.”
Clearly, there will be more controversy and volatility before the market for these toxic assets comes into equilibrium but today’s actions will hopefully help this process.