Attention: This may be the single most important piece of news regarding the financial industry you will read this week. Maybe for the whole month. Maybe for the whole year. Okay I'll stop being melodramatic and get right to it. The Financial Accounting Standards Board (FASB) is in the process of making banks very unhappy. In a complete reversal from their revised policy released in April, it is considering vastly tightening mark-to-market requirements to include virtually all securities on a bank's balance sheet. Yes, it even wants the very, very illiquid stuff marked-to-market.
To understand a bit more about what how assets are valued, this entry I wrote a while back may help. Mark-to-market is an accounting concept requiring that banks mark the value of the assets on their balance sheets up or down depending on how their values change in the market. Right now, very illiquid assets do not have to be marked-to-market, so instead can be valued by the bank using internal assumptions.
Here's a blurb from FASB's July 15th board meeting:
The Board agreed to propose that all financial instruments will be presented on the balance sheet at fair value with changes in value recognized in net income or other comprehensive income with an optional exception for own debt in certain circumstances, which will be measured at amortized cost.
Why almost no one is reporting on this shocks me, because it's a huge deal. FASB is suggesting that all financial instruments -- the good, the bad and the ugly -- must be valued on a bank's balance sheet at their market value. Illiquid CDOs, property holdings, credit derivatives and anything else you can think of will all now be marked, mostly down, to what they would trade for in the market. Currently, banks can classify the most illiquid stuff on their balance sheet as "held for investment" or "held to maturity" and use whatever value they believe the assets are worth based on internal assumptions.
One of the only articles I could find about this was a good one by Jonathan Weil at Bloomberg from last Thursday night. I didn't write about it until now because it took me all week to have FASB verify that Weil's interpretation was correct. He realizes how big this news is. He provides a really great example of the implications:
Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT's reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn't show it.
Banks will be relieved to know that this accounting change will not have a major effect on net income as it appears on an income statement:
The Board agreed to propose that changes in an instrument's value may be recognized in other comprehensive income on the basis of qualifying criteria related to an entity's management intent/business model and the cash flow variability of the instrument.
But not all the income statement news is good. Some potentially illiquid instruments' gain/loss will be included in net income:
The Board agreed to propose that changes in value for derivatives, equity securities, and hybrid instruments containing embedded derivatives requiring bifurcation . . . will be recognized in net income. The Board agreed to propose that for all financial instruments, interest and dividends will continue to be recognized in net income. Credit impairments, as well as realized gains and losses from sale and settlement, also will be recognized in net income. The classification of instruments will be determined at initial recognition of the instrument and will not be subsequently changed.
FASB's rationale for this change can be found in its project update. Here are its goals:
a. Reconsider the recognition and measurement of financial instruments
b. Address issues related to impairment of financial instruments and hedge accounting
c. Increase convergence in accounting for financial instruments.
These proposed changes certainly would satisfy those goals, especially part c). Right now, there can be huge divergence for how banks value similar illiquid assets, because their assumptions can provide whatever value they believe the assets are worth. FASB's project would change all that. It would let the market decide.
Would this change be good or bad? Well banks will think it's bad. Much of the revenue they see throughout the year will now be eaten away by accounting losses for these asset re-valuations.
Investors, however, should think it's good. This does create greater transparency and lessen the possibility that a company is hiding losses that bad assets might not realize until sale or maturity.
It also took me so long to get this piece out because I was waiting for the minutes to come out for a joint meeting between FASB and the International Accounting Standards Board (IASB) that occurred last Friday in London. They still aren't out, but Deloitte's unofficial minutes indicate that FASB's proposal was discussed. IASB's standard is not as conservative. From the minutes it seems IASB remains a little unconvinced that FASB's suggestion is a good one. It is waiting to see a more detailed exposure draft. My favorite quote:
The FASB needed more time to complete its deliberations, but acknowledged the pressures on the IASB and the reasons it was pursuing the project in the way it was.
Yes, FASB understands those pressures all too well. They're called angry bankers.
The FASB spokesperson I spoke to explained that in August, FASB will decide whether to release a final exposure draft of this proposal. If it decides to do so, it will request feedback from the public. Then it will take that feedback into consideration and potentially release a new rule sometime in the fall. Watch for it, because these changes would shake the financial world.
(In the meantime, for anyone interested here's some much deeper detail on their proposal -- opens .pdf.)
This article is so much nonsense
For starters, the "revisions" which supposedly eased market to market this spring (FAS 157 - R) meant very little. Bankers still had to prove to their auditors that they could "exit" at Mark-to-model prices. Few bothered.
Only a handful of banks(those that are active traders) had the b**ls to do this, because they actually trade. Surprisingly, most banks are not really in the habit of buying and SELLING securities. Mark-to-market (to the extent a bank is required to do it) is a mark to an exit(sale) price if the bank is long the security. Practically speaking FAS 157R had no effect on most banks. It was not a big deal and neither is the gist of David's story.
FASB is trying to get itself out of the stupid corner it painted itself (and all financial institutions)into when it created rules requiring writing assets down to the values seen in even the most disorderly distressed sales such as the Lehman bankruptcy. It took a crisis to see just how idiotic this was. There are some things that sound great in concept ("fair value") but are in practice so dumb that only academics and geeks in Washington actually believe them.
Further, Indiviglio apparently does not understand what "comprehensive income" is in the first place, so the discussion about changing comprehensive income reporting goes over his head. I defy him to show a single example of a company that reports GAAP comprehensive income on a per share basis.
This is far from the single most important news regarding the financial industry for the week, month or year. More like the man who learned he was speaking prose.
I'm not sure how to respond to this because first you're saying that mark-to-market rules don't really matter to banks. Then you're saying that they matter a lot because that's why Lehman failed and other banks are having problems. Which is it? It can't be both.
The bankers, accountants and experts I've talked to prefer the latter interpretation: that it matters a lot. That's why the most illiquid securities (which currently are marked based on a bank's internal assumptions rather than market values) suddenly needing to be marked-to-market has the potential for some market disruption.
Furthermore, the "only a handful" that you say are active traders happen to be the ones that matter most -- the large investment banks. They're the ones that needed tens of billions in bailout cash. So I'm not sure how their health isn't something to worry about. But I agree: banks that do not have these securities have little to worry about. The problem is all the big guys do.
Next, I never meant to imply that any company currently reports EPS with comprehensive income. Sorry if I wasn't clear on that. I think I said "will be" instead of "will continue to be." My mistake. My point was just to say that it will continue to be that way, so the marking down of these assets won't hit EPS, which banks will surely like.
This new proposal would go further in the direction opposite to where FAS 157 was heading in April and require level 2 and 3 assets all be marked-to-market. I think that's pretty big news if it goes into effect. Time will tell.
Daniel, your reference to other comprehensive income was still in the wrong context. It is located on the balance sheet, in the equity section. It has nothing to do with the income statement, much less being "below net income."
None of this necessarily invalidates your main premise, but if you don't even have a basic understanding of what OCI is, then as a reader, I really need to view all of your analysis with skepticism.
Thanks. I actually just removed that paragraph due to the inaccuracy. I was getting too deep in the weeds, and frankly, the comprehensive income aspect of the change is pretty insignificant anyway, especially compared to everything else. I spoke with an accounting professor and FASB to validate the main premise, so I hope the small mistake does not induce too much skepticism.
http://studentweb.usq.edu.au/home/W0054016/Pages/Financial_Acct_Folder/Example_Comprehensive_Income_Statement.htm
What are you talking about Josef? This is going to cause all the derivatives, underwater mortgages, and every other piece of trash on the banks balance sheets to be valued for what it's worth - zero. That will bankrupt many banks and send them tumbling. I don't think you see the significance of this. If it's not important, then why are all the bankers up in arms about it? This was the one thing that save the financial system last fall, when they changed the ruling about having to report mark to market assets. Now, the banks are going to be failing in droves and the only thing that will be worth anything will be hard assets like gold and silver, not worthless pieces of paper. Buy gold and silver now before they got parabolic after the paper fiat currency jig is up.
Er, Banimal - derivatives and "toxic trash" are already marked to market (FYI.) Often written down to shockingly low level. I work with lots of banks,hedgies, etc.
Many banks, for example, have already written down (M-T-M'd) legacy subprime and Alt-A mortgage-backed securities so far that the differences between a hyterical mark-to-market and a reasonable mark to model really does not have that much of an impact on earnings or capital any more (depending on the classification of the assets, the income and capital treatments vary).
As for Daniel's comment that I was saying MTM is why Lehman failed, I suggested no such thing. I said FASB "created rules requiring writing assets down to the values seen in even the most disorderly distressed sales such as the Lehman bankruptcy" e.g.,marking-to-market should not reflect a firesale liquidation such as Lehman. Never for a minute did I suggest MTM CAUSED Lehman to fail. (It was an old fashion - hysteria-induced - run on the bank.) Either Daniel is obfuscating to cover his sloppy thinking/writing or his reading comprehension is as poor as was the case when he tried to write about OCI accounting.
HINT - Do not write about things like the financial reporting of securities and derivatives valuation if you do not understand them. There are readers who know far more than you (probably many readers) Pick a simpler subject or write about politics.
Ok, I don't know much about this, I am a novice for these terms and had wondered about this for the past few weeks based on some conversations.
I think I understand from the point of view of the big 10 investment banks.
But what about the smaller banks?
I have close friendly relationship with some Bankers.
This conversation following had me wondering:
I recall them moaning about "mark to market". They hold mortgages and they believe them to be "underwater". That is, the mortgage owed is not met by the home value. I get that. I understand that as housing values fall, folks have 95% mortgage's it will end up being 110,120 150% of loan to value. I didn't know that the bank has to show "something" on their books. I figured they showed 100% secured and the other portion as unsecured.
Is this issue being addressed. These guys are major players in a major market. They own paper on 100's of millions of real estate, but somehow they have not taken huge losses. Is it because they are not marking their properties as having lower values or are they marking loans as secured and un-secured?
Then, you have defaulted mortgages...
An example: I overheard the bankers speaking, A "wheel" customer returned a house. He is underwater, company is bust, and he can't make the payments. He mailed the bank his keys and said "adios". Loan was for 3+m. I asked what the house was worth,...3.2? Nope... 2.2? Nope. 1.2? Nope. What is it worth? (Checking, it has property tax based on 914,500 as home and land value).
The statement implied it is worth more on their books as a non income asset at 3.2mil. It seemed they won't even try to sell it, they will sit on it for as long as possible. To do otherwise will they have to recognize the loss? Later, I asked one of these guys, is this isolated? Nope. They have piles of these.
How can the Fed's allow this? I know they have auditors on a regular basis, as do all banks, but I would wonder when the real shoe will drop.
Will the shoe drop?
Will they have to put a 3.2m assett on their books for less?
Thanks for your help from a lay man.
Good Question Commissioner
These are Apples and Oranges things.
Mark to Market - really only applies to securities and derivatives, and only affects loans that are either "available for sale", meaning the banker intended to sell the loan at some point or in "trading accounts" - an accounting designation. Usually, but not always, marking-to-market values is based on either sales of comparable assets (loans, securities) or "marked"/revalued using yields of comparable loans and securities. What is comparable is the big issue of course.
Loans,such as mortgage loans, however. are generally addressed via reserves for loan losses. There are so-called general reserves and specific reserves. Banks make estimates of potential losses (specific reserves) when they believe that loan will (or has) stopped paying or the bank will otherwise not recover all of the contractual principal and interest. When the bank estimates loss reserves, they take into acount the value of the collateral like you described.
However,banks don't writedown loans simply becasue the value of the homes backing the loans has declined in value (though they might increase so-called "general" reserves). The bank has to believe: 1) that the borrower will stop paying and 2) the collateral/security the bank will recover is worth less than the loan. Declines in real estate prices simply are not enough in themselves to mark down loan values across the board. Most borrowers - thank God - keep making loan payments even if the property declines in value. They should. Some, like cited in your anecdote about the $3.2 million house, walk away, but often those types of borrowers have something else going on, though in the Great Recession, lots of people have something else going on.
There is a lot of confusion about what mark-to-market means and what recognizing loan losses means. The terms are not interchangable.
Hope this helps
Jozef,
Thanks. I think another issue is builders who take out large loans to build homes on spec, then go out of business leaving homes 1/10th to 9/10th complete. The bank takes those homes, in those conditions, and without a doubt have loaned the builder money to complete the home.
It is the developer/builder's internal ponzi scheme. Start one house, then another and use the funds from the second home to build the first, sell at a profit. When the home market tanked, then they were screwed.
The 3.2m home owner lost a high flying job, had invested in his company, and when the stock tanked, he lost his job and lost his home. The 3.2m home was not his primary residence.
So, when looking at the banks books, public records, I should look for a notation of 'specific reserves' or 'loss reserves' and see if they reflect the numbers that they talk about as their potential.
So, why would a smaller regional bank be concerned about mark-to-market unless they are speaking about mortgage loans? Or, are they engaged in securities and derivatives that are hard to see on their financial statements? This bank is a publicly traded one. I look at their fillings to see if they have made some sort of provisions about these losses.
Once again, thanks Jozef. This is the understanding that I need....so I don't seem like a novice the next time I am sitting around the table with these guys. But, once again, it is better to sit and listen, than open your mouth and prove that you don't have a clue!
As another learner, may I ask whether all this shows that banks that do savings and mortgage lending should not be kept separated from the investment (gambler) outfits?