Should we trust Citigroup with "significant judgment" on accounting?

The Financial Accounting Standards Board agreed to relax accounting rules for the benefit of troubled financial institutions like Citigroup:

April 2 (Bloomberg) -- The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value rules that Citigroup Inc. and Wells Fargo & Co. say don’t work when markets are inactive.

The changes to so-called mark-to-market accounting allow companies to use “significant” judgment when gauging the price of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ writedowns and boost their first-quarter net income by 20 percent or more. FASB voted on the rules at a meeting today in Norwalk, Connecticut. [Bloomberg]

The article continues...

Fair-value requires companies to set values on most securities each quarter based on market prices. Wells Fargo and other banks argue the rule doesn’t make sense when trading has dried up because it forces companies to write down assets to fire-sale prices.

By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB’s changes could raise bank industry earnings by 20 percent, according to Robert Willens, a former managing director at Lehman Brothers Holdings Inc. who runs his own tax and accounting advisory firm in New York.

Companies weighed down by mortgage-backed securities, such as New York-based Citigroup, could cut their losses by 50 percent to 70 percent, said Richard Dietrich, an accounting professor at Ohio State University in Columbus. [Bloomberg]

After all that's happened why on earth should we trust Citigroup's internal models to value anything, especially when Citigroup stands to massively reduce its losses by its choice of model?

How does allowing the banks to make self-serving guesses about what their worthless assets might be someday be worth help anything? The market will know the banks are viewing their toxic portfolios through rose colored glasses and discount accordingly. 

Comments

[Eric Jaffa]

"letting banks use internal models" = bad idea

If they're going to change the pricing method to be less harsh during a recession, then they should say EVERY company evaluates mortgage-related securities based on an average for the past two years (for example.)

Letting each company evaluate it's mortgage-related securities it's own way is garbage. It makes it too difficult for investors to assess companies.

[epc]

I have mixed feelings about this and don't know the right answer. On one hand mark-to-market is horribly flawed, but something like it is needed.

You have an asset "A" which you valued at $1000 when you bought it. "A" pays $100 per year.
Potential Scenarios:
- the economy booms. The value of other assets comparable to "A" doubles to $2000. Under various accounting regimes and tax laws you must account for this.
- the economy crashes. The value of other assets comparable to "A" shrinks from $2000 to $500. Again, you have to account for this both under GAAP and IRS regulations.

Through all of this "A" still generates $100. It will continue to generate $100 for quite some time. You haven't sold "A". And due to the economy, no one is selling their comparable "A"s.

If you are a bank, you've been able to use "A" to gain more leverage. Something like for every $1000 of value of "A", you can loan out $1000. So if "A" doubles in value, you can loan out $2000. But if "A" drops in value, you're over extended. If "A" drops in value a lot, from $2000 to $500, you've gone from a 1:1 debt:equity ratio to 3:1. Depending on the laws of the jurisdiction you are in you may be technically bankrupt.

Through it all, "A" continues to spin off $100 per year.

If you're forced to mark the value of "A" down to $500, you're technically bankrupt or are otherwise violating some covenant you're allowed to issue debt under. What do you do? You can try to raise equity (hence the US infusions of $$$ into various banks), you can shed the debt (canceling credit cards and mortgages) or you can try this thing FASB is trying today.

Individuals are seeing this on a personal level as their home equity lines are cancelled: the banks are looking at that initial $1 million valuation for your Manhattan condo and seeing that comparables are now selling for $500,000. The loan to equity ratio is too high now so they demand, they HAVE to demand, that you pay down the HELOC and even close it. It isn't a matter of choice, they are only allowed to carry so much debt on their books relative to the value of the backing assets (and I think the ratios are closer to 10:1 or even 30:1 depending on the debt. That is, for ever $1 of asset value I can loan out $30).

You as an individual are pissed because you've been making the payments as scheduled, have never been late, and here's the bank calling the loan. But the bank is calling the loan because they're REQUIRED to call the loan. It's not a personal choice on their part, if the valuation of the assets backing their debt drops, they need to reduce the ratio of debt to equity (again, they could also raise equity by selling more stock or gaining more deposits).

If you don't use mark-to-market, then assets can't appreciate or depreciate in value until they are traded.
But if you do use mark-to-market, you are potentially subject to sudden and wild swings in loan-to-equity ratios.

Back to the bank: they write down the value of "A" on their books to reflect the current "market" model. So now their debt/equity ratio has worsened. But they believe they are safe because this is a temporary economic downturn, "A" continues to spin off revenue, and it's all accounting anyway.

Except that stock market traders, seeing that the bank's debt to equity ratio has worsened, start short selling the stock and driving down the price.

By driving down the price of the stock, they're lowering the equity of the bank, which in turn worsens their debt to equity ratio.

You can see where this goes. Bear Stearns was taken down by exactly this process.

I'm not trying to defend the banks in this. But the financial system we've come up with is designed to leverage the increasing value of assets to provide debt for whatever purpose (business, mortgages, credit cards, etc). Which works fine in a normal economy. This isn't a normal economy, and the same structure that works so well in a growing economy, is almost disastrous in a shrinking economy.

So mark-to-market is in some ways necessary for a growing economy, but when the economy is, I don't know what this economy is doing, shrinking seems to be too mild. But, if we force the banks to hold to a strict mark-to-market method of devaluing assets it will force a lot of banks to call in debts, which will force even a further shrinking of the economy through firings, business closures. People who have underwater mortgages, who continue to pay those underwater mortgages, may find themselves foreclosed on because the bank cannot afford to continue to hold the mortgage for the house because the mortgage is worth more than the house; plus there's the risk that the homeowner will walk away.

We're already in the early stages of this vicious cycle, it hasn't accelerated yet because of the election and because everyone has a sort of wait-and-see attitude with the Administration. It's sort of like a game of musical chairs, the rules of which state that if you don't get a seat you lose. And under the routine game play only one chair is taken away at a time. But starting in October five chairs at a time were taken away much to all of the player's surprise. And instead of accepting that, they're all waiting to see if the Administration changes the rules "just this once" to get through this period.

[Lindsay Beyerstein]

Thanks, epc, that's very helpful.

[Lindsay Beyerstein]

The CP article makes a valid point that not everyone in Iceland was working for a hedge fund. On the other hand, Iceland is a democracy and the fact remains that according to Lewis the government and the banking system were up to their eyeballs with the active encouragement of the former prime minister who got himself appointed to a high-ranking banking post.

Lewis is clear that Iceland got caught up in the very excesses and pathologies of global capitalism that Burris accuses him of ignoring. Lewis is very clear that the tragedy of Iceland is a symptom not the main problem.

Lewis is arguing that Iceland as a nation got caught up in a speculative craze that could have been ripped from the pages of "Extraordinary Popular Delusions and the Madness of Crowds." He claims that it wasn't just a bunch of people who happened to work for hedge funds, but a national reorientation towards global finance. Lewis talks about how popular attitudes in Iceland shifted from skepticism to uncritical embrace of all kinds of risky deals. Iceland has fewer people than Staten Island--so it's not hard to see how a fad could have far-reaching consequences.

[epc]

To followup what I posted: part of the wait-and-see is: is this thing we're in temporary or long term? If it's temporary everyone will kind of stick their fingers in their ears and say "la la la I'm not hearing nothing about a depression la la la". But if it's longer duration, then they have to write the values of the assets down. And while that is likely the right idea technically (if "A" has no chance whatsoever of selling at your original valuation any time in the "near" future, "near" being a vague term), it would be horribly destructive on the economy and devastating to lower and middle classes worldwide who depend more on short and long term debt for day to day life, regardless of whether or not that's smart.

[Eric Jaffa]

epc -

Maybe corporations should calculate the worth of their assets in a new way.

But it should be done the same way at every corporation. They shouldn't be allowed to each invent their own calculation methods.

Or to each change their calculation method when they feel like it.

[Lindsay Beyerstein]

Epc makes a good case for change. My concern is letting each bank make up its own model on the fly.

The whole bailout program hinges on figuring out a way to value the same toxic assets that the banks are struggling to describe on their balance sheets. If the government is already working on a model, why not create a common accounting standard for all banks based on the work the Treasury is already doing? It seems crazy to let each bank make its own self-serving guesses about what their assets are worth.

Isn't all this accounting reform just re-description of the same dismal facts on the ground. Many banks really aren't solvent because their assets are based on loans that will never be paid, and/or because they bought and sold unregulated "insurance" on all these crappy investments, oblivious to the fact that the insurers couldn't possibly cover their losses if they actually had to pay out.

[epc]

I mostly agree. I don't really disagree at all.

Part of my queasiness of the whole thing is that if they all use the same model, and it's wrong, then we could be in even worse shape. See the Wred article about the risk equation that a lot of these shops used, believed in, and all fell victim to because it had a fatal flaw: "Recipe for Disaster: The Formula That Killed Wall Street" http://www.wired.com/techbiz/it/magazine/17-03/wp_quant

What's needed is transparency of the valuation methods. Have the FDIC or Fed or Treasury review them both to validate the model as well as to ensure that all of the banks don't make the same fatal assumption.

Alternately declare the banks insolvent but cushion the impact on the larger economy: your debt isn't necessarily cancelled if the bank goes under but allow the Fed to restructure the debt to account for current and expected market values.

[kharris]

"The market will know the banks are viewing their toxic portfolios through rose colored glasses and discount accordingly."

In the abstract, perhaps. However, if sophisticated investors are in on the game, and understand that the game is meant to allow financial firms to benefit at the cost of tax payers and non-financial counterparties, then "discount accordingly" means mark up bank shares from where they were prior to the FASB decision.

The reality, I suspect, is that neither FASB nor the SEC nor the Fed nor every Nobel Prize winner in economics that ever lived stuck in a room full of computers could find a rule according to which the assets that currently reside on banks books could be realistically valued. Mark-to-market represented a principle and a mechanism that avoided that problem. As long as there is a market in which representative assets trade hands, no problem. That is no longer the case, or at least not the case in a way that serves the interests of interested parties, so now we will move from rules to discretion.

Anybody remember Paulson's push to rewrite financial regulation prior to the bad news? His goal was to make the US more competitive in financial markets. That's spin-speak for reducing protections for share holders, tax payers and other outsiders, while Wall Street churns up more gazillions. Paulson's plan involved moving from rules imposed from the outside to discretion exercised from within. Disinterested parties cannot write rules to adequately regulate the financial industry, but interested parties can, with proper discretion, manage to regulate themselves in a way that serves the greater good. Really. A Goldman guy said so.

[Eric Jaffa]

epc -

RE: what "if they all use the same model, and it's wrong"?

We're talking about a company saying how much its holdings are worth.

It could be a simple formula.

They could all price mortgage-related securities in their reports by taking an average of what the market is willing to pay for them over the last 8 quarters.

Then the start of a recession wouldn't force a company to say it's holding are worthless, and there would be a connection to reality during good times and bad times.

[parse]

The changes to so-called mark-to-market accounting allow companies to use “significant” judgment when gauging the price of some investments on their books, including mortgage-backed securities.

What does "significant judgement" mean? Is it different than "use your own judgement"?

[Lindsay Beyerstein]

I think it means that banks get to more or less decide for themselves how to value their toxic assets. By mark-to-market rules, the bank would have to say that those assets were worthless because nobody will buy them, period. However, the banks would like to be able to say that they're worth something. And many of these toxic assets are worth more than zero, in the sense that they're still bringing in a certain amount of money each month as long as some of the borrowers continue to make payments on the underlying loans. There's just no way of knowing which mortgages are going to continue to be paid and which aren't or what proportion of the loans that have been resold and chopped up and repackaged and resold to create securities are actually going to be okay. So, no sane person would buy these securities for a price the bank would even consider selling. Hence the zero in market-to-market terms.

I think the change in accounting rules works as follows. The regulators are saying, okay, fine, not zero--just figure out what you want to say they're worth. And each bank pulls a number out of the air and puts that on the financial statement instead of zero.

[Eric Jaffa]

The market prices of mortgage related securities are generally greater than zero.