Efficient Stupidity Hypothesis and Mark-to-Market

[The Minsky Moment]

If you're holding a bundle of thirty-year investments, then what they are worth right now isn't really relevant.

I believe existing rules allow avoidance of MTM treatment if you are holding a long-maturing asset, and if you plan to hold to maturity.  Also, under the old MTM rules, even if an asset did not qualify for hold for maturity accounting, a write down of "other than temporarily impaired" assets could be avoided if the bank asserted it had the intent and ability to hold the asset until the impairment ceased.  That requirement has been relaxed.

[DGuller]

Berkut, Guller -

There are two regulatory requirements that could be at issue here.  One is the amount of reserves the bank is required to keep at the Fed.  Reserve requirements are a function of the level of deposits (liabilities) and hence an accounting change that relates to valuation of assets should not have an effect.

The second are min capital requirements, and these are based on assets.  However, the minimum capital requirement is calculated based on the *face value* of the asset, not the actual value.  Were the requirements instead based on actual value, then a revaluation of assets upwards would increase (not decrease) the required regulatory capital.

What about contracts where minimum capital is specified, in one way or another?

[alfred russel]

My two cents: it isn't a major change in accounting.

A brief timeline and overview:
FAS 157
In 2008 companies were required to adopt FASB's FAS 157 (the FASB is the group that sets US accounting rules). This statement gave a methodology to use whenever other accounting statements required fair value. Over the decades fair value concepts were in a number of statements, but these would often give conflicting definitions of how to determine fair value. The idea of 157 is that the exit price of the asset or liability should be used, with market values determining fair value. Market values are only to be used if the market is "orderly." Assets in this category are "Level 1".

If an "orderly" market does not exist, a model is to be used to estimate a selling price. This model should use market inputs when they are available to derive a risk adjusted fair value using discounted cash flows. (For example, if I lent the government $100 for 1 year in an OTC transaction, the interest rate on a 1 year T bill would be a good discount factor for one year). These are "level 2" assets.

If market factors are not available to determine the asset value, then I need to fully construct a model. This is "level 3."

SFAS 157 requires disclosure of all fair value assets, and which category they are in. The methodology for Level 2 and 3 assets must be explained, especially for level 3 assets.

Late 2008 Clarification
In the later part of last year, when there were protests over FAS 157, the SEC and FASB issued a joint statement reiterating FAS 157 only requires the use of Level 1 methodology if the market is orderly.

Recent FASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.

I don't see this as a big change, and any company that tries to hide a bunch of losses by avoiding level 1 treatment under this revised guidance is going to have to disclose this in the footnotes for the world to see.

[alfred russel]

If you're holding a bundle of thirty-year investments, then what they are worth right now isn't really relevant.

I believe existing rules allow avoidance of MTM treatment if you are holding a long-maturing asset, and if you plan to hold to maturity.  Also, under the old MTM rules, even if an asset did not qualify for hold for maturity accounting, a write down of "other than temporarily impaired" assets could be avoided if the bank asserted it had the intent and ability to hold the asset until the impairment ceased.  That requirement has been relaxed.

Any asset that is exempt from fair value standards--such as those that are held to maturity--doesn't have to be marked to market (assuming it isn't "other than temporarily impaired). That has always been the case. Held to maturity assets are less common than you would think because the accounting guidance has a presumption that assets are not held to maturity and are at least available for sale.

To gain held to maturity accounting, management has to positively assert an intention to hold to maturity and does not foresee any likely circumstances that may cause an early sale due to liquidity constraints. If you are talking about assets that will be maturing over 10-15 years, both of those are difficult for management to sign their names to.

[The Minsky Moment]

My two cents: it isn't a major change in accounting.
. . .

RecentFASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.

I don't see this as a big change, and any company that tries to hide a bunch of losses by avoiding level 1 treatment under this revised guidance is going to have to disclose this in the footnotes for the world to see.

But in addition to the new position on 157, the FASB also changed guidance on recognition of temporary impairments:

The Board decided to replace the existing requirement that the entity's management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert

a. It does not have the intent to sell the security; and

b. It is more likely than not it will not have to sell the security before recovery of its costs basis.

That looks like a pretty significant change to me.

[The Minsky Moment]

Any asset that is exempt from fair value standards--such as those that are held to maturity--doesn't have to be marked to market (assuming it isn't "other than temporarily impaired). That has always been the case. Held to maturity assets are less common than you would think because the accounting guidance has a presumption that assets are not held to maturity and are at least available for sale.

Actually, I had thought held-to-maturity was rare and that was one reason for concern about tinkering to MarktoMarket.

But according to the folks at McKinsey, *60 percent* of the assets on bank balance sheets are accounted for using held to maturity.

That raises the suspicion that the bank management may be trying to hide assets that they really don't intend to (or are not capable of) holding to maturity, and FASB has now given them cover.

I am not an accountant but I have seen in gory detail what happens when financial institutions blow up, and everyone sues everyone in sight, and the old books and audit papers are examined to figure out what the hell happened.  There can be some difference between the theory and the artfully worded pronouncements of GAAP and GAAS on the one hand and the sticky details of what actually happens between auditor and client in the concrete application on the other hand.

[DontSayBanana]

Trying to get a handle on what's going here. Minsky's saying the market could not beat itself, but the new rules might allow it to do just that through Level 2 and Level 3 accounting, and AR's saying that essentially, nothing has changed in whether or not they can do that; am I right?

[Admiral Yi]

Trying to get a handle on what's going here. Minsky's saying the market could not beat itself, but the new rules might allow it to do just that through Level 2 and Level 3 accounting, and AR's saying that essentially, nothing has changed in whether or not they can do that; am I right?

Joan was saying that investors got duped by the decision to not require companies to list assets at current market prices.

[DontSayBanana]

Joan was saying that investors got duped by the decision to not require companies to list assets at current market prices.

Ah. Well, in that case, I'd say they're both right. While the government may not have really lightened up on accounting rules, this thread is proof enough that not everyone who's got hands in this is as qualified an accountant as the situation really demands; a lot of people may not be doing enough due diligence to know about the difference between the Level 1, 2, and 3 accounting... so while the accountants certainly should not be getting duped, that might not mean the investors, by and large, aren't getting duped, and we could still see reflections of herd-mentality stocks transactions.

[alfred russel]

My two cents: it isn't a major change in accounting.
. . .

RecentFASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.

I don't see this as a big change, and any company that tries to hide a bunch of losses by avoiding level 1 treatment under this revised guidance is going to have to disclose this in the footnotes for the world to see.

But in addition to the new position on 157, the FASB also changed guidance on recognition of temporary impairments:

The Board decided to replace the existing requirement that the entity's management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert

a. It does not have the intent to sell the security; and

b. It is more likely than not it will not have to sell the security before recovery of its costs basis.

That looks like a pretty significant change to me.

It isn't.

An overview of the old accounting rules for those that aren't up on them: at a high level, excluding equity transactions (selling or buying stock and dividends), an increase or a decrease in an asset not involving a liability must equally increase or decrease comprehensive income.

Comprehensive Income has two components: net income and other comprehensive income.

Investments were and are classified as in one of three categories, and the accounting is as follows (excluding "other than temporary impairment", which I'll address below, and has changed):

1. Held to Maturity: The Company can affirmatively state that they both intend to and are able to hold the investment to maturity. These are recorded as assets at amortized cost (usually about equal to the amount paid for the investment). The value does not change with market fluctuations.
2. Trading Securities: These are assets that are being actively marketed and are expected to be disposed in a short time. They are recorded at their fair value. Any increase or decrease in fair value is recorded through Net Income.
3. Available for Sale: These are all assets that don't fit into the other two categories. They are recorded at fair value. Any increase or decrease in the fair value is recorded through Other Comprehensive Income.

None of what I wrote above changed in the past few years.

What has been tweaked is the concept of "other than temporary impairment." This is an old concept that applies to both Held to Maturity and Available for Sale securities. In the past, if the fair value of either category of asset declined and management determined the decline was "other than temporary," the asset was impaired and the difference was recorded through net income. Note that in terms of asset value this only effects Held to Maturity assets, as Available for Sale were already held at fair value. The difference for Available for Sale is that rather than recording the decline through Other Comprehensive Income it is being recorded through Net Income.

The recently approved standard tweaks this treatment, but only for debt securities (equity investments are not changed, and I do not believe loans qualify as debt securities, though I'm not sure of this). The change is that for Held to Maturity securities and the subset of Available for Sale Securities that management does not intend to sell and is most likely able to hold the security past the point it will recover its value, the impairment is bifurcated into two categories: the impairment due to the credit worthiness of the counterparty and the impairment due to market conditions. The loss due to the former category is still recognized in Net Income, but the latter category is now recognized into Other Comprehensive Income (which is then amortized into Net Income over the life of the security).

All of this has to be disclosed. There is no change in reported asset values.

[alfred russel]

Any asset that is exempt from fair value standards--such as those that are held to maturity--doesn't have to be marked to market (assuming it isn't "other than temporarily impaired). That has always been the case. Held to maturity assets are less common than you would think because the accounting guidance has a presumption that assets are not held to maturity and are at least available for sale.

Actually, I had thought held-to-maturity was rare and that was one reason for concern about tinkering to MarktoMarket.

But according to the folks at McKinsey, *60 percent* of the assets on bank balance sheets are accounted for using held to maturity.

That raises the suspicion that the bank management may be trying to hide assets that they really don't intend to (or are not capable of) holding to maturity, and FASB has now given them cover.

I am not an accountant but I have seen in gory detail what happens when financial institutions blow up, and everyone sues everyone in sight, and the old books and audit papers are examined to figure out what the hell happened.  There can be some difference between the theory and the artfully worded pronouncements of GAAP and GAAS on the one hand and the sticky details of what actually happens between auditor and client in the concrete application on the other hand.

I'm not an accountant either (though I do work with this stuff) and I've never worked in banking. But I'd be interested to see what McKinsey is considering as a held to maturity investment. It is possible they are considering line items like equity method investees, joint ventures, intangibles such as goodwill, and PP&E as held to maturity assets.

[alfred russel]

Recent FASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.

I had read the comment draft, and when I read in the press of the changes figured that it was approved. But I should have read the version that was approved, because it was tweaked (I don't believe they released the final official draft yet). Where I wrote that there is a presumption that the transaction is in an orderly market was altered in the final draft to state that management must weigh the evidence of an orderly or disorderly market and determine which is most appropriate based on the preponderance of the evidence.

[Admiral Yi]

In related news bank shares jumped today based on a record Wells Fargo profit report.