This headline is the headline of an article I would recommend everyone read about the financial crisis. This article, by Floyd Norris, can be found in the Friday morning New York Times (see http://www.nytimes.com/2009/09/11/business/economy/11norris.html?ref=business). As readers of this blog know, I have been a strong advocate of more transparent and open reporting from all organizations, but especially from financial institutions. Mark-to-market and the determination of fair values of financial assets, I believe, is a must going forward!
The bankers cry only after-the-fact, that is, once their bets on mismatched maturities on their balance sheets or on the assumption of riskier assets has gone sour. They can’t have it both ways, which is how little children want it. If you are going to take risks, Mr. Banker, then accept the responsibility for the risks that you take. Don’t cry about unfair accounting standards once the milk is spilt.
To me there are two major reasons why shareholders and regulators should be alerted to the bets that bankers have placed. The first has to do with achieving a more appropriate valuation of the stock of the bank or financial institution. Owners should know what bets have been placed so that they can incorporate risk into the valuations they are placing on the stock of the company they are interested in investing in. Regulators need to know as truly as possible the potential danger a bank faces and the treat the bank poses to the bank insurance fund.
The second reason has to do with management, itself. I have led the successful turnaround of three financial institutions. In each case, a major reason the banks got themselves in trouble was that managements repeatedly postponed, and then postponed again, dealing with problems because they could hide the problems from both the investment community and the regulatory bodies. This is also the case in the vast majority of troubled or failed institutions.
Successful managements must own up to the problems that they have created and act to correct those problems as soon as they can. The openness and transparency created by good accounting standards are important tools to create an environment in which managements do identify problems early and then act on them.
In a real sense, however, accounting standards are a crutch. Good executives require full disclosure of asset values and report this information to shareholders and regulators. They also act to resolve problems in a timely manner, as the problems are identified. Good executives create a culture in which they learn about problems as soon as possible because they don’t want surprises. I was taught that this is what good management is all about.
Perhaps we should post a list of all banks and bankers that are in favor of easing these reporting rules and discount the price of their common stock by 30% to 40% from current levels.
The reason?
To me, any banker that wants to ease up the rules on reporting the fair value of assets is, by definition, a poor manager and a poor leader. And, I do not want to invest in any organization that has poor management or poor leadership.
Showing posts with label accounting rules. Show all posts
Showing posts with label accounting rules. Show all posts
Friday, September 11, 2009
Thursday, April 2, 2009
FASB and the Mark-to-Market Rules
The Financial Accounting Standards Board (FASB) should have released their easier guidelines on ‘mark-to-market’ accounting on April Fool’s day because that date would have been much more appropriate for what they have done.
Once again the accounting profession has shown that accounting is an “art” rather than a professional practice and art, as we well know, like pornography, is in the eye of the beholder.
FASB has “revised the rules to allow companies to use their judgment to a greater extent in determining the ‘fair value’ of their assets. In other words, there are no rules!
Arguing for the change is, of course, the banks. The banks “have contended that during the current financial crisis, when many markets are frozen or not functioning smoothly, the rules have unfairly pushed those valuations lower and forced them to take big losses on the basis of market fluctuations that are temporary.”
There are three points I would like to emphasize here. First, an appropriate accounting for the financial condition of a firm is a prerequisite for understanding the state that the company is in. Without this knowledge, the customers of the banks, lenders as well as depositors, are at a loss about the financial condition of the bank, investors are at a loss about the condition of the bank, and regulators are at a loss about the condition of the bank.
Second, if the revised rules “allow companies to use their judgment” then there are no unbiased standards or relatively objective criteria by which to judge the condition of the bank. What good are financial statements if people can put whatever they want on their balance sheet?
Third, the explanation for the change includes the assumption that the problems being faced by the affected financial institutions are ones of liquidity and not ones of solvency. We are told that “when markets are frozen or not functioning smoothly” it will be hard to price the assets. We are being told that this is what the banks face today, the problem that for some bank assets, the markets in which they trade are illiquid.
What if the problem is, as some of us believe, that a few (or more) of these banks are insolvent and it is not just a problem of the liquidity, or illiquidity, of their assets?
The administration and the congress keep giving us solutions to the financial chaos around us that are intended to relieve the problem of liquidity. They seem to keep their head in the sand when it is suggested that maybe the problem is one of solvency.
And, what is the real underlying situation here? Banks and other financial institutions, in an effort to squeeze out a few extra basis points in terms of their return on equity, not only added assets to their balance sheets that exhibited a greater amount of credit risk, they also increased their leverage ratios to extraordinary lengths, and, in addition, added further interest rate risk to their balance sheets by increasing the mis-match of the maturities of their assets and liabilities.
They knew what they were doing! And, they knew what the consequences would be if things went against them!
Now, these same people are crying false tears because events did not go their way and they got caught!
Congress and others got mad at the executives of AIG for attempting to live up to the contracts that were given to employees in terms of the bonuses they were to receive. In the current situation, Congress and others are up-in-arms because they want to change the rules under which the banks and other financial institutions were to be held accountable for.
And Rick Wagoner can be forced out of GM, but the same bank leaders that got the banks where they are remain in their executive lofts.
Go figur’.
The financial performance of the banks will now improve. There are a dozen or so articles in the financial press contending that the new P-PIP will suffer because of the change in the accounting rules. Just what we need—another government program, like TARP, in which the nature of the program changes once the program has been presented to the public.
In truth, the condition of banks and other financial institutions has not changed! Those that are insolvent are still insolvent. Those that are not insolvent are still not insolvent. But, the public, the lenders, the depositors, the investment community, and the regulators are worse off.
The change in the accounting rules is another bailout for the bankers!
Happy April Fool’s day!
Once again the accounting profession has shown that accounting is an “art” rather than a professional practice and art, as we well know, like pornography, is in the eye of the beholder.
FASB has “revised the rules to allow companies to use their judgment to a greater extent in determining the ‘fair value’ of their assets. In other words, there are no rules!
Arguing for the change is, of course, the banks. The banks “have contended that during the current financial crisis, when many markets are frozen or not functioning smoothly, the rules have unfairly pushed those valuations lower and forced them to take big losses on the basis of market fluctuations that are temporary.”
There are three points I would like to emphasize here. First, an appropriate accounting for the financial condition of a firm is a prerequisite for understanding the state that the company is in. Without this knowledge, the customers of the banks, lenders as well as depositors, are at a loss about the financial condition of the bank, investors are at a loss about the condition of the bank, and regulators are at a loss about the condition of the bank.
Second, if the revised rules “allow companies to use their judgment” then there are no unbiased standards or relatively objective criteria by which to judge the condition of the bank. What good are financial statements if people can put whatever they want on their balance sheet?
Third, the explanation for the change includes the assumption that the problems being faced by the affected financial institutions are ones of liquidity and not ones of solvency. We are told that “when markets are frozen or not functioning smoothly” it will be hard to price the assets. We are being told that this is what the banks face today, the problem that for some bank assets, the markets in which they trade are illiquid.
What if the problem is, as some of us believe, that a few (or more) of these banks are insolvent and it is not just a problem of the liquidity, or illiquidity, of their assets?
The administration and the congress keep giving us solutions to the financial chaos around us that are intended to relieve the problem of liquidity. They seem to keep their head in the sand when it is suggested that maybe the problem is one of solvency.
And, what is the real underlying situation here? Banks and other financial institutions, in an effort to squeeze out a few extra basis points in terms of their return on equity, not only added assets to their balance sheets that exhibited a greater amount of credit risk, they also increased their leverage ratios to extraordinary lengths, and, in addition, added further interest rate risk to their balance sheets by increasing the mis-match of the maturities of their assets and liabilities.
They knew what they were doing! And, they knew what the consequences would be if things went against them!
Now, these same people are crying false tears because events did not go their way and they got caught!
Congress and others got mad at the executives of AIG for attempting to live up to the contracts that were given to employees in terms of the bonuses they were to receive. In the current situation, Congress and others are up-in-arms because they want to change the rules under which the banks and other financial institutions were to be held accountable for.
And Rick Wagoner can be forced out of GM, but the same bank leaders that got the banks where they are remain in their executive lofts.
Go figur’.
The financial performance of the banks will now improve. There are a dozen or so articles in the financial press contending that the new P-PIP will suffer because of the change in the accounting rules. Just what we need—another government program, like TARP, in which the nature of the program changes once the program has been presented to the public.
In truth, the condition of banks and other financial institutions has not changed! Those that are insolvent are still insolvent. Those that are not insolvent are still not insolvent. But, the public, the lenders, the depositors, the investment community, and the regulators are worse off.
The change in the accounting rules is another bailout for the bankers!
Happy April Fool’s day!
Sunday, March 1, 2009
Uncertain Asset Values and the Stock Market
“Value investors prefer to estimate the intrinsic value of a company by looking first at the assets and then at the current earnings power of a company.” This comes from the book “Value Investing: From Graham to Buffett and Beyond” by Greenwald, Kahn, Sonkin, and van Biema.
In value investing, the value of the assets is the first thing you should look at. Value, however, is uncertain and decisions about value are risky…that is, placing a bet on the value of an asset is a risky decision…and this throws us into a probabilistic world.
But uncertainty comes in different flavors. For example, in some situations we have a relatively good idea about what the underlying outcome distribution looks like. Games of chance like roulette or blackjack have uncertain outcomes but the probability distribution of possible outcomes is well known. On the other hand, the possible outcomes of a war are uncertain and we generally have very little knowledge of the probability distribution of possible outcomes. So at one end of the spectrum of uncertain situations we can say that our estimated probability is objectively determined, while at the other end we have to admit that our estimated probability distribution is entirely subjective.
The United States is at war right now…at war against an economic and financial crises. And, investors, as well as everyone else, have no idea what the probability distribution of possible outcomes looks like. We can’t even approximate such a distribution from historical statistics because there is insufficient information to produce any kind of a result that would be relevant in the current situation. The information that we are getting seems to be getting worse and worse.
This, to me, is why financial markets are performing as they are at the present time. No one can state with any certainty the values relating to the vast majority of assets in the United States.
Until people can gain some confidence that they know…even approximately…what is the value of assets relevant to them…they will not be willing to place substantial “bets” with much confidence. And, this will mean that financial markets will continue to meander lower.
One effort to get a handle on asset values is the “stress test” exercise of the Federal Government on large commercial banks. The effort is, of course, to see whether or not the asset values of these banks will hold up in a relatively severe economic downturn. The outcome of these stress tests will determine, to a large degree, the amount of financial help these institutions will get from the Treasury Department.
The problem is that the whole economy needs to face a stress test. It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets. This is scary!
We have heard over and over again in the past year that one factor that has “caused” or at least “exacerbated” the current crisis is accounting rules such as the “mark to market” requirement faced by many institutions. I think that this is nonsense!
The problem, to me, is that there has been too little information forthcoming from the businesses and financial institutions in this country. I contend that the only reason the “mark to market” requirement might have caused organizations any trouble is that the managements of these companies believed that they would never be held to live up to this standard.
The “mark to market” requirement is meant to warn managements that their decisions with respect to asset choices will have consequences on their balance sheets and this will be revealed to the investment community in real time. Therefore, Mr. Management, if you want to invest in riskier assets or mis-match the maturities of your assets and liabilities in order to increase your return on equity, you will have to account for them “up front” if your decisions sour.
Knowing this to be the case, why would these managements go ahead and assume riskier positions unless they believed that the accounting rules would not be enforced?
Another bad argument to me is the one used by Long Term Capital Management in terms of the portfolio positions they took…”We can’t release information on our positions because of the fact that if we did our competitors would know what we are doing and copy us.”
Well, guess what? Their competitors knew what positions they were taking and copied them. And, the spreads Long Term Capital Management worked with got narrower and narrower…and so LTCM needed to use more and more leverage to get the returns they were shooting for…and trouble developed…and who knew about it? Not their banks…not their investors…not the regulators…no one but them. And, we ended up with another crisis.
And, this goes back even further. I am reading a book about Goldman Sachs. One situation stands out…the financial crisis created by the Penn Central bankruptcy in the early 1970s. The Penn Central hid information about its financial problems from Goldman Sachs, as well as others in the financial community, which resulted in a collapse of the commercial paper market leading to a Federal Reserve rescue and millions and millions of dollars in losses as well as an enormous amount of time in law suits and other regulatory assessments.
In doing bank turnarounds I found out very quickly in each bank I was involved in that the first thing an organization does when their decisions start going south is that they attempt to “cover up” results. One of the first things needed in any turnaround situation is to open up the books and let the fresh air in. It always seemed to me that greater openness and transparency of reporting results would have reduced the number of bank problems and bank failures that took place in this country.
Many argue that if people knew the trouble that banks had gotten themselves into there would be more “runs” on banks and the system would be less stable. This is an argument “after the fact” much as is the argument about “marking to market.” If the information were available earlier to the public and the investment community, there would be pressure on managements to respond quicker to bad decisions and resolve them before they got out-of-hand. Allowing the managements to delay action on these issues only exacerbates the problem, for it does not force the managements to solve them.
If there are to be any regulatory changes…and I am afraid that there will be way too many of them in our future…I would argue that the most important one would be related to the reporting requirements of all businesses in the United States. The records of American businesses…non-financial as well as financial…need to be more timely and more open and transparent to the world.
The investment community and the regulatory community should never be in a position where there is such uncertainty about asset values as there is at this time! We have the computer systems to accommodate a requirement to be more open and transparent…there is no reason why more information should not be forthcoming on a real time basis.
The stock market…as well as other financial markets…will continue to move lower as long as the uncertainty exists about asset values. A government “recovery program,” a plan to ease the burden of foreclosures, and even a bank bailout plan, will not stimulate bank lending and move the economy out of recession until we get a handle on asset values…throughout the whole economy. Valuing assets will take time…and even more time will be required to work out the associated solvency issues. But, even now, greater openness and transparency would help speed this process along. And, maybe give investors enough confidence to start buying again
In value investing, the value of the assets is the first thing you should look at. Value, however, is uncertain and decisions about value are risky…that is, placing a bet on the value of an asset is a risky decision…and this throws us into a probabilistic world.
But uncertainty comes in different flavors. For example, in some situations we have a relatively good idea about what the underlying outcome distribution looks like. Games of chance like roulette or blackjack have uncertain outcomes but the probability distribution of possible outcomes is well known. On the other hand, the possible outcomes of a war are uncertain and we generally have very little knowledge of the probability distribution of possible outcomes. So at one end of the spectrum of uncertain situations we can say that our estimated probability is objectively determined, while at the other end we have to admit that our estimated probability distribution is entirely subjective.
The United States is at war right now…at war against an economic and financial crises. And, investors, as well as everyone else, have no idea what the probability distribution of possible outcomes looks like. We can’t even approximate such a distribution from historical statistics because there is insufficient information to produce any kind of a result that would be relevant in the current situation. The information that we are getting seems to be getting worse and worse.
This, to me, is why financial markets are performing as they are at the present time. No one can state with any certainty the values relating to the vast majority of assets in the United States.
Until people can gain some confidence that they know…even approximately…what is the value of assets relevant to them…they will not be willing to place substantial “bets” with much confidence. And, this will mean that financial markets will continue to meander lower.
One effort to get a handle on asset values is the “stress test” exercise of the Federal Government on large commercial banks. The effort is, of course, to see whether or not the asset values of these banks will hold up in a relatively severe economic downturn. The outcome of these stress tests will determine, to a large degree, the amount of financial help these institutions will get from the Treasury Department.
The problem is that the whole economy needs to face a stress test. It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets. This is scary!
We have heard over and over again in the past year that one factor that has “caused” or at least “exacerbated” the current crisis is accounting rules such as the “mark to market” requirement faced by many institutions. I think that this is nonsense!
The problem, to me, is that there has been too little information forthcoming from the businesses and financial institutions in this country. I contend that the only reason the “mark to market” requirement might have caused organizations any trouble is that the managements of these companies believed that they would never be held to live up to this standard.
The “mark to market” requirement is meant to warn managements that their decisions with respect to asset choices will have consequences on their balance sheets and this will be revealed to the investment community in real time. Therefore, Mr. Management, if you want to invest in riskier assets or mis-match the maturities of your assets and liabilities in order to increase your return on equity, you will have to account for them “up front” if your decisions sour.
Knowing this to be the case, why would these managements go ahead and assume riskier positions unless they believed that the accounting rules would not be enforced?
Another bad argument to me is the one used by Long Term Capital Management in terms of the portfolio positions they took…”We can’t release information on our positions because of the fact that if we did our competitors would know what we are doing and copy us.”
Well, guess what? Their competitors knew what positions they were taking and copied them. And, the spreads Long Term Capital Management worked with got narrower and narrower…and so LTCM needed to use more and more leverage to get the returns they were shooting for…and trouble developed…and who knew about it? Not their banks…not their investors…not the regulators…no one but them. And, we ended up with another crisis.
And, this goes back even further. I am reading a book about Goldman Sachs. One situation stands out…the financial crisis created by the Penn Central bankruptcy in the early 1970s. The Penn Central hid information about its financial problems from Goldman Sachs, as well as others in the financial community, which resulted in a collapse of the commercial paper market leading to a Federal Reserve rescue and millions and millions of dollars in losses as well as an enormous amount of time in law suits and other regulatory assessments.
In doing bank turnarounds I found out very quickly in each bank I was involved in that the first thing an organization does when their decisions start going south is that they attempt to “cover up” results. One of the first things needed in any turnaround situation is to open up the books and let the fresh air in. It always seemed to me that greater openness and transparency of reporting results would have reduced the number of bank problems and bank failures that took place in this country.
Many argue that if people knew the trouble that banks had gotten themselves into there would be more “runs” on banks and the system would be less stable. This is an argument “after the fact” much as is the argument about “marking to market.” If the information were available earlier to the public and the investment community, there would be pressure on managements to respond quicker to bad decisions and resolve them before they got out-of-hand. Allowing the managements to delay action on these issues only exacerbates the problem, for it does not force the managements to solve them.
If there are to be any regulatory changes…and I am afraid that there will be way too many of them in our future…I would argue that the most important one would be related to the reporting requirements of all businesses in the United States. The records of American businesses…non-financial as well as financial…need to be more timely and more open and transparent to the world.
The investment community and the regulatory community should never be in a position where there is such uncertainty about asset values as there is at this time! We have the computer systems to accommodate a requirement to be more open and transparent…there is no reason why more information should not be forthcoming on a real time basis.
The stock market…as well as other financial markets…will continue to move lower as long as the uncertainty exists about asset values. A government “recovery program,” a plan to ease the burden of foreclosures, and even a bank bailout plan, will not stimulate bank lending and move the economy out of recession until we get a handle on asset values…throughout the whole economy. Valuing assets will take time…and even more time will be required to work out the associated solvency issues. But, even now, greater openness and transparency would help speed this process along. And, maybe give investors enough confidence to start buying again
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