Banks Demand Fantasy Fair Value

Investors locked horns with the banking industry on Wednesday on whether U.S. regulators should suspend or change accounting rules used to value assets such as mortgage-backed securities.

Fair value accounting, which requires assets to be valued at market prices, has been blamed for billions of dollars in writedowns by some U.S. banks and policymakers. But investors and accountants say the approach gives investors a clearer window into banks' balance sheets.

The U.S. Securities and Exchange Commission was charged by Congress to produce a study by early 2009 analyzing the effects of fair value accounting rules on financial firms' balance sheets and examining alternative accounting standards. The SEC held a public meeting on Wednesday to gather information on the accounting rules, also known as mark to market or FAS 157.

Charles Maimbourg, senior vice president of KeyCorp bank, told the SEC that what management intends to do with an asset should help determine the fair value of the asset.

"You have to include management intent. They have opinions, they are in the best position to do that," Maimbourg said.

Under the fair value rules, assets can be valued based on a simple price quote in an active market. But hard to value assets rely on management's best estimate derived from computer models.

Given that there is no market for certain securities such as those linked to mortgages, banks say they have been forced to value assets at fire sale prices they could fetch in the current market. That is misleading, they contend, because the banks do not plan to sell the assets immediately and their value could rise in the future.

"There are loans that banks hold and intend to hold," said Maimbourg. "The fact that the market will only pay us 20 cents ... (is not) a reason to mark it down to 20 cents on the dollar."

Patrick Finnegan, a director at CFA Institute, disagreed and said allowing management intent to influence the value of an asset was an "insidious" idea.

Reuters

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This is quite astonishing. The idea is that by sleight of hand companies can massage their balance sheets to make themselves look better. Indeed, I heard one senior commentator on Bloomberg some days ago openly say that as far as he was concerned banks should value these "assets" at whatever level is necessary to make their balance sheets look good! A blatant public plea to companies to swindle their investors.

And as for the pathetic quote above, that just because an asset is now worth 20% of its "value" as it might be worth more in the future companies should be allowed to reprice it, they should call it "unfair value accounting" or "fantasy book value". That is the whole point of fair value accounting - by booking it to 20% now, if the value should rise to say 50% then that's a profit compared to the present valuation. By creating a fantasy valuation companies are not only misrepresenting their liabilities to shareholders they are also going to be presenting losses for years to come as they chip away at these "liability assets".

As an example, if I have an account with a broker I need to place a deposit for every trade. The beauty of leveraging is that I can place a fraction of the real value of the trade. This increases profits in percentage terms. However, if suddenly the market for an instrument evaporates and the price drops to zero, my broker is going to phone me and ask me to either put up the money for the whole trade or close that trade. If I say to him that surely this is just temporary and that once markets stabilize the value will look less distressed, the broker is going to turn round and say to me,"Sure, you may be right, but that's your risk! At the moment it is worthless - put up the money on the assumption it remains worthless."

Surely if a market in a particular instrument just disappears, that is telling us something important. The problem with leveraged trades is that one can lose more money than one has put in. If I buy a stock at $100 but only need to deposit 10% of the price, my liability is just $10. If the price rises to $110 I have made $10 profit. Notice that the asset price has risen 10% but my profit is 100% - that's the nature of leveraged positions. However, if the price drops to $50 I am $50 down with only $10 deposit. I have to find the money to cover that extra $40 loss. As far as my leveraged trade is concerned my asset, the stock, is actually a liability, and will remain so until the price goes back to $100. Perhaps these bank "assets" are worth negative amounts of money. Perhaps these assets should be moved to the liabilities column. Then we can see their fair value.

Fed Cuts Rate to 1% - So What Now For Your Investments?

Yesterday the Fed's FOMC cut US rates by half a percent to 1%. As predicted, the dollar has weakened, losing about 10% in two days. The corporate media loves to talk up stocks (especially their own) but the effervescence went flat pretty quickly, with the Dow index doing its now legendary nose-dive in the last 10 minutes. The Dow plunged some 400 points in those closing minutes. There's confidence for you!

The resistance level it is trying to break through is around 9350, which was last week's high. It did peer above it yesterday but then suffered altitude sickness and collapsed. The level above that is around 9800, but if it fails at 9500 we continue to be in a downward trend. Nobody knows what will happen and anybody that says they do is just guessing. As I've said before, shouting "bottom!" every time we hit a new low will be correct one day, we just don't know when.

However, US interest rates cannot go much lower. They could fall to Japanese levels but that is absolutely no guarantee that it will help stock prices recover. It is a sobering thought that the Nikkei peaked at about 39,000 in 1989 - it is now, 20 years later, at about 9,000. It has lost some 75% in 20 years. Beware of the broker mantra that stocks always outperform bonds.

Treasury 10-year bonds are still yielding 3.8% in spite of the discount rate dropping to 1%. In 10 years, compounded, that comes to a 45% profit - after 20 years the profit would be 110%. Many people have now been through two serious bear markets. The promise of retirement wealth may ring hollow to many of them. All pundits repeat their sacred mantra, mainly because they cannot breathe without their broker fees, but investing in Japan may be a warning that things do not always get better. I think many individuals need to carefully rethink their retirement investments. Holding a majority in sovereign bonds and having the stock markets and commodities as the froth on top would have been the wisest thing to do 20 years ago. It may well be the wisest thing to do for the next 20 years.


This article also appears at Xomba

FOMC Meeting - Time for a Dollar Collapse?

Later today the Federal Reserve's Open Market Committee will announce its decision on US interest rates. Many are expecting another half a percentage point cut, bringing the discount rate down to 1%. What effect will this have on the dollar?

We have seen the dollar rally spectacularly in the last couple of months from an all-time low of the dollar index. However, this has been largely due to the fall in the Euro and Sterling, which account for a majority of the dollar index. The dollar has actually fallen against the yen.

Now, the media pundits are nothing if not cliche-merchants, and the mantra has been that the resurgent dollar is due to a "flight to quality". Quality!? With so much dollar wealth being destroyed it seems a flight of fancy to see the remaining dollars as quality. And at potentially just a 1% yield that seems very poor value - OK 30-year treasuries are still around 3%, an indication that the market doesn't see such low rates lasting for long.

But that is partly the point, at 1% there is very little lower it can go. What this also means is that bond prices - treasuries - cannot go much higher (unless the US has a credit downgrade). So by the end of today we could see treasury yields at their lowest and their bond prices at their near-term highest. If I was a foreigner holding billions of dollars worth of treasuries, this looks like a good time to get rid of them.

One thing that seems to be being forgotten is that a huge amount of US debt is in the hands of foreigners, both corporations and foreign government sovereign funds. This rise in the dollar seems to me to have little to do with quality and everything to do with corporations needing to liquidate assets in order to buy dollars so they can keep afloat as credit is expensive or non-existent. As has been noted elsewhere, this is not a flight to quality but a concerted repatriation of global dollar assets. This is a flight to self-security! However, what happens when other governments, dragged down by the US mess, decide that it is in their own self-interest to repatriate their own foreign investments?

The decisions of the inner sanctum of central bankers may well be a mystery to most of us. The manipulations are evident but in whose interest is often less so. However, if Americans are being bounced into repatriating assets, then everybody else in the world can do the same. Once treasury bonds have maxed out, what is the point in holding them? Indeed, with the combination of the dollar rally and bonds rising, many foreigners are holding onto very large profits from the last couple of months. What will happen when those profits are taken? What will happen when other countries start doing the same as the USA?

The markets are currently predictably unpredictable. But I for one will be keeping one eye on currencies, one eye on treasuries and the other on the stock markets. I know, it's not easy!


Also posted at Xomba