Monday, February 23, 2009

Accounting Bitch #2

John Allison's superb speech that I posted on a few days ago raises an accounting issue I would like to bitch about now. The issue is "Fair Value Accounting," and Allison discusses it in depth. I cannot add much to what Allison said, but I can try to sum it up and provide a brief explanation of why this particular accounting requirement is evil, both morally and epistemologically.

The rule in question is one which states that certain assets must be regularly marked down in value to accurately represent their "Fair Market Value," or the value at which they could sell it today if they had to. In most firms, this kind of accounting is limited to what are called "tradable securities," those securities a firm owns, but actively trades. These can be contrasted with available-for-sale securities and hold-to-maturity securities. These are not "marked to market" normally. Typically, these assets do not constitute a large portion of a firm's balance sheet, and the effect is negligible. In fact, this use of mark-to-market is actually quite appropriate.

In finance, however, for the last two years, banks have been required to mark their asset-backed securities to market value. This violates a fundamental principle behind the mark-to-market tool, namely that management must be intending to sell the asset in question. Allison points out that it is dishonest to write down an asset as though it were to be sold when management intends to hold it and collect its cash flows.

Now, this was not much of a problem until the market for mortgage-backed securities dried up and no one wanted to buy them. By law, banks must write down these assets to fire-sale prices because those are the only prices people are willing to pay. This is ludicrous, though, as Allison points out, because a market requires both a willing buyer and a willing seller.

So, you might be saying "Ok, it's a pain, but investors understand that these assets are still bringing in cash and are worth a lot more. They'll price that in. What's the big deal?" Normally, your logic would be correct. However, this is America, where we have laws to make sure logic is never correct. If a bank's equity drops below a certain percentage of capital (say, due to massive write-downs of its assets) it has to go to the capital markets and raise new capital. If it cannot, it must shut down, by regulatory fiat, even though it might still be generating positive cash flow. Another delightful aspect of the combination of accrual-based accounting and bumbling regulators.

Enter bailouts. Enter systemic risk and crisis. Enter his Obama-ness, fixer of things, bringer of change.

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