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SFAS 157: Market Prices Too Low? Just Ignore Them!

Here's a honey of an idea that almost slipped by unnoticed last week. Thankfully, the NYT's sharp eyed business columnist, Floyd Norris, caught it.

An SEC opinion letter advising companies how to deal with their Level 3 assets made a rather curious suggestion. They advised that if the prices of mark-to-model crappy paper are underwater, well then, declare it the result of forced  liquidation -- and then you can simply ignore them.

It truly boggles the mind.

Would someone please explain to me how providing an official mechanism for allowing companies to ignore market values of the bad investments they made help investors? Instead of working towards transparency, the SEC is providing a mechanism to allow banks to hide losses from their shareholders. This is nothing short of an invitation to commit fraud.   

Here's the offending passage:

“Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.” (emphasis added)

Norris suggests this is an invitation for banks having two sets of books. One for Bank disclosures for shareholders: Ignore these paper losses, the prices are only due to a forced liquidation -- and another for Margin calls: Hey! You are underwater by XX% in this; send in more money! Apparently, the SEC believes prices are irrelevant, except when it comes to margin calls.

Stop and think about this for a moment: Every margin call is essentially a forced sale. Consider the alphabet soup of highly leveraged derivatives out there, where many of the most recent trades  have occurred because some hedgie has blown up. What might the unintended consequences of this rule actually be?

Today is the last day of the quarter. There is often window dressing to the upside the last few days before a Q's end to make the fund's performance look better. Imagine if there was an incentive to make a huge category of derivatives' last trade appear to be the result of a margin call? We would have this enormous window dressing down -- so as to not have to come up with a legitimate value for tier 3 junk.

This is a directive to banks to make the situation much, much worse. They can clean up their own books by forcing liquidations elsewhere. Un-fricking-believable.

Holy shnikes, have any of these people at the SEC every worked on a trading desk?

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Source:
If Market Prices Are Too Low, Ignore Them
Floyd Norris
NYT, High and Low Finance
March 28, 2008,  6:21 pm
http://norris.blogs.nytimes.com/2008/03/28/if-market-prices-are-too-low-ignore-them/

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Monday, March 31, 2008 | 06:47 AM | Permalink | Comments (65) | TrackBack (1)
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Comments

Help investors? Help investors?? Hahaha...

Maybe at the next press conference someone should ask the Occupant-in-Chief, "Mr. President, where are the voter's yachts?"

Posted by: VennData | Mar 31, 2008 7:26:15 AM

I have a question:
If a bank is keeping two sets of "books", one regulated by the SEC, and the other isn't, then why can't the unregulated funds be quarantined by law? What would be the effect? Why should they be allowed to disrupt the regulated arm of the businesses?

I am not a financial major, so please stay polite.

Posted by: Bill in IL | Mar 31, 2008 7:32:39 AM

Guv'mint has plenty of experience in trading desks.

Posted by: zell | Mar 31, 2008 7:41:06 AM

We are witnessing the culturalization of fraud.

Posted by: Marcus Aurelius | Mar 31, 2008 7:53:40 AM

It is assumed that the SEC as well as the funding counterparts know and read a balance sheet as being in two parts assets and liabilities. Accounting level 3 for its residual value will prolong the funding agony of these financial institutions with an average leverage of 32/40 and a shrinking capital.One should be reading this advise as an invitation to make a true recognition of their financial illness.

Posted by: Philippe | Mar 31, 2008 8:01:44 AM

I can see it no in economics textbooks written 50 years in the future:

"The US financial sector, having learned nothing from the collapse of the Japanese equity market during the 1990's, proceeded to make exactly the same mistakes as the Japanese, albeit by an order of magnitude."

Honestly, it's unreal how banks, regulators, investment companies, etc. have taken one of the biggest financial clusterfucks in the history of earth and decided the only appropriate way to pay homage is by creating an even bigger clusterfuck.

Posted by: Byno | Mar 31, 2008 8:10:01 AM

The SEC, hell all central authorities, are desperate for banks to stop writing down assets. They will pull all stops, including looking the other way, passively condoning reporting fraud to get what they want. Foreign investors have to be complicit or beyond foolish to be investing in anything marketed by wall street, or under SEC regulation anywhere. This is outrageous. Alot of folks will get out of dodge on this news.

Posted by: Stuart | Mar 31, 2008 8:14:59 AM

One other thing, all should notice the SEC was fine when assets were shooting to the moon. I certainly didn't see such a similar statement when asset prices were afflicted with another bout of "irrational exuberance" and reflecting bubble-like pricing. This double standard could not be more obvious and more damaging to the credibility of US capital markets and its regulators.

Posted by: Stuart | Mar 31, 2008 8:18:34 AM

I think you may be misreading this. The way I read it, you must use observable inputs for your asset pricing if available, but if that input involved a forced liquidation of a similar asset, you're free to ignore that particular piece of data.

In other words, just because BSC was sold for $10/share doesn't mean that's what it was really worth had it not been forced into it. Given that forced liquidation is a circumstance for the entity owning the asset and not necessarily for the asset itself, it's possible that the asset price is not a true market price and you're free to ignore that data point.

Posted by: Andy | Mar 31, 2008 8:31:43 AM

I read this with disbelief but gradually it just reconfirmed for me what is going on here and that is that the administration and all the other regulatory bodies are going to do whatever it takes to avoid a market collapse. In my judgement, others may disagree, this is essentially a political decision like the Potemkin regulatory changes that Paulson is going to announce to fanfare today. Whatever happens they are desperate to prevent a total collapse during a Republican administration. Remember what happened last time. If this means throwing overboard conservative principles to rescue investment banks and homeowners so be it. If it means creating loopholes for financial institutions to lie to their shareholders so be it. We shouldn't really be surprised this is a administration that has cheerfully made lying and corruption systemic, who have launched expensive failed wars and seriously damaged our diplomatic and strategic global clout. Why should a little book cooking surprise anyone. Sorry for the political dimension but it really does seem all of a piece with their incompetence, short sightedness, mendacity and total disrespect for good govt.

Posted by: john | Mar 31, 2008 8:38:16 AM

@andy um no if US widget co. goes bankrupt its stock of widgets goes to the creditors for the famous pennies on the dollar, and you're right that does not make the widgets intrinsic value less (a big supply of widgets on the market will depress the value in the short run). What this is is 2 sets of books to try and stave off that bankrupcy.

Posted by: Mark D | Mar 31, 2008 8:53:21 AM

RE: Stuart

By any definition of free markets, the market price is the correct price.

Bear had a book value of $80 on March 1 and $10 on March 31. Even Cramer knows that the last price is the correct price.

Using your logic, if I paid $1,000,000 for my house last year but every appraiser says its now worth $500,000 because all my neighbors have been foreclosed on and I live in a ghost town; my bank must still give me a loan based on the $1,000,000 price.

Oh right, since I'm not too big to fail I don't get this bail-out.

Posted by: tbapple | Mar 31, 2008 8:57:03 AM

I agree with john. It doesn't make sense to ignore the political dimensions of this mess.

Posted by: Renting in Mass | Mar 31, 2008 8:57:32 AM

Can we all stop pretending that it's a liquidity crisis now?

If this was a liquidity crisis, you would want to mark down everything in sight, and open your books to inspire confidence.

If, on the other hand, it was a SOLVENCY crisis - well, you'd do this. Hide the losses, hope they go away. Because if everyone didn't... the system might collapse.

So, if we could now just stop pretending that it's liquidity, maybe we can fix this thing.

Posted by: Jim D | Mar 31, 2008 8:59:29 AM

Posted by: john | Mar 31, 2008 8:38:16 AM

________

Mendacious fiscal buggery ensues.

Posted by: Marcus Aurelius | Mar 31, 2008 9:05:23 AM

I agree, it's a solvency crisis.

The only solution for investors is to get the hell out until someone takes the bull by the horns and cleans up this mess.

I'm reasonably confident that won't occur in the current administration. And god help us if it doesn't happen in the next administration.

Posted by: JP | Mar 31, 2008 9:05:50 AM

tbapple

"Using your logic, if I paid $1,000,000 for my house last year but every appraiser says its now worth $500,000 because all my neighbors have been foreclosed on and I live in a ghost town; my bank must still give me a loan based on the $1,000,000 price."

No, exactly the opposite. My logic conclude your house is now only worth $500,000. I wasn't critizing the SEC for not issuing a similar statement to the upside in asset values. I was pointing out the fact that because they didn't, it is overt evidence the SEC is much more interested in preserving asset values than they are protecting investors.

Posted by: Stuart | Mar 31, 2008 9:08:08 AM

Next administration?

Posted by: Marcus Aurelius | Mar 31, 2008 9:08:42 AM

Stuart - Pushing your analysis of the million dollar appraisal: the right comparison may be, if a bank lent based on a $1 million collateral value, and then the estimated value was $500,000, BUT, the loan was current, what do you do? The answer is nothing because your underwriting took (supposedly) into consideration fluctuations in value. Someone pointed out the solvency vs liquidity differentation - right on. I recall living in mexico city in 12/1994 when they let the peso float freely. Financing evaporated overnight, literally. Then money in general became more scarce. If you had USD (which I didn't), you bought things in then devalued pesos for half - and I mean big ticket items like Cartier watches and new cars. The US Govt stepped in then as well. Essentially US Treasury (I assume backed by the Fed) propped up the Mexican Govt, directly. The Mexican banking was definitely toast but the government was next in line to collapse. I for one am grateful that the US Govt was in a position to backstop the Mexicans. Why is it that we find it so easy to criticize ourselves when the truth is, it's grey. There are no hard and true answers to any of this but one thing is sure - criticize the Fed all you want but I'll take the full faith and credit of the US Government over basically any other alternative.

Posted by: Fred | Mar 31, 2008 9:33:46 AM

Add Chris Cox to the list of Bush appointees that were formerly thought of as intelligent. I agree that you cannot avoid the political aspect of this crisis and Paulson's comment in his soon to be delivered speech that you cannot blame the regulatory system for the crisis is scary. If markets work and the regulatory system works, then what happened? Is it the bogeyman's fault? Is it Al Queda? If nobody takes responsibility, we will be sorting this out for years.

Posted by: larster | Mar 31, 2008 9:33:54 AM

"I'll take the full faith and credit of the US Government over basically any other alternative."

Good luck with that. Ultimately value is what someone else will pay. Regulators are there to protect investors not prop up interests intent on privatizing gains and socializing losses.

Posted by: Stuart | Mar 31, 2008 9:40:29 AM

I have to chime in and support john's point that there is nothing surprising about this, and that it is clearly political. The problem most people have in responding to what the administration does is assuming that they are playing by the old rules -- they aren't. They do not do things because 'it makes sense', for a given role or function to be more or less effective, or because that is what the mandate of a given entity is. They do things to manipulate the public and promote the interests of their friends.

Example: They have announced that 'because we have a big financial mess, the right thing to do is to completely gut the regulatory systems (and build a new bureacracy), and institutionalize the illegal 'bailout' of Bear Stearns. Right, because one things for sure -- there's no way that *anybody* could have forseen that a right wing takeover of the federal government would result in an out of control business environment, so ... (say it with me now) It's all Bill Clinton's fault. Well, and Roosevelt, who was obviously a commie, and stupid besides.'

How did we manage all those decades without the guidance of the right wing? No one can explain it.

I have to tangentially disagree with John however about 'principles' -- Republicans have no principles, though they really like all the intellectual fools who buy into the 'principles' they claim to espouse, oh and the religious fools who buy into them too. The reality is that any so called 'right wing principle' can be demonstrated to be a con easily and quickly, and that most particularly includes all the economic ones. Anybody who gets their 'principles' from Newt Gingrich is in for a rude awakening, though they may manage to take the rest of us down with them.

Posted by: VoiceFromTheWilderness | Mar 31, 2008 9:44:53 AM

Photo of banking members back in 2003 cutting regulatory paperwork (symbolically) with a chainsaw:

http://tinyurl.com/28oq9q

Krugman makes mention of it in today's article in the NYTimes...had to see it for myself.

Posted by: Camille | Mar 31, 2008 9:48:12 AM

I'll take the full faith and credit of the US Government over basically any other alternative.

Posted by: Fred | Mar 31, 2008 9:33:46 AM

_____

Maybe Mexico will return the favor and prop us up. I suggest you hoard dollars.

Posted by: Marcus Aurelius | Mar 31, 2008 9:52:22 AM

If what is being proposed (by the corrupt POS Paulson) is allowed to exist in it's "draft form" that is tantamount to stealing and glossing over the largest fraud and deception in the market's history. I hope that the "congress" truly looks at what is being attempted here....and it's not for our benefit.

Where do I get my pitchfork and torch??
I feel the strong need for one about now.

Ciao
MS

Posted by: michael schumacher | Mar 31, 2008 10:08:01 AM

December 2008

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