Correctly Political Action Alert: Can We Stop The Deepening Fraud of "Unobservable Inputs"?!?

Fiend of Wall Street, former AIG Chairman Maurice "Hank" Greenberg.

Big @!$%#pile

Paul McCarthy's @!$%# Pile, Middelheimmuseum; Photo by Uw Moeder; Creative Commons Licence

Level 3? Or Third Circle?

Chart quoted from Goldman Sachs Level 3 Assets Jump, Exceeding Rivals'.

Give Geithner a Little Credit, Okay?

Secretary of the Treasury Tim Geithner isn't as bad as he could be. Really. At any rate, that was going to be the hypothesis of an article I started writing this week. The reason is, I had a memory of Geithner last Autumn when he was still with the New York Branch of the Federal Reserve rather stridently rejecting calls to loosen "mark to market" accounting rules. But before I started writing I figured I better check to make sure that he maintained that position.

Luckily for the purposes of the article I was going to write, it turned out that just last week in Senate testimony Geithner had been asked about it and he had maintained his position. (Although it's curious that his comments were written out of later versions of this story such that Google cache was required to document it.) He may not be the most sparkling public speaker. He may have made a variety of technical or political errors in his Cabinet post. But at least he remained committed to genuinely prudent accounting rules.

Whew.

However, while reading the news stories, I discovered that on the same day over on the House side, Representative Paul Kanjorski, a Pennsylvania Democrat, had convened a hearing on mark-to-market accounting rules in his Subcommittee on Capital Markets.

Perpetuated Perpetrators

Yowser. The Chair of the Financial Accounting  Standards Board, Robert Herz, got pulverized by Kanjorski and Representative Gary Ackerman, another Democrat, for having steadfastly refused to loosen mark-to-market throughout this current crisis. Now it's true that most of the loudest and shrillest partisans of loosening mark-to-market are corporatist Republicans in both office and in the media. Cocaine-addled con man Larry Kudlow has been banging that drum for months.. Republicans in the House, including the Ranking Member of the Banking Committee Spencer Bachus and Representative Gary Miller of California have also loudly demanded such loosening.

The hearing ended with Kanjorski threatening to pass legislation to force Herz to loosen standards. In fact, the pressure was so intense that the FASB announced the new rule after only a week. The Chairman of the full committee, Barney Frank, seems to have accepted it as a foregone conclusion. This is absolutely unacceptable. Democrats pressing for this, like Paul Kanjorski and Gary Ackerman, need to stop. Go-along Democrats like Senator Christopher Dodd and Barney Frank need to stop going along. As a Democrat myself, I can complain about the Republicans all I want but the fact remains, the Democrats hold power and it is only because of pressure from Democrats that this loosening is being rushed to implementation. At the end of the day, loosening mark-to-market will only allow the fraud that is the current financial system to be perpetrated, er, I mean, perpetuated.

What the Heck Am I Talking About?

Here's the issue in a nutshell. According to FASB Rule 157, there are three Levels of assets on a bank's books which require an assessment by the bank itself, the "reporting entity," as to those assets' "fair value.

Level 1 is easy: Market value. If you own a house, and you sell the house for $100,000, and you get cash for it, you know the fair value and FASB standards would require you to list that figure as the value of that asset. That you mark to market.

Level 2 is slightly trickier, but still quite reasonable. If you own a house in a development of very similar houses, all of the same age and condition but you have not sold your house, how do you determine fair value? Well, the house next door recently sold for $105,000 while the house on the other side sold for $95,000. Although technically that's a model not a market value, a mark-to-model valuation (your model assumes that similar houses in a development will sell at around the same time for approximately the same price), your model consists of observable inputs because real money changed hands in a real market for similar assets. For all intents and purposes that is mark-to-market as well because the model includes only market-determined inputs. You list the value as $100,000.

Level 3, though, is where the action is. Suppose there hasn't been a sale at all in your development for three years, well, except that one where the drunken guy fell asleep smoking and luckily survived but there was smoke damage and then he lost his job and the bank foreclosed. What's the market? Where are the observable inputs?

Well, gee. Problem. What to do, what to do? Turns out, the proposed new rule allows you to make stuff up about what value your house should be listed at. Since there's no market and no observable inputs except for that one sale by the unemployed drunk (and taking that price as a Level 2 input would push you into technical insolvency), you may, according to this rule, construct a model of UNOBSERVABLE INPUTS and then apply that model in determining fair value. So, what the heck. It's a nice neighborhood, the cat-piss stains on the living room carpet are well-hidden, there's a dogwood shading just your portion of the back alley, let's say it's worth $125,000.

The Rules

Don't believe me? Check this out, directly quoting the actual proposed rule change:

Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk).

Got that? The Bank gets to assume what other people would assume about the asset's value, then list that as "fair value." But wait, it gets better. For clarity's sake, this is from the executive summary rather than the actual rule:

For example, the reporting entity could use an income approach, such as a present value technique to estimate fair value. The inputs to the present value technique should reflect an orderly transaction between market participants at the measurement date.

"Present value" is when you know the nominal value of something at some time in the future but you want to know what it's worth now. For instance, I give you a $100 cashier's check post-dated a year from now. How much are you willing to sell it for? In ordinary circumstances, probably like $93 or $94. However, in certain circumstances you might get $100 or even more than that if the people you are selling it to expect deflation to occur in the next year, that is, if the $100 check will be worth $110 in current dollars a year from now.

So. Put together the technique recommended by the FASB with the method allowed for Level 3 valuation: Banks get to assume what market participants will assume about what market conditions will be at some unspecified point in the indefinite future. Then they get to use those assumptions to spit out a number, then enter that number into their books as "fair value."

The Too-Big-To-Fail Boys Love This

This is bloody insanity. It wouldn't be so insane if we had reason to believe that the reporting entities would utilize honest, prudent and empirically-tested "unobservable inputs." As I'll concede below, there may indeed be situations where Level 3 valuation is appropriate. Except for one teensey-weensy detail: If there's one thing we know from all this it's that reporting entities can't be trusted with models that they themselves create to serve their own bottom lines.
 
A little visit to the wayback machine, let's jump in the time machine and travel all the way back 11 months ago to a point after Bear Stearns had been absorbed by JP Morgan but before Lehman Brothers went belly up. The chart above, from the linked Bloomberg article, documents the the change from 4Q 2007-1Q 2008 and the dollar-total of Level 3 assets held by Goldman Sachs, Morgan Stanley and the late, sidewalk grate Lehman Brothers. Goldman increased it's Level 3 accounting by upwards of 50% to the tune of about $100 billion.

Thus. After the first loosening of mark-to-market in 2007, you can see who took advantage and to what extent. The only reason Lehman's quarter-to-quarter rate of increase was so low is that .... they had already packed as much as they could get away with into the Level 3 pile during the quarters previous.

In Dante's Inferno, Level 3, that is, the Third Circle, is reserved for the gluttonous. 'Nuff said?

And now the banks and their fronts in Congress think even those earlier rules are too tight? And they want looser rules?

Well, okay. I must admit that as I was researching this article I discovered that there actually are good reasons why mark-to-market might be hurting some banks unnecessarily and perhaps exacerbating a problem that could be prudently solved. And it kind of explains why lots of members of Congress of both parties are so committed to this seemingly insane project. It seems that lots of small and medium-sized banks, community and regional banks, exactly the kinds of financial institutions that are most important in a given Congressional District or state but NOT so much national or international players, many of those banks are using Level 2 rules when they should be using Level 3, in other words, they really are under pricing their assets to some detriment to their capital requirements. One of the best places to get fair-minded (even if somewhat self-serving but aren't we all?) argument in favor of looser mark-to-market rules is a site called Mark To Market Debate.

So maybe the FASB isn't absolutely insane. But still, this is the wrong rule at the wrong time because it is absolutely certain to be exploited by the WRONG PLAYERS. Wondering how Citigroup ended up with such pleasantly surprising recent results, supposedly, maybe, anyway, according to a memo by Citigroup Chairman Vikram Pandit? How about the INCREASE, yes, you read me right, the INCREASE in Level 3 assets carried on Citigroup’s books from year-end 2007 to year-end 2008? Look at the chart above listing Lehman as having $42 billion in Level 3 assets on their books, a bankrupt Lehman, and realize that Citigroup has $146 billion in such assets (listed on page 199 of the linked 2008 annual report, a big .pdf file), and then you tell me what your assumption is about what other people will assume about Citi's "fair value" sometime whenever.

Yeah. Right.

The simple and absolutely undeniable FACT is that the large national/global financial firms cannot be trusted to use unobservable inputs honestly. They use those accounting rules to lie, cheat, steal and defraud--legally, perhaps, but it's still lying, cheating, stealing and defrauding.

In which I Concede Some Ground But Not the Standard

The FASB may in truth need a rule to assist the smaller institutions, but this proposed rule is an absolute outrage. It cannot stand as written because the literal costs of allowing the known fraudsters to legitimize their fraud far outweigh the benefits of allowing smaller institutions the leeway they need to weather this cyclone of financial crisis. It’s penny wise and trillions of pounds foolish.

I can imagine some sort of rule or rules that might allow some loosening only for those institutions genuinely and unjustly damaged, but we cannot have that rule apply to institutions that exploit that rule to inflict catastrophic damage on the financial system. One idea might be to restrict the rule by way of a sliding scale according to size. The larger a reporting entity is, the less it is allowed to use Level 3 mark-to-model accounting.

Another idea might be to empower a Federal agency (the Commerce Department hasn't done anything lately) and only that Federal agency, to either construct or approve the "unobservable inputs" and make those models public knowledge. So that we all know, investors, citizens, taxpayers, members of Congress, so that everyone knows what assumptions underlie the "fair value" claimed on an institution's books.

Senator Dodd's compromise seems reasonable, too. He wants to establish preset “breaker” conditions similar to the trading curbs on the stock exchanges such that if there are unusual, temporary circumstances in which mark-to-market is having pernicious, unintended effects, then the rules could be eased until orderly markets return. But all that is for later.

CALL TO ACTION!

Meanwhile, back at the ranch, after his beating before Congress, Herz took a mere week to produce a proposed rule and it's set to go into effect immediately after the public comment period which ends April 1. Like THIS April Fools' Day, like, a few days from now, like another week. Like, things are happening fast as FASB. And lo and behold, the FASB website does not have a convenient or prominent form to register a public comment. In order to find out how and where to submit a comment on this monstrosity, you have to actually download the .pdf file, then read the whole damn thing and hope your eyes haven't glazed over and you missed it.

Luckily for Newsvine, I did that. Follow these instructions to the letter (remember, you're writing to a bunch of folks anal-retentive about details) and let the FASB know that the way to stop corruption in the system isn't to legislate the corruption into the system:

Responses must be received in writing by April 1, 2009. Earlier responses are encouraged. Interested parties should submit their comments by email to director@fasb.org, File Reference: Proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b. Those without email may send their comments to “Technical Director, FASB, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, File Reference: Proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b.” Responses should not be sent via facsimile.

If, as is most likely, your Representative in Congress supports this loosening, or is willing to go along with it, write to them immediately! Strangely enough, this appears to be one of those issues where the wingnut right-wingers in Congress and their moonbat left-wing colleagues seem to agree. Witness lefty populist Florida Democrat Alan Grayson, on the one hand, and Senate Banking Committee Ranking Member Richard Shelby, right-wing Alabama Republican, on the other hand.  That particular strange-bedfellowing has become so much more common lately that it doesn’t seem so strange anymore. And things are getting to the point now that whenever I see the wingnut/moonbat coalition emerging I’m going to just support the wingnut/moonbats until I have reason to know different. They may have different premises but their conclusion--The System is corrupt and seeking ways to maintain its corrupt benefits—is absolutely correct.

If you read or watch the testimony before Kanjorski's committee, I think it's clear that the FASB is proposing this rule only under duress, which means just a little citizen action may be enough to convince them to slow down or halt this crazy accounting gimmick. So.

Take.

Action.

NOW!

Back To Top

Mark-to-Market: The Bogeyman of the 1930s Is Back -- Seeking Alpha

Energy Sector and Stocks Analysis from Seeking Alpha

Sun Mar 22

0