FAS 157 and the significance of distress versus bankruptcy

It wasn’t until I read about a massive writedown by a German bank associated with the bankruptcy of Lehman Brothers that I started to connect the dots. But, there is a hidden flaw in our accounting system which accounts for some of the distress associated with the Lehman bankruptcy. And it all leads back to marking to market.

As you may know, marking to market is a practice mandated under a rule called FAS 157 issued by the Financial Accounting Standards Board (FASB). This ruling has been fairly controversial as the fair value accounting instituted has meant large writedowns as asset values have fallen. FAS 157 is pro-cyclical. Basically, it says that any security which is freely traded in liquid financial markets must be accounted for on balance sheets at the price determined by the marketplace.

On its website FASB says:

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).

What that should mean to you is that financial institutions have been and will continue to write down assets on their balance sheet as they fall in the free market except when prices are the result of a distressed/forced sale. That exception is significant because it gives an out to banks which would be writing down their asset values even more right now.

Back in March, the SEC said the following (my highlighting):

Fair value assumes the exchange of assets or liabilities in orderly transactions. 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.

Translation: hide your bad assets in Level Three Assets that you are allowed to mark to make believe if you don’t want to mark to market.

But, what happens when a company is not just distressed but goes bankrupt? What happens to the debt issued by that company? What happens to the Credit Default Swaps associated to that company? A ha, this is the problem.

HSH Nordbank AG’s write-down of EUR450 million unveiled earlier this week is largely due to exposure to the collapsed investment bank Lehman Brothers Holdings Inc., a person close to HSH Nordbank told Dow Jones Newswires on Thursday.

A structured credit portfolio with a nominal value of EUR600 million is composed “mainly” of Lehman paper, the person said. On Tuesday the bank said that the value of the portfolio had to be written down to EUR150 million.

In November, HSH Nordbank said its losses from Lehman exposure amounted to EUR140 million.

You see where this is headed? We’re back to mark to market, essentially. Before Lehman went bankrupt, I’m thinking one could mark Lehman CDS paper to make believe. When they went bust, that game was over because the credit event meant it was time to settle and those writedowns came onto the books.

As I see it, this is another reason why Mssrs. Paulson, Bernanke, and Geithner erred in allowing Lehman to go bankrupt in the way they did. If any other company were to go bankrupt the way Lehman did — and if there is a huge volume of CDS paper associated with that company (think General Motors, Citigroup), then…..Bang!

HSH Nordbank EUR450 Million Write-Down Mainly Due To Lehman Source – CNN Money
Summary of Statement No. 157 – FASB Website
Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements) – U.S. Securities and Exchange Commission

  1. Emma says

    Amazing catch there. Thank you for this! And thank you for this site, you provide the best analysis out there.

    1. Edward Harrison says

      @Emma, thanks for the compliment. It’s always gratifying to know that you add value. I appreciate the kind words.

  2. John Creighton says

    Yesterday, I learned about credit default swamps and it almost makes me angry the lack of sound regulations to deal with defaults and counterparty risk. For private companies making deals to hedge against risk I’m not overly concerned about regulations but for publicly traded companies to declare them as an asset to me is equivalent to fraud.

    Perhaps it is technically legal and maybe their exposure to this risk can be found in the documents that they give to the securities and exchange commission. First if a bank makes a loan, they can list the loan as an asset but they have a corresponding deposit which shows up as a liability to balance the asset. The bank must also have enough capital to deal with risks associated with loans defaulting and people requesting their deposits back.

    Thus in the case of a banks the asset is balanced against the liability but in the case of a credit default swap my understanding is the potential liability is not shown on the balance sheet. In my opinion proper reporting would be to show the liability as the amount that they would owe in the case of default. The asset would show the amount they would owe in case of default plus the value the credit default swap is worth on the market.

    Given that these represent potential gains and losses they should be separated on the balance sheet as potential assets and potential liabilities. Now the question is should the company be required to have a net capital which is a given percentage of these potential liabilities. That is should they have similar rules as the capital requirements that banks are required to have. In my opinion if it is a finical institution then these capital requirements should be necessary.

    Not sure about CDS rules in Canada but as I understand one thing that reduced Canada’s risk to the sub prime crisis is credit unions and other finical intuitions were required to play by the same rules as banks.

    Now as for your “mark to make believe” section of this thread. Where do I begin. How can companies declare they have an asset without any real basis for the value?

    Oh yeah, one last thing that bugs me about credit default swaps is how can you sell your liability? Shouldn’t that require you to renegotiate the CDS you had with the original buyer as selling the liability could increase the original buyers counterparty risk without his consent? Rather then selling the liability shouldn’t you renegotiate a new CDS agreement with a third party to cover the risk of your liability?

    1. Edward Harrison says

      @John, I have to say the CDS disaster is yt again a sign of deregulation run amok. I said to you in a reply to my post “A brief philosophical argument about the role of government, stimulus and recession” that I felt we were seeing an excessive concentration of power and wealth.

      I feel that deregulaton is a symptom of the problem. In essence, the financial services industry has started to control too much power and have cajoled government into reducing oversight. This power breeds a contempt for rules and regulations and is at the core of the desire to deregulate. We need to regulate and have checks in balances all along the way to maintain a stable and functioning system. Deregulation i.e. no regulation leads to excess, which leads to depression, resentment, revolution, and all manner of ills.

      I know this is a somewhat philosophical reply to your comment, but I genuinely believe the root of the problem lies in the excessive concentration of wealth and power in the financial services industry.

  3. John Creighton says

    Would the CDS disaster be as big if the centrally planed monetary institutions (Socialist finial system) didn’t allow people to excessively leverage as a consequence of keeping the interest rate artificially low? Ive heard the fed compared to a banking cartel. Given that it is independent to the Untied States government and that the ability to control the money supply gives in incredible power, I don’t think it is unreasonable to say the financial sector is too powerful. I do believe that CDS should be better regulated as I suggested above. I say this not because I believe in government regulation but because the public markets are a collective enterprise to exchange goods. It would seem like a waste devote so much collective energy to trading junk. Why not turn them into something that is worthwhile to trade.

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