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FAS 157

 



About Savvysoft: Savvysoft offers valuation models for plain vanilla and exotic derivatives across all markets, as well as hedge accounting systems. The company has been named the #1 Derivatives Analytics supplier each of the past four years in surveys by Risk Magazine. For a demonstration of our TOPS valuation models, our STARS Accounting hedge accounting system, or the Savvysoft Hedge Accounting Service Bureau, click here. To contact the author please visit www.Savvysoft.com/contactus.htm

In Defense of FAS 157

By Rich Tanenbaum, Savvysoft

As government officials debate the emergency rescue plan, one of the key issues being raised is an arcane accounting statement called FAS 157, also known as mark to market accounting. Some versions of the bill call for rescinding it, and some call for the SEC to investigate whether or not it has exacerbated the credit crisis. It’s important to understand the role FAS 157 plays, and also why it became an accounting standard in the first place, to be sure we don’t throw out the baby with the bath water. This understanding will also serve to help frame the debate over what the implications of the rescue plan are, and shed some light on how sound the plan is.

Let’s start with some background. One of the roles of accounting is to determine the value of a firm. Investors need to know how well a company is doing to decide what to pay for their stock or bonds. Accounting standards exist so that investors can be sure that the same rules are being applied to every company. At least, that’s how it is in an ideal world, though the reality is not always that simple.

Individuals don’t issue stock in themselves, but they do borrow. And so lenders, too, want to assess the net worth of someone before giving them a loan. And by far, the biggest loan most people have is the mortgage on their home, and lenders are rightfully concerned about the value of that home.

So let’s say John buys a house for $200,000, putting down 10%, or $20,000. A year later, thanks to a housing boom, other houses in his neighborhood are selling for $240,000. John decides he wants to build an addition, so he gets a home equity line of credit against his $40,000 profit. How was he able to do that? Simply, because an appraiser said the house was now worth $240,000. John didn’t need to sell the house to see what it was worth, but instead an appraiser likely applied a mathematical model, based on where he saw market transactions, to come up with a market price of the house.

This is very similar to what can happen in a stock portfolio: if John has a margin account with $80,000 worth of stock in it, he can borrow up to $40,000 against it. But there’s a key difference between the two when the stock market, or the real estate market, goes down. In the margin account, if the stocks drop to $40,000, his broker is going to give John a margin call, which means he needs to repay part of the loan. But if the value of the house drops, John can keep making his mortgage payments and not worry about repaying any of the loan early.

So there is an inherent asymmetry in real estate that we don’t have in stocks: gains can be recognized with a home equity line or a refinanced mortgage, but losses can be ignored. However, if John applies for a car loan after his house has dropped in value, chances are the lender will be less likely to make the loan, making the two, real estate and margin, more similar than they might otherwise seem.

When it’s a company, and not an individual, we have more reasons to want to know the current value of both the assets and the liabilities, on a regular basis, and not just when a company wants to borrow. And that’s the reason mark to market accounting has become a standard: so investors know, every accounting period, the value of the firm.

While companies have been marking their assets and liabilities to market for several years under FAS 133 (an earlier standard related to FAS 157), there are portions of FAS 157 which give guidance on how to mark things to market. Specifically, it says if an instrument trades on an exchange, it should be marked where it closed on the exchange. That seems reasonable. These are often called Level 1 instruments. Level 2 instruments are not traded on an exchange, but their price can be determined based purely on observable values like exchange prices, using a simple mathematical model. An example of this might be an OTC stock option with a strike price and expiration very similar to those that trade on an exchange. And finally there are Level 3 instruments, where assumptions must be used to come up with a fair value. So far, so good.

But there’s one extra little tricky clause in FAS 157: if you price a Level 3 instrument, the value should reflect where the firm can get out of the position (sell an asset, or buy back a liability). In a liquid market, with no distress selling, that would seem to be quite reasonable. Sure, a company may suffer a loss if they bought a bond, and interest rates subsequently rose, so their mark to market will recognize that loss. But it’s altogether different if they buy a bond at par, and when it should be worth 80 there are no buyers out there, except for vulture funds willing to pay 30. Where should it be marked then?

FAS 157 says: if anyone sells it for 30, then similar instruments should be marked to market at 30. This has triggered huge accounting losses at many firms, and a case could be made that 30 is not the right price because it reflects an individual situation, not the market. Going back to John, if he is transferred to a new town and must sell his house right away to get the cash to buy a new one, his discounted price shouldn’t be naively taken into account by appraisers valuing other houses in the neighborhood.

But it would be just as wrong to let the companies continue to price the bond at par, if it really is worth less than it used to be. That would distort the earnings in the other direction, which is not fair to investors who buy the stock while the assets are marked artificially high.

The best price, I think, is the 80. In the case of a mortgage backed security, the 80 reflects the fact that some homeowners will default on their mortgages, but not as many as are implied by the distressed price of 30. The price of 80 is not observable in the market, but it is calculated, based on a mathematical model, based on where other, liquid, instruments are trading, and based on sound assumptions like expected defaults, which are clearly stated in financial reports. Without this number it is not possible to create the most meaningful valuation for the firm.

There is one other aspect of FAS157 which impacts how to price instruments, and that is to take credit risk into account where applicable. In over the counter contracts, as opposed to those traded on an exchange, two parties shake hands and agree to payment terms. In an interest rate swap, for example, Party A pays money to Party B when interest rates are high, and Party B pays money to Party A when rates are low. When each party calculates a value for the swap, they need to consider the likelihood that there will be a default on the payments. If Party A is near bankruptcy, that means that its expected payments should be discounted at a rate which reflects their credit spread. Under FAS 157, this fact needs to be taken into account by both Party A and Party B. While this turns out to be a somewhat laborious task even for computers to deal with, it makes economic sense. For example, if Party A is expecting payments from Party B on a swap, and Party B is downgraded and has a higher credit spread than before, the swap should be marked down, just like Party B bonds would also drop in value in those circumstances. And Party B should recognize a gain on the swap, just as they would recognize a gain when their bonds, which are liabilities, drop in value.

This aspect of FAS 157 is not often noticed. The implication is that as a company’s fortunes decline, so does the value of their liabilities, which actually results in profits. So when AIG had problems, the billions of dollars worth of credit default swaps they wrote (effectively, the insurance they wrote on other company’s bonds) went way up in value, allowing AIG to report a huge profit under FASB 157 (or at least less of a loss than would have reported otherwise). Although it seems like a counter-intuitive result, it does reflect greater consistency of OTC instruments with exchange traded, and we feel that has also made FASB157 a sensible standard.

Therefore, I urge Congress, the SEC, and FASB, to retain the principles of fair value accounting, and require firms to mark their assets and liabilities to reflect changes in value, including taking counterparty credit risk into account. But I also urge these bodies not to force companies to take illiquidity into account when determining fair values. This will allow the financial system to retain the transparency which in turn creates liquidity, without unduly hampering the ability of firms to raise capital when their assets and liabilities are temporarily illiquid.

And what does all this mean for the rescue plan? It’s now clear that if the government pays 30 for the distressed securities, when they are really worth 80, that the government, and taxpayers, are going to be reaping a huge windfall. But the firms selling the assets should be indifferent to selling them to the government for the same 30 they can get from the vulture funds. At the same time, if the government pays 80, while they will have gotten the instruments at fair value, they would still be subject to the many risks that they will rise or fall in value due to market fluctuations, and greater or lesser homeowner default experience. The government, under prudent risk practices, should therefore look to purchase the securities for a reasonable discount to fair value which reflects the illiquidity, and the risks that they could drop further in value before they are sold in an orderly fashion. The discount does not need to be reflected in the purchase price, though. The plan which was proposed on September 28 called for the government to receive stock warrants or senior debt in any firm which sold distressed securities to the government. The stock and debt has a quantifiable value, which can allow for a price closer to 80 to be paid. With the appropriate risk adjustments and illiquidity adjustments being made as instruments are purchased, the rescue plan can safeguard the government’s (and taxpayer’s) interest, while insuring the stability of the financial system. All of this doesn’t require rescinding FAS 157.

About Savvysoft: Savvysoft offers valuation models for plain vanilla and exotic derivatives across all markets, as well as hedge accounting systems. The company has been named the #1 Derivatives Analytics supplier each of the past four years in surveys by Risk Magazine. For a demonstration of our TOPS valuation models, our STARS Accounting hedge accounting system, or the Savvysoft Hedge Accounting Service Bureau, click here. To contact the author please visit www.Savvysoft.com/contactus.htm

 

 

 

 


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