An article titled ‘Credit markets regain record pace’ says that “Taking advantage of open markets, companies rich and poor are selling debt - whether they need to or not”, reporting that “Bankers and investors are expecting a flood of such fundraising transactions after both bond and credit markets have soared in the past month, driving down the cost of raising capital”.  Finance 101 would say there is a prospective danger in companies borrowing more than they need, or borrowing because they can’t (or don’t want to for shareholder dilution reasons) raise equity.  Depending on fact specific circumstances, such borrowing may increase the risk profile of a company’s outstanding equity shares.  This in turn ultimately may lead to even more shareholder dilution than might be experienced today if and when equity capital must be raised to repay that debt, or in an ultimate bad result, ‘business failure’.  In my view it is one thing to be conservative and add equity financing when it is available to strength a company’s balance sheet, or to create a ‘rainy day fund’ for a company ‘because equity financing is available’ on favourable terms.  It is quite another to raise unneeded cash through debt because ‘one can’.  The latter could prove to be a dangerous game for the companies that do it if we don’t experience near-term economic recovery, and a particularly dangerous game if the world economy worsens from here.

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An article yesterday titled ‘Banks applaud planned mark-to-market rules’ says Canada’s Accounting Standards Board unveiled proposed changes Thursday to relax mark-to-market rules that apply to some troubled holdings that have been affected by the market turmoil, making it easier for banks and other companies to avoid writedowns. Why wouldn’t banks applaud this? It will enable them to report better earnings and balance sheets than they otherwise would have to do. That said, a modification to the previously approved U.S. model is that the proposed rule change is only available for debt instruments that companies intend to hold to maturity. Canada will still require securities being held for sale to be recorded at fair market value. The proposed change is a compromise that moves Canada largely in line with recent mark-to-market accounting rules while not fully copying the new U.S. model – but in my view is nonetheless wrong-headed. Essentially what this does is to some degree create ‘lipstick on a pig’ balance sheets, and defers the problem of loss recognition where losses on debt instruments expected to be held in the long term ultimately are realized. It also may, depending on how it is drafted, give Bank managements the subjective ability to place debt instruments in the ‘hold to maturity category’ when otherwise they might not have done this.

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An article yesterday titled ‘Toxic debt writedowns may reach US$4.1-trillion’ reports the International Monetary Fund now thinks Global writedowns of toxic debt among banks and other financial institutions in the United States, Europe and Japan could reach US$4.1-trillion of which the deterioration in U.S. originated assets may account for as much as U.S.$2.7-trillion – up by $500 billion from the IMF’s January forecast, and that globally banks will face the bulk of the writedowns. The article reports that “Since the start of the crisis (presumably dated to about September 2008), market capitalization of global banks has more than halved to US$1.6-trillion from US$3.6-trillion. The IMF apparently thinks Financial Institutions are likely to face losses for a period that would be broadly consistent with the time it took banks to recover during the Great Depression and in Sweden in the early 1990s, but that current writedowns are likely to be more severe than during those crises.

The question I continue to have with respect to these IMF quantifications of forecasted ‘toxic asset’ losses is what accounting standard is assumed when they are generated. If conventional mark-to-market rules are being applied to generate these forecasts it seems to me that is one thing. However, if the new and more subjective mark-to-market rules are being use to generate them the picture may turn out to be far worse than any current forecast implies.

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An article today titled ‘Criticism of U.S. accounting changes mounts, and IASB said the rationale for watering down fair value is “crazy”’, reports that Tom Jones, vice-chair of the International Accounting Standards Board, has said Wall Street lobbyists and U.S. politicians are damaging the credibility of corporate reporting and hurting the interests of investors around the world by pulling-back on fair value accounting. In an interview with the Financial Post, Jones warned of “a loss of credibility” and said the rationale for watering down fair value is “crazy.” He also cited concerns about political interference that could undermine the independence of accounting rule setters, a fear that was echoed Monday by other senior accountants. Criticism of those seeking to do away with fair value accounting was echoed by Nouriel Roubini, the widely reported New York University economist and founder of the RGE Monitor website. On Monday Mr. Roubini called the U.S. rule changes “a big mistake” that have allowed Wall Street banks to “fudge” their latest set of quarterly accounts. The article also reports that at a London meeting of the Financial Crisis Advisory Group, senior industry experts expressed concern about the politicization of the process of revising accounting standards. Harvey Goldschmid, the group’s joint chair who is a former commissioner of the Securities and Exchange Commission, and IASB chair Sir David Tweedie, were among those who warned of the dangers of political pressure that could weaken the independence of accounting standard setters.

This is precisely what I have said in different ways in several posts on this blog dating back to September, when the SEC first became involved in the mark-to-market debate. Importantly in my view, the recent rise in the U.S. stock market indices frequently has been attributed at least in part to Q1 positive earnings reports from some of the large U.S. banks. The open question is: Would they have been profitable under the old mark-to-market rules. The sad truth is that no one likely will ever know, or if they would not have been will only know ‘too late’. Ultimately; however, Mr. Market will price stocks based on free cash flow and solid ‘properly valued asset’ balance sheets, not based on highly subjective decisions made within the accounting reporting rules of the time.

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An article yesterday says ‘Wall Street rallies on mark-to-market easing’ on Thursday after FASB - the U.S. Federal Accounting Standards Board that sets U.S. accounting standards - agreed to give banks more flexibility in applying mark-to-market accounting to their toxic assets. The same article says “Optimism was also boosted as leaders of the G20 nations agreed to put an additional trillion dollars into the ailing global economy through extra funding for groups like the IMF”.

Please take the time to read the last two of my prior posts on Mark-to-Market accounting. I consider the reaction of the stock markets to the aforementioned news – if indeed that has contributed to the U.S. market indexes rising yesterday morning – as truly ludicrous. Not only will this change make the financial statements that will be produced by the banks going forward less reliable in my opinion, it is not earnings and book value – which are the only things this change results in – that ultimately determine share value. It is after-tax discretionary cash flow that dictates value in the end. This is something that not all stock analysts seem to focus on. If they did, accounting changes that simply enable manipulation of numbers would be disregarded by Wall Street.

A ‘Money and Markets’ article today titled ‘Mark to Market Madness … Geithner Plan Shenanigans … the Economy … and More’ is as negative on the Mark-to-Market changes as I am.

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An article yesterday titled ‘FASB Plan To Allow Cos More Leeway Under Mark-To-Market’ says “Accounting rule-makers have proposed allowing companies to use more leeway in valuing their assets under “mark-to-market” accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis, and that the Financial Accounting Standards Board (FASB) agreed Monday on proposed guidance that would make it easier for companies to use their own models, estimates and judgment in determining the “fair value” of their assets. The new proposal clarifies and modifies when companies can find that trading in an asset has occurred in an inactive market and under distressed circumstances, and in such circumstances would enable companies to use their own valuation techniques in pricing the asset, instead of relying on what they contend are market prices that are temporarily weighed down and unnaturally low. FASB says this approach will require companies to exercise ” significant judgment.” FASB plans a final vote on the matter on April 2, after providing a 15 day public comment period.

I have spent my adult life as a fee earner giving objective opinions on company share and asset valuations. My firm - Campbell Valuation Partners Limited - does that every day, and potentially stands to benefit hugely from such the suggested change. That said, I completely disagree with what FASB is proposing. If implemented, and I am virtually certain it will be (what with U.S. government and SEC pressure on FASB to enable U.S. financial companies to no longer play by the ‘transparency rules’ existing market-to-market rules enforce) the result inevitably will be inconsistent reporting among financial institutions as their managements ‘lipstick up’ their balance sheets and profit and loss statements from what they would be under existing mark-to-market rules. I think this may lead to potential stock market losses for investors whose investment advisors rely on those ‘tarted-up’ financial statements to make financial stock recommendations. Investors savey enough to know that share value ultimately is driven by discretionary free cash flow – which can’t be ‘played with’ – and not by subjectively determined accounting numbers ought not to be hurt by these proposed changes. Less sophisticated investors in my view likely are going to suffer a bad result in the end. Simply put, the world stock markets may go up in the near-term, but changing accounting rules, and hence what financial statements say will not solve the current economic problems. Old sayings are ‘old sayings’ because they have stood the test of time. ‘Figures lie, and liar’s figure’ is a venerable old saying – in my view we are seeing ‘first hand’ the beginnings of application of that old saying.

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An article Thursday titled ‘U.S. nears mark-to-market accounting guidance’ reported U.S. accounting rule makers and regulators said they were pushing ahead with new guidance on mark-to-market accounting, saying Financial Accounting Standards Board (FASB) member Lawrence Smith said Wednesday FASB would ‘in the real short term’ include guidance on whether a market is active or inactive and whether a transaction is distressed.  SEC Chairman Mary Schapiro told Congress she was keeping the pressure on FASB, saying “FASB has committed to us that the guidance will be out in the second quarter”.  The article says the mark-to-market accounting rule is defended by investor advocates, but that the banking industry has pleaded for a suspension or modification of the rule.  The article further reports the SEC and FASB oppose suspension or elimination of the rule, and that Fed Chairman Bernancke is against suspension but called for improvements.  On Thursday before a Congressional hearing the Office of the Comptroller of the Currency said it was inappropriate to suspend the accounting rule.

See my post of yesterday on this subject.  As I have previously said, in my view allowing management subjectivity to assess whether markets are ‘normal’ or ‘not normal’ – which seems to be a mantra of those who want to change the rule – would be a ‘recipe for disaster’ from a ‘reliance on financial statements’ point of view.

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I first discussed ‘Mark to Market’ Rules on this blog on October 1 when it was announced the SEC provided new guidance on the ‘mark-to-market’ rules for at least the financial industry.  Among the several points I made then were:

•    ‘Mark-to-Market’ accounting rules were put in place to subject company management to financial reporting rules and reduce their ‘reporting latitude’, and to let investors and others to better measure management performance and know sooner than later whether a company’s net asset values (and hence capital) had been eroded by prevailing open market conditions.

•    if implemented, the new SEC guidance would be ‘letting the camel in the tent’ as company managements would have more latitude when deciding whether or not to write down under-performing assets based on their subjective views as to whether ‘relevant market evidence exists’ and whether the assets they hold are subject to ‘distressed or forced liquidation sales and (hence) are not orderly transactions’;

•    I think importantly, improving balance sheets and income statements through changes to accounting treatments would result in many less sophisticated investors assuming a business that does not mark its assets to market is in better financial shape than it is; and,

•    accounting rules and their application can change balance sheet and income statement ‘cosmetics’, but they do not change the ultimate valuation fundamental which is ‘how much cash does a company have in its coffers to operate its business day to day, and will its prospective cash flow sustain the business and result in appropriate after-tax free cash flow returns on invested capital’.

I commented on this subject again on February 6 when I said:  In yet other developments that strike me as inconsistent, there are reports this morning that “U.S. officials are examining ways to convert government stakes in banks into ordinary shares as banks accumulate losses” and that (paraphrased) “a senior U.S. Senator yesterday said it might be possible to modify ‘mark-to-market’ accounting rules for U.S. banks facing steep write-downs of troubled assets without abandoning the underlying accounting standard”.  I concluded then that if the U.S. government converted its preferred shares in the ‘bail-out banks’ to common shares it likely would do that at prevailing stock market prices.  I further concluded that if it did that, and likewise purchased more bank common shares as it proceeds with its ‘bail-out’ packages, the U.S. government likely would end up overpaying for those common shares if it simultaneously pushed for and got revisions to the accounting ‘mark-to-market’ rules.

I was heartened by a Bloomberg article titied ‘Nobody Says Mark to Market Doesn’t Matter as GE Falls’ which reported that Fed Chairman Bernanke said on Tuesday he wouldn’t support any suspension of mark-to-market accounting.  While the referenced article discusses GE and its stock price at length, my interest is far more in the broader picture.  The article says that:

•    banks say the mark-to-market rule requires them to report losses from falling values even if they don’t expect to incur penalties because the assets aren’t for sale, and that resultant lower asset valuations can force them to raise capital to comply with federal regulations;

•    the Blackstone Group LP Chairman, the American Bankers Association, and 65 lawmakers in the House of Representatives urged that mark-to-market rule be suspended last September (see above), that William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985, has called fair value “extremely and needlessly destructive” and “a major cause” of the credit crisis, and that Robert Rubin, the former Citigroup Inc. senior counselor and Treasury secretary, said in January that the rule has done “a great deal of damage.”

Any bank representative, lawmaker, or other person making such suggestions in my view needs to give their ‘head a shake’.  The time to have complained about the mark-to-market rule was when it was in the discussion stage.  The banks clearly knew about the rule when they made the loans they did during the ‘Bush/Greenspan’ years.  For them to now say “gosh, these rules are causing us problems’ is in my view ridiculous – and I say “Good on You Ben Bernanke”, and stick to your guns.

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