Attention: This may be the single most important piece of news regarding the financial industry you will read this week. Maybe for the whole month. Maybe for the whole year. Okay I'll stop being melodramatic and get right to it. The Financial Accounting Standards Board (FASB) is in the process of making banks very unhappy. In a complete reversal from their revised policy released in April, it is considering vastly tightening mark-to-market requirements to include virtually all securities on a bank's balance sheet. Yes, it even wants the very, very illiquid stuff marked-to-market.
To understand a bit more about what how assets are valued, this entry I wrote a while back may help. Mark-to-market is an accounting concept requiring that banks mark the value of the assets on their balance sheets up or down depending on how their values change in the market. Right now, very illiquid assets do not have to be marked-to-market, so instead can be valued by the bank using internal assumptions.
Here's a blurb from FASB's July 15th board meeting:
The Board agreed to propose that all financial instruments will be presented on the balance sheet at fair value with changes in value recognized in net income or other comprehensive income with an optional exception for own debt in certain circumstances, which will be measured at amortized cost.
Why almost no one is reporting on this shocks me, because it's a huge deal. FASB is suggesting that all financial instruments -- the good, the bad and the ugly -- must be valued on a bank's balance sheet at their market value. Illiquid CDOs, property holdings, credit derivatives and anything else you can think of will all now be marked, mostly down, to what they would trade for in the market. Currently, banks can classify the most illiquid stuff on their balance sheet as "held for investment" or "held to maturity" and use whatever value they believe the assets are worth based on internal assumptions.
One of the only articles I could find about this was a good one by Jonathan Weil at Bloomberg from last Thursday night. I didn't write about it until now because it took me all week to have FASB verify that Weil's interpretation was correct. He realizes how big this news is. He provides a really great example of the implications:
Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT's reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn't show it.
Banks will be relieved to know that this accounting change will not have a major effect on net income as it appears on an income statement:
The Board agreed to propose that changes in an instrument's value may be recognized in other comprehensive income on the basis of qualifying criteria related to an entity's management intent/business model and the cash flow variability of the instrument.
But not all the income statement news is good. Some potentially illiquid instruments' gain/loss will be included in net income:
The Board agreed to propose that changes in value for derivatives, equity securities, and hybrid instruments containing embedded derivatives requiring bifurcation . . . will be recognized in net income. The Board agreed to propose that for all financial instruments, interest and dividends will continue to be recognized in net income. Credit impairments, as well as realized gains and losses from sale and settlement, also will be recognized in net income. The classification of instruments will be determined at initial recognition of the instrument and will not be subsequently changed.
FASB's rationale for this change can be found in its project update. Here are its goals:
a. Reconsider the recognition and measurement of financial instruments
b. Address issues related to impairment of financial instruments and hedge accounting
c. Increase convergence in accounting for financial instruments.
These proposed changes certainly would satisfy those goals, especially part c). Right now, there can be huge divergence for how banks value similar illiquid assets, because their assumptions can provide whatever value they believe the assets are worth. FASB's project would change all that. It would let the market decide.
Would this change be good or bad? Well banks will think it's bad. Much of the revenue they see throughout the year will now be eaten away by accounting losses for these asset re-valuations.
Investors, however, should think it's good. This does create greater transparency and lessen the possibility that a company is hiding losses that bad assets might not realize until sale or maturity.
It also took me so long to get this piece out because I was waiting for the minutes to come out for a joint meeting between FASB and the International Accounting Standards Board (IASB) that occurred last Friday in London. They still aren't out, but Deloitte's unofficial minutes indicate that FASB's proposal was discussed. IASB's standard is not as conservative. From the minutes it seems IASB remains a little unconvinced that FASB's suggestion is a good one. It is waiting to see a more detailed exposure draft. My favorite quote:
The FASB needed more time to complete its deliberations, but acknowledged the pressures on the IASB and the reasons it was pursuing the project in the way it was.
Yes, FASB understands those pressures all too well. They're called angry bankers.
The FASB spokesperson I spoke to explained that in August, FASB will decide whether to release a final exposure draft of this proposal. If it decides to do so, it will request feedback from the public. Then it will take that feedback into consideration and potentially release a new rule sometime in the fall. Watch for it, because these changes would shake the financial world.
(In the meantime, for anyone interested here's some much deeper detail on their proposal -- opens .pdf.)