SEC Schizophrenic on Global Accounting

With surprising absence of fanfare, the Securities and Exchange Commission released over the weekend a 165-page document outlining its delayed and long-awaited proposals for how the US might switch from using its own generally accepted accounting principles to new international financial reporting standards. The release bears a schizophrenic quality. It offers one unsurprising and one surprising proposal.

The unsurprising portion reflects what the Commission reluctantly came to accept last summer: the US is not ready for such a switch and is not likely to be until 2014 at the earliest. Accordingly, the release principally outlines the many obstacles to such a switch and lays out milestones that would have to be met before considering such a radical move.

The surprising portion contemplates allowing selected US issuers voluntarily to make the switch as early as the year after next—2010. This radical proposal would be limited to US issuers whose industry uses IFRS as the basis of financial reporting more than any other set of standards. The release struggles to explain why this special approach for such issuers overcomes the many obstacles facing other US issuers.

It is not obvious that it succeeds. It is possible that the curious pair of proposals is the product of political compromise among internal SEC staff members—many passionately devoted most of their recent several years at the Commission to the project. But given the generally negative reception the SEC’s earlier more ambitious proposals received there is a serious risk that this attempt at a compromise approach will backfire.

Comments on the proposal, which warrants careful study, are due February 19, 2009. Alas, the new SEC release arrives too late for me to say anything about it in my analysis of the SEC’s vision—and obstacles it had not addressed—forthcoming in North Carolina Law Review that is literally being printed this week.

Hat tip: Barbara Black, Securities Law Prof, among the first to report the SEC's surprisingly low-key release.

Posted by Lawrence Cunningham at 11:05 PM | Comments (1) | TrackBack

Rescue Plan Relies on Accounting Finesse

Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.

Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.

The warrants pose an additional problem as wsj.online reports. To treat them as permanent equity capital, ordinarily a firm must prepare financial statements as if the warrants had been converted into common stock. But doing so would increase reported common shares outstanding, diluting earnings per share and book value per share. To avoid that, Treasury seems to have gotten the SEC to say it would not object to treating warrants as equity capital now so long as the bank has, or within one quarter obtains, shareholder authority to issue the required number of new common shares.

Must finessing accounting standards play so central a role in Treasury’s plan and balancing political need to sell deals as temporary with regulatory need to say banks have enough permanent capital? If Treasury thinks government’s investments give banks adequate permanent capital, why not simply modify existing capital adequacy rules to support this conclusion instead of manipulating design and classification to get desired accounting treatment?

Finessing accounting treatments tend to exacerbate problems, not cure them. This lesson is frequently re-taught. Examples include 1980s US thrift crisis, 1990s Japanese banking crisis, Enron's early 2000s fraud, and even this 2008 credit crisis Treasury is trying to fix.

Hat tip: Lynn Turner, Former SEC Chief Accountant

Posted by Lawrence Cunningham at 11:08 AM | Comments (3) | TrackBack

The Craziest Claims Yet about the Credit Crisis

The credit crisis has provided ample opportunities for foolishness. Certainly California Republican Darrell Issa’s claim that the House bill would have been a “coffin on top of Reagan’s coffin” was an oddly necrophilic bunkmate to President Bush’s penetrating insight that “this sucker’s going down.”

But the prize for crazy claims about the credit crisis must go to former Dallas Fed President Bob McTeer, whose Monday post on the New York Times’ Economix blog claims that: (i) Wall Street banks were the real victims of the crisis; (ii) the real villains were minorities; and (iii) the only thing needed to fix the crisis is to change accounting rules.

I kid you not.

Let's consider each in turn.

1. Banks are Victims

“[A]ll the focus on C.E.O. salary caps,” he writes “implied that the holders of illiquid mortgage-backed securities were the villains in this drama rather than the victims. They didn’t package the securities, or sell them; they bought them as an investment.”

Excuse me? I didn’t get that.

Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, Citibank and many others now in or near trouble did not package or sell these securities? Perhaps the league tables were just lies?

The reality, of course, is that investment banks were both issuers and purchasers. That was the point: To keep the paper moving as fast as possible, hoping that once the music stopped, there would still be a seat. No one realized (or admitted) that this game of musical chairs was being played on the deck of the Titanic.

2. It’s Minorities’ Fault

The real villains, McTeer would have us believe, are minority borrowers. This was because “the government had encouraged the purchase of mortgage-backed securities by giving banks C.R.A. (Community Reinvestment Act) credit for securities that contained mortgages made in ZIP codes.” While he concedes that this lending may not have played a “decisive” role, the implication is clear: It was lending to people who look like, you know, Barack Obama, who are really to blame here.

This is truly outrageous. There is not a shred of evidence that CRA-based lending had anything to do with the credit crisis. The CRA is an extremely weak piece of banking legislation that in theory requires banks to lend in their “communities,” which has usually (albeit mistakenly) been taken to mean “minority” communities. Excess liquidity doubtless resulted in mortgage lending to all sorts of bad risks, including minorities. But it wasn’t the CRA that caused this.

And, while it is true that a disparate amount of subprime lending was to African Americans, it wasn’t by banks. It was by non-bank originators like Countrywide.

You would expect a former Fed branch president to know this.

3. The Magic Cure: New Accounting!

To the extent the credit crisis is not the fault of minority borrowers, McTeer appears to believe it was caused by “mark to market” accounting rules that forced holders of toxic securities to write these assets down if they couldn’t offload them quickly. This is not really McTeer’s insight. Many, including William Isaac, who was the F.D.I.C. chair during the S&L crisis, believe this was a critical part of the problem, since it forces lenders to declare something valueless simply because it is illiquid, which really doesn’t make much sense.

I am not an accountant, so offer no opinion on whether this is true. But what McTeer doesn’t bother to tell us is what should now replace it? “Marking-to-model?” That got us into this problem in the first place, because it enabled sponsors—you know, McTeer’s victims—to claim unrealistical valuations and amortization rates for the securities they issued. Should we go back to that? How would that revive the market for these securities? If you add zeroes to the balance sheet, will the credit market miraculously revive?

4. Who IS this Guy?

McTeer is not only a former President of the Dallas Fed. He has a PhD in economics from the University of Georgia, is a former of Chancellor of Texas A&M, and self-published poet. He is a zealous free marketeer, whose insights include this: “The market system features consumer sovereignty, meaning that the consumer is king. We decide what will be produced by casting dollar votes for the things we want and by not spending on the things we don’t want.”

That may well be true--in a world where people have dollars that are worth something. So far as I can tell, his version of the free market has gone a long way to making sure that we have fewer dollars, and those we have are weaker.

He is also a management guru who’s maxims include this mind-bender: “Too long” and “too short” appear to mean the same thing. Go figure.”

Perhaps he’s right. Only a man who thinks opposites are identical could believe investment banks are victims and minority borrowers villains.

Posted by Jonathan Lipson at 12:52 PM | Comments (12) | TrackBack

More on Accounting as Policy Lever

Debate intensifies on the topic of my Monday post: accounting as a policy tool. (David Zaring captures divergent views.) The intensity shows in today’s NYT column by Floyd Norris, a columnist noted for accounting acumen. I usually agree with Mr. Norris, but have quibbles with today’s column, excerpts of which follow (emphases added):

banks and legislators are pushing for a change in accounting rules to end mark-to-market accounting for financial assets. They are sure that market values are too low, so why not just assume they are really higher? That illogic has caught on [as (1) both of this week’s intervention bills encourage the SEC to consider suspending those rules, in a] push for bad accounting [and (2) the SEC this week issued a statement giving issuers considerable flexibility in measuring fair value amid distressed market conditions].

The American Bankers Association concluded that [the SEC] had slapped down auditors who were forcing banks to unreasonably reduce the value of assets no one was buying. . . . Auditors cringed, awaiting appeals of clients to let them value assets as they please. [Still, the SEC statement] could persuade Congress not to make things worse, and not really give the banks new permission to fudge their books.

It is possible, perhaps probable, that many mortgage securities are undervalued now, amid [prevailing] uncertainty and fear . . . [Pending legislation] calls for the government to buy securities from banks for more than current market value but less than the government hopes they will be worth someday. Whether it will succeed depends in part on whether banks conclude that other banks are solvent after the money arrives and the dodgy securities depart. . . .

Quibbles:

First, if (a) it is probable, or even possible, that emotional market conditions mean relevant assets are undervalued and (b) government purchases will target a more accurate value, proposals to tailor fair value accounting standards to reflect those dual realities present no “illogic” and do not amount to a “push for bad accounting.”

Second, neither the SEC statement nor alternatives to fair value accounting, which would apply if those rules are suspended, allow firms to “value assets as they please” or “to fudge their books.”

Serious policy is at stake that such language may obscure. Accounting purists, including Mr. Norris, oppose relaxation or suspension of the standard and there is a good case for accounting purity. (I am an accounting purist as well.)

But accounting purity has given way at least once in the past, in the name of resolving the national emergency presented by 1970s energy crisis. Today, Congress considers financial intervention legislation that is unprecedented.

Certainly it would be imprudent to allow “fudging” of numbers, reporting “as a firm pleases”, or otherwise to endorse “bad accounting.” But it is not obvious that the SEC statement, or alternatives to fair value accounting, does any of that.

Posted by Lawrence Cunningham at 12:26 PM | Comments (0) | TrackBack