Using Their Illusion

by Johnny Debacle

How about Manhattan for two of theseWhen loan assets go down, you typically have to mark-to-market which leads to unseemly things like Important Banks having to announce write-downs. This is patently unfair and not just because Important Banks should not be subject to rules that apply to others or to reality. If they have to write down loan assets, they should be able to write down (where down is up for them) loan liabilities on a mark-to-market basis. Now, thanks to Statement 159 and the FASB, they finally can.

Here’s how it works, according to Richard Bove, an analyst at New York-based Ladenburg Thalmann & Co. A company decides to designate $100 million of its subordinated bonds as subject to mark-to-market accounting. The price of the bonds drops to 80 cents on the dollar from 100 cents. So the firm books $20 million on the “presumed savings that you have on your liabilities,” Bove said.

“In the real world you didn’t save a dime,” he said. “You still owe the $100 million. It’s another one of these accounting rules that basically takes you further and further away from reality.”

Rule in this context is really a perjorative. The preferred nomenclature is accounting innovation. Recent financial innovations include The Off-Off Balance Sheet, Earnings Before Everything and Citi’s Reality Distortion Field. The crucial part of this innovation is that banks have the discretion to determine what liabilities should be marked-to-market and which ones should just be ignored.

“As in all things, except the iPod, oh and Google too, more choice and control is always better. For example, say you were a farmer and you had a bunch of hens. Wouldn’t you want to empower the wolf to have discretionary control, e.g. choice, on how to account for the number of hens left? Of course, you would, it’s just common sense. This would smooth uneconomic hen earnings volatility, which is good for everyone. And that’s why we lobbied the FASB so hard on this matter,” said an anonymous and probably made-up senior Important Banker.

Isn’t this just a continuation of most Important Banks’ core business, namely shell gaming money away from other people?

So far, most banks’ writedowns are “unrealized,” meaning they’ve been unwilling or unable to liquidate distressed assets. If prices reversed, the banks would record mark-to-market profits.

The same is true for the liabilities. Companies can’t “realize” the mark-to-market gains on their debt unless they buy it back at the discounted price. They’re unlikely to do so, because the deterioration in creditworthiness means they’d have to replace the debt with higher-cost borrowings, Willens said.

“No one’s going out in the market and actually retiring this debt,” Willens said. “It’s a shell game.”

Like I said, it’s a shell game, the staple business of Important Banks. Why say it like it’s a bad thing?

Recommendation: Given no forseeable disruption in the supply of shells, Long Important Banks.

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  1. Theoretical
    June 10th, 2008 | 11:53 am

    As someone currently studying and taking the CPA examination, I just love it when the FASB jerks us around like that! It makes all the stuff I learned in school obsolete, so I have the joy of relearning everything. I say long pointless learning as well.

    By the way, the CFA Exam Preparation Class Drinking Game also works very well for the CPA Exam Preparation Class, though since I chose to be an accountant, I should probably double the amount I drink…..

  2. June 10th, 2008 | 5:23 pm

    Use Your Illusion I will be pretty solid, with one or two really great hits. The second time around though, will be 1 step away from the spaghetti incident, you mark my words…

  3. rain
    June 11th, 2008 | 10:46 am

    you are a little late to the “FAS 159 is stupid” party

  4. jag
    June 11th, 2008 | 1:37 pm

    The pair trade here is to be long the CFA Institute and AICPA, and short reality.

  5. June 11th, 2008 | 3:59 pm

    Is this the follow-up to FASB’s “you don’t have to amortize Goodwill, but you do have to write it off when the rest of the world realises you made up the number (and were off by a factor of infinity) in the first place” rule? That one was a gift to balance out the “report your derivatives exposure in a footnote rule.”

    What’s the quo for this quid?

  6. Jeremy
    June 11th, 2008 | 9:37 pm

    The construct is sound. In the old days if you made a loan and the market rate of interest went up, you didn’t take additional reserves against that loan. Therefore you didn’t change the value of your liabilities.

    Today, due to mark to market accounting, you have to mark the position down when the market rate of interest goes up, but on the other side before this rule change you saw no benefit when in issuing $100 million of 30 year paper at the top of the market. There was really a mismatch of accounting concepts in regards to present value.

    It has nothing to do with the nominal amount that needs to be paid back when thinking about a liability, it’s the present value of that nominal amount. If the market rate of interest one year after the issuance of a 30 year bond goes up 2%, then the present value of the money the company will have to spend to retire that bond is less.

  7. Dirty Sanchez
    June 12th, 2008 | 12:00 am

    Check out RVI. They made a boatload this quarter because they are short their own warrants and the stock tanked.