Fair Game for Asset Values
Explaining the Mark-to-Market Controversy
by Virginia B. Morris
If you want to know what a stock sells for, you look at its current market price. That price might be different from what it was yesterday or what it will be later today or tomorrow. But it’s what the stock is worth right now because it’s what you could sell it for. The value of an investment, in this sense, is determined by how interested other investors are in owning it at this moment.
The market price of a mutual fund share is also clear — although it’s determined by the value of its underlying investments and the number of outstanding shares in the fund, rather than by what people are willing to pay for fund shares. Once a day a fund, using a process known as mark-to-market, finds the closing prices of the securities in its portfolio. Then it calculates the fund’s net asset value, which is its per-share price for the next 24 hours.
Futures contracts, which tend to be significantly more volatile than either stocks or mutual funds, are also marked-to-market every day to make those markets more transparent.
The Fairness of a Fair Value Price
In effect, mark-to-market is a widely recognized method for determining the fair market value of an investment. If that’s the case, why do some people want regulators to suspend this established accounting practice amid the current financial uncertainty?
For starters, it helps to know about rule FAS 157, which U.S. government regulators introduced in 2007. This rule requires publicly traded financial companies to report the value of some, though not all, of their assets and liabilities by marking them to market. The controversy arises because the assets that must be marked-to-market are those that either trade infrequently or don’t trade at all, basically because nobody wants to buy them.
If you own something you can’t sell, what’s its value? Often, it isn’t worth what you paid for it. And if you borrowed money to buy the asset, it could be worth less than you owe. That’s the predicament many homeowners face as housing values have dropped and credit has dried up.
This problem of owning assets whose value has shrunk is magnified for financial companies, partly because so much money is at stake. In addition, these companies are required to keep a certain amount of capital on hand to meet their obligations.
If cash is running short — perhaps because clients pull their money out — these companies have to sell whatever assets they can, at whatever prices they can get, to have adequate funds on hand. These fire-sale prices become the new valuation for similar assets that the company retains and for comparable assets owned by other firms.
When these diminished values are reported on a company’s balance sheet, as they must be under the rules, the firm’s financial situation appears significantly less healthy than it would be if the assets’ purchase prices were being reported instead. And the less value a company’s balance sheet shows, the harder it is for that company to borrow, potentially threatening its ability to survive.
To Mark or Not to Mark
Would relaxing or eliminating the mark-to-market rules loosen up credit and help trigger an economic recovery? Advocates of this approach insist that in bad times, assets can be hard to value and harder to sell. Further, they argue that firms shouldn’t have to value long-term assets for what they could be sold for immediately, especially if the companies don’t want or need to sell them.
Opponents of relaxing the rule are equally adamant. They maintain that transparency is essential for a strong and healthy economy and that the current financial problems aren’t the result of mark-to-market rules. Rather, they point out, many of the companies at risk were eager for outsized profits, so they invested in innovative and perhaps fatally flawed products whose true value was never established.
One of the first things you learn as an investor is that you should avoid securities you don’t understand and that a thinly traded product puts you at increased risk. So you may wonder why these investment basics seem to have escaped the notice of so many experienced financial professionals.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0109abpublic.htm
Showing posts with label mark to market. Show all posts
Showing posts with label mark to market. Show all posts
Saturday, 12 September 2009
Saturday, 14 March 2009
Bankers Say Mark to Market Rules Are the Problem
Bankers Say Rules Are the Problem
by Floyd Norris
Friday, March 13, 2009
If mark-to-market accounting is to blame for the current financial crisis, then the National Weather Service is to blame for Hurricane Katrina; if it hadn't told us the hurricane hit New Orleans, the city would never have flooded.
This is the logic the bankers are using, and they are getting sympathetic ears in Congress. The bankers have gotten two members of Congress to introduce a bill to establish a new body that could suspend accounting rules for financial institutions.
Edward L. Yingling, the president of the American Bankers Association, says the proposal addresses "systemic risks that accounting standards can have on the economy."
Steve Forbes, the publisher and erstwhile presidential candidate, goes even further. "Mark-to-market accounting is the principal reason why our financial system is in a meltdown," he wrote in a Wall Street Journal op-ed piece.
They say the problem, in short, is not that the banks acted irresponsibly in creating financial instruments that blew up, or in making loans that could never be repaid. It is that someone is forcing them to fess up. If only the banks could pretend the assets were valuable, then the system would be safe.
On Thursday, members of a House subcommittee joined in demanding that the rules be suspended. It was a bipartisan lynching of the accounting rule writers.
The panel's chairman, Representative Paul E. Kanjorski, Democrat of Pennsylvania, said the accounting rule "does provide transparency for investors," but that "strict application" of the rule had "exacerbated the ongoing economic crisis."
Then he issued the threat. "If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself."
Sadly, a victory for the bankers would not help them much. Even if it were true that banks would be held in higher regard now if they had not been forced to write down the value of their bad assets -- and that is, at best, debatable -- changing the rules now would be counterproductive. Would you trust banks more? Would other banks be more inclined to trust banks?
It is true, as the bankers argue, that valuing illiquid instruments is tricky. And it is true that markets can overshoot. Some of these securities may well be undervalued now. But the solution is not to go to what Robert H. Herz, the chairman of the Financial Accounting Standards Board, calls "mark-to-management" accounting.
I call it "Alice in Wonderland" accounting, after Humpty Dumpty's claim in that book that "When I use a word, it means just what I choose it to mean, neither more nor less." After Alice protests, he replies, "The question is, which is to be master -- that's all."
Although you would not know it from the angry complaints, the accounting board's Statement 157 did not require mark-to-market accounting. That was already required under earlier rules. What it did do was clarify how such values should be determined. That stopped banks from defining "market value" as meaning whatever they chose it to mean.
Conrad Hewitt, who was chief accountant at the Securities and Exchange Commission when it conducted a Congressionally mandated review of the issue late last year, said at a recent Pace University accounting forum that he asked all the complainers if they had a better way to determine market value than the one prescribed by Statement 157. None did.
That statement set out procedures for dealing with illiquid markets and distress sales, and the board is now at work on setting out more guidelines on how to do that. You can bet that its efforts will not satisfy the banks.
But there are three steps that could improve the situation.
First, the regulators could make it clear they are committed to what is now called countercyclical regulating. They could ease capital rules when things are bad, and require more capital as the economy improves. As Ben S. Bernanke, the Federal Reserve chairman, said this week, regulations should allow capital "to serve its intended role as a buffer -- one built up during good times and drawn down during bad times in a manner consistent with safety and soundness."
In other words, accept that market values are low and report the facts to investors. But give the banks a break by not acting as if that will last forever.
Of course, many will doubt that the regulators will really get tough when things improve. They stood by mutely while the banks went on the binge that created this crisis. But we can hope.
The second step would be to force banks to disclose -- to the public and to the other banks that trade with them -- just which toxic assets they own.
The bankers assert that those assets are now trading for less than they will be worth at maturity. In fact that is unknowable, which is one reason we have markets. If the current deep recession turns into Great Depression II, then even today's market values may prove to be too high.
But if we knew which securities each bank owned, and where it was valuing them, we could go over each security and reach our own conclusions as to values. We could also see which banks seemed to be more or less optimistic in their estimates of market value.
When I suggested that to a top official of one big bank, he dismissed the idea, saying it would damage his bank's trading position to advertise what it had. Of course, he also complained that there was virtually no trading going on, so I'm not sure what the damage would be. But if the banks want to disclose the information with a three-month delay, so that there is no way to know if they still own the securities, that would be fine with me.
The final step would be to get the market for such securities functioning. Right now, it is largely blocked by the Obama administration's slow efforts to design a program to stimulate such sales by offering generous financing and partial guarantees to buyers. No one wants to buy now if a much better deal might be available next week. The Treasury Department needs to get the details out, and then see who is willing to buy, and at what price.
Of course, any such government-subsidized market would need to make widely available what was on offer, to assure that the price received was the best one possible. It's not a market price if market participants cannot bid.
It is possible that there will be few trades even then. Edward J. Kane, a finance professor at Boston College, suggests that banks, particularly those that know they need a miracle to regain solvency, will be unwilling to sell. "Cheap volatile assets with a huge upside are precisely the kinds of optionlike investments that clever zombie managers are energetically looking for," he said. If they soar, the banks' stock may be worth something. If not, the taxpayers will take the loss.
Next time you hear a banker denounce mark-to-market rules, ask if he runs his business that way. Will he offer you a mortgage loan based on what you think your home should be worth, which you can repay only if you make a lot more money than anyone will pay you? If so, then perhaps the bank should be able to use "Alice in Wonderland" accounting on its own books.
Or maybe that is not such a good idea. The banks already tried that, with liars' loans. Those loans did not work out so well.
Floyd Norris's blog on finance and economics is at nytimes.com/norris.
http://finance.yahoo.com/banking-budgeting/article/106746/Bankers-Say-Rules-Are-the-Problem;_ylt=Aqc620M0nd9ZfdYWQBwa529O7sMF
by Floyd Norris
Friday, March 13, 2009
If mark-to-market accounting is to blame for the current financial crisis, then the National Weather Service is to blame for Hurricane Katrina; if it hadn't told us the hurricane hit New Orleans, the city would never have flooded.
This is the logic the bankers are using, and they are getting sympathetic ears in Congress. The bankers have gotten two members of Congress to introduce a bill to establish a new body that could suspend accounting rules for financial institutions.
Edward L. Yingling, the president of the American Bankers Association, says the proposal addresses "systemic risks that accounting standards can have on the economy."
Steve Forbes, the publisher and erstwhile presidential candidate, goes even further. "Mark-to-market accounting is the principal reason why our financial system is in a meltdown," he wrote in a Wall Street Journal op-ed piece.
They say the problem, in short, is not that the banks acted irresponsibly in creating financial instruments that blew up, or in making loans that could never be repaid. It is that someone is forcing them to fess up. If only the banks could pretend the assets were valuable, then the system would be safe.
On Thursday, members of a House subcommittee joined in demanding that the rules be suspended. It was a bipartisan lynching of the accounting rule writers.
The panel's chairman, Representative Paul E. Kanjorski, Democrat of Pennsylvania, said the accounting rule "does provide transparency for investors," but that "strict application" of the rule had "exacerbated the ongoing economic crisis."
Then he issued the threat. "If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself."
Sadly, a victory for the bankers would not help them much. Even if it were true that banks would be held in higher regard now if they had not been forced to write down the value of their bad assets -- and that is, at best, debatable -- changing the rules now would be counterproductive. Would you trust banks more? Would other banks be more inclined to trust banks?
It is true, as the bankers argue, that valuing illiquid instruments is tricky. And it is true that markets can overshoot. Some of these securities may well be undervalued now. But the solution is not to go to what Robert H. Herz, the chairman of the Financial Accounting Standards Board, calls "mark-to-management" accounting.
I call it "Alice in Wonderland" accounting, after Humpty Dumpty's claim in that book that "When I use a word, it means just what I choose it to mean, neither more nor less." After Alice protests, he replies, "The question is, which is to be master -- that's all."
Although you would not know it from the angry complaints, the accounting board's Statement 157 did not require mark-to-market accounting. That was already required under earlier rules. What it did do was clarify how such values should be determined. That stopped banks from defining "market value" as meaning whatever they chose it to mean.
Conrad Hewitt, who was chief accountant at the Securities and Exchange Commission when it conducted a Congressionally mandated review of the issue late last year, said at a recent Pace University accounting forum that he asked all the complainers if they had a better way to determine market value than the one prescribed by Statement 157. None did.
That statement set out procedures for dealing with illiquid markets and distress sales, and the board is now at work on setting out more guidelines on how to do that. You can bet that its efforts will not satisfy the banks.
But there are three steps that could improve the situation.
First, the regulators could make it clear they are committed to what is now called countercyclical regulating. They could ease capital rules when things are bad, and require more capital as the economy improves. As Ben S. Bernanke, the Federal Reserve chairman, said this week, regulations should allow capital "to serve its intended role as a buffer -- one built up during good times and drawn down during bad times in a manner consistent with safety and soundness."
In other words, accept that market values are low and report the facts to investors. But give the banks a break by not acting as if that will last forever.
Of course, many will doubt that the regulators will really get tough when things improve. They stood by mutely while the banks went on the binge that created this crisis. But we can hope.
The second step would be to force banks to disclose -- to the public and to the other banks that trade with them -- just which toxic assets they own.
The bankers assert that those assets are now trading for less than they will be worth at maturity. In fact that is unknowable, which is one reason we have markets. If the current deep recession turns into Great Depression II, then even today's market values may prove to be too high.
But if we knew which securities each bank owned, and where it was valuing them, we could go over each security and reach our own conclusions as to values. We could also see which banks seemed to be more or less optimistic in their estimates of market value.
When I suggested that to a top official of one big bank, he dismissed the idea, saying it would damage his bank's trading position to advertise what it had. Of course, he also complained that there was virtually no trading going on, so I'm not sure what the damage would be. But if the banks want to disclose the information with a three-month delay, so that there is no way to know if they still own the securities, that would be fine with me.
The final step would be to get the market for such securities functioning. Right now, it is largely blocked by the Obama administration's slow efforts to design a program to stimulate such sales by offering generous financing and partial guarantees to buyers. No one wants to buy now if a much better deal might be available next week. The Treasury Department needs to get the details out, and then see who is willing to buy, and at what price.
Of course, any such government-subsidized market would need to make widely available what was on offer, to assure that the price received was the best one possible. It's not a market price if market participants cannot bid.
It is possible that there will be few trades even then. Edward J. Kane, a finance professor at Boston College, suggests that banks, particularly those that know they need a miracle to regain solvency, will be unwilling to sell. "Cheap volatile assets with a huge upside are precisely the kinds of optionlike investments that clever zombie managers are energetically looking for," he said. If they soar, the banks' stock may be worth something. If not, the taxpayers will take the loss.
Next time you hear a banker denounce mark-to-market rules, ask if he runs his business that way. Will he offer you a mortgage loan based on what you think your home should be worth, which you can repay only if you make a lot more money than anyone will pay you? If so, then perhaps the bank should be able to use "Alice in Wonderland" accounting on its own books.
Or maybe that is not such a good idea. The banks already tried that, with liars' loans. Those loans did not work out so well.
Floyd Norris's blog on finance and economics is at nytimes.com/norris.
http://finance.yahoo.com/banking-budgeting/article/106746/Bankers-Say-Rules-Are-the-Problem;_ylt=Aqc620M0nd9ZfdYWQBwa529O7sMF
To Mark-to-Market, or Not to Mark-to-Market?
To Mark-to-Market, or Not to Mark-to-Market?
By Matt Koppenheffer
March 12, 2009 Comments (6)
As investors and traders keep trying to figure out whether the market has bottomed, or whether Citigroup's (NYSE: C) health report holds any truth, one question seems to pop up over and over again: Should we jettison mark-to-market accounting?
The assumption is that forcing companies to mark their investments to markets that are under significant pressure, or downright frozen, helped exacerbate the panic that has engulfed Wall Street for more than a year now. Opponents of mark-to-market accounting believe that if banks and other financial institutions weren't forced to mark down their assets, there wouldn't be the dire concerns over liquidity that pushed Lehman Brothers over the precipice and into bankruptcy, and forced Bank of America (NYSE: BAC), Citigroup, and JPMorgan (NYSE: JPM) to take billions in government money.
But worrying about mark-to-market lets a bigger issue slide.
Leveraged into oblivion
Mark-to-market certainly played its part, but the only reason it had such a catastrophic impact was because of the massive leverage employed at the major financial institutions. Had banks and brokerages used only a moderate amount of leverage, marking down assets wouldn't be nearly as big of a deal. Sure, the firms' book values would still fall, but it's less likely that those markdowns would imperil them.
As we increase the leverage on a firm's balance sheet, though, ever smaller losses can start to put it at risk of failing. Lever it up 2-to-1, and assets would have to decline 50% to wipe out the firm's net worth. Lever it up 3-to-1, and it takes a 33% drop to leave the company grasping at straws. Put leverage at 10-to-1, and it only takes a 10% hit to assets to get to the same end. Of course, 10-to-1 leverage was on the low end of what financial firms were doing. Here's a look at where some of the major financials stood when their 2007 fiscal years ended:
Company
Assets
Financial Leverage
Citigroup
$2.2 trillion
19.3
Goldman Sachs (NYSE: GS)
$1.1 trillion
26.2
Merrill Lynch
$1 trillion
31.9
Lehman Brothers
$691 billion
30.7
Bear Stearns
$395 billion
33.5
Source: Capital IQ, a Standard & Poor's company. All numbers are as of fiscal year end 2007.
For sake of comparison, Coca-Cola was leveraged 2-to-1 at the end of 2007, Halliburton was at 1.9-to-1, and Wal-Mart (NYSE: WMT) clocked in at 2.5-to-1. Of course, we can also note here that the danger of leverage is certainly not industry-specific. Lately, we've been treated to the tribulations of the U.S. automakers, but we shouldn't have been surprised -- Ford (NYSE: F) had an amazing 50-to-1 leverage at the end of 2007, and as for General Motors (NYSE: GM), well, the last time it didn't have a negative book value was in 2005, when it was leveraged 32-to-1.
The answer to mark-to-market
Even if mark-to-market isn't the right question right now, there's still an answer to it: It needs to be kept in place. Turn to any accounting book, and you'll see that the purpose of a balance sheet is to provide a picture of the company's assets and liabilities at a point in time. If financial institutions want to give investors additional disclosure showing them what management thinks its assets are worth, that's great. But for a balance sheet to be a worthwhile measure, we need to be marking assets to market when markets exist.
Keeping mark-to-market in place has the added benefit of discouraging financial companies from stacking up similar levels of leverage in the future. If they have to prepare their balance sheets for potential adverse market movements -- as opposed to the placid stability of a given company's valuation models -- then 30-to-1 leverage suddenly sounds a little less appealing.
There's no doubt in my mind that the debate will rage on over whether mark-to-market should be pulled, and the opponents of the convention may even come out on top. But investors who want to avoid buying into stars destined to become supernovas need to keep in mind that massive leverage, not mark-to-market accounting, was the real seed that grew into financial disaster.
Further financial Foolishness:
The Biggest Bubble the World Has Ever Seen
Who Should Go to Jail?
It's Time to Sell and Walk Away
The Coca-Cola Company and Wal-Mart Stores are Motley Fool Inside Value recommendations. Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not own shares of any of the other companies mentioned.
http://www.fool.com/investing/value/2009/03/12/to-mark-to-market-or-not-to-mark-to-market.aspx
By Matt Koppenheffer
March 12, 2009 Comments (6)
As investors and traders keep trying to figure out whether the market has bottomed, or whether Citigroup's (NYSE: C) health report holds any truth, one question seems to pop up over and over again: Should we jettison mark-to-market accounting?
The assumption is that forcing companies to mark their investments to markets that are under significant pressure, or downright frozen, helped exacerbate the panic that has engulfed Wall Street for more than a year now. Opponents of mark-to-market accounting believe that if banks and other financial institutions weren't forced to mark down their assets, there wouldn't be the dire concerns over liquidity that pushed Lehman Brothers over the precipice and into bankruptcy, and forced Bank of America (NYSE: BAC), Citigroup, and JPMorgan (NYSE: JPM) to take billions in government money.
But worrying about mark-to-market lets a bigger issue slide.
Leveraged into oblivion
Mark-to-market certainly played its part, but the only reason it had such a catastrophic impact was because of the massive leverage employed at the major financial institutions. Had banks and brokerages used only a moderate amount of leverage, marking down assets wouldn't be nearly as big of a deal. Sure, the firms' book values would still fall, but it's less likely that those markdowns would imperil them.
As we increase the leverage on a firm's balance sheet, though, ever smaller losses can start to put it at risk of failing. Lever it up 2-to-1, and assets would have to decline 50% to wipe out the firm's net worth. Lever it up 3-to-1, and it takes a 33% drop to leave the company grasping at straws. Put leverage at 10-to-1, and it only takes a 10% hit to assets to get to the same end. Of course, 10-to-1 leverage was on the low end of what financial firms were doing. Here's a look at where some of the major financials stood when their 2007 fiscal years ended:
Company
Assets
Financial Leverage
Citigroup
$2.2 trillion
19.3
Goldman Sachs (NYSE: GS)
$1.1 trillion
26.2
Merrill Lynch
$1 trillion
31.9
Lehman Brothers
$691 billion
30.7
Bear Stearns
$395 billion
33.5
Source: Capital IQ, a Standard & Poor's company. All numbers are as of fiscal year end 2007.
For sake of comparison, Coca-Cola was leveraged 2-to-1 at the end of 2007, Halliburton was at 1.9-to-1, and Wal-Mart (NYSE: WMT) clocked in at 2.5-to-1. Of course, we can also note here that the danger of leverage is certainly not industry-specific. Lately, we've been treated to the tribulations of the U.S. automakers, but we shouldn't have been surprised -- Ford (NYSE: F) had an amazing 50-to-1 leverage at the end of 2007, and as for General Motors (NYSE: GM), well, the last time it didn't have a negative book value was in 2005, when it was leveraged 32-to-1.
The answer to mark-to-market
Even if mark-to-market isn't the right question right now, there's still an answer to it: It needs to be kept in place. Turn to any accounting book, and you'll see that the purpose of a balance sheet is to provide a picture of the company's assets and liabilities at a point in time. If financial institutions want to give investors additional disclosure showing them what management thinks its assets are worth, that's great. But for a balance sheet to be a worthwhile measure, we need to be marking assets to market when markets exist.
Keeping mark-to-market in place has the added benefit of discouraging financial companies from stacking up similar levels of leverage in the future. If they have to prepare their balance sheets for potential adverse market movements -- as opposed to the placid stability of a given company's valuation models -- then 30-to-1 leverage suddenly sounds a little less appealing.
There's no doubt in my mind that the debate will rage on over whether mark-to-market should be pulled, and the opponents of the convention may even come out on top. But investors who want to avoid buying into stars destined to become supernovas need to keep in mind that massive leverage, not mark-to-market accounting, was the real seed that grew into financial disaster.
Further financial Foolishness:
The Biggest Bubble the World Has Ever Seen
Who Should Go to Jail?
It's Time to Sell and Walk Away
The Coca-Cola Company and Wal-Mart Stores are Motley Fool Inside Value recommendations. Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not own shares of any of the other companies mentioned.
http://www.fool.com/investing/value/2009/03/12/to-mark-to-market-or-not-to-mark-to-market.aspx
Saturday, 14 February 2009
Financial Crisis: Mark to Market Accounting Demystified
Financial Crisis: Mark to Market Accounting Demystified
written by Andy on Wednesday, October 8, 2008
Of late there has been a lot of negative press around the accounting requirements for companies and the methods by which they have to value their assets. Some critics and company executives have even attributed the accounting requirements, and specifically the Mark to Market valuation method, as a major cause behind the rapid failure of some of our largest financial institutions, because they were forced to value assets at unrealistically low levels. The Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) which sets accounting rules for companies, are being pressured by lawmakers, corporation and big investors to overhaul or suspend the current Mark to Market accounting rules that these companies have to follow. This type of accounting (like leverage), works great in boom times but can place a lot of pressure on companies and their stock prices when asset values fall. As an investor it is important to have a general understanding of how this type of accounting works in order to get a better of the state of the company's real financial health (and so you know what those pundits on CNBC are talking about!). Here, Tony Parker assists in breaking down Mark to Market accounting in an easy to understand format with examples and why it is causing so many headaches for companies.
What is it?
The act of assigning a value to an asset based on it current market value (what it could sell for today) as determined by the going "market price". For example, your house may have been worth $300,000 on 1/1/2007 but today according to the market it is worth $230,000. If you kept track of your assets like a company did, you would be required to "write-down" the value of your house by $70,000 to reflect the fact that if you had to immediately liquidate that asset (your house), it would not bring the kind of cash it would have about two years earlier.
Why was it implemented?
It was primarily intended to prevent shady accounting practices that hide underlying liabilities. The Accounting Standards bodies were concerned that companies were keeping "bad" assets on their books instead of "writing them down" to their real value (assigning a new, lower value to the asset). Mark to Market gives investors a much better "picture" of the health of the company if their assets are correctly priced (i.e. market price).
Example: Ford is holding 100,000 F-150 trucks on a storage lot. Ford originally valued these at $20,000 each. So, Ford books this as an asset with a value of $2,000,000 (100,000 x $20,000). But several months go by and Ford has not sold these trucks (high gas prices, economy, etc.). Now it is 6 months later and Ford must mark to market the value of those trucks for their quarterly reporting. Over the six months the true market value of trucks has dropped to $15,000 (based on what customers are currently paying). In this case, Ford should write-down the total value of the trucks to $1,500,000. This means Ford's assets (the trucks) have fallen in value by $500,000.
So why is this important?
To keep it simple, the most basic thing in accounting is the equation: Assets – Liabilities = Equity or, in common terms, Assets (things owned) minus Liabilities (debt) = Equity (value of the company - reflected in the stock price). If you reduce the value of the assets, then the value of the company must drop, thereby pushing down the equity (stock price). So continuing with the example above, Ford's share price will drop as the value of it's assets (trucks) are marked down. So do you see now how the falls in assets prices can quickly translate to stock prices drops under mark to market accounting?
Why is it causing so much controversy?
The Mark to Market rule works well until you cannot get a realistic price for an asset. Currently, many of the Mortgage Backed Securities (a combination of many mortgages pulled together as one security) that are behind the financial crisis have NO market and hence almost impossible to assign a fair value (unlike those of Ford trucks). Because of their perceived risk and unknown exposure nobody wants them and in many cases if there is no demand they become worthless ($0 value). This obviously is NOT true. Even if the value is 5 cents on the dollar, they still have a value. But the securities are so complex and the economic environment so uncertain, that nobody is willing to "stick their neck out" and try to pick the correct price.
Here is an analogy: Say there is a unique subdivision with 100 gorgeous houses. If these houses were any place "normal" they would be worth $1,000,000 each. But this subdivision sits on top of an old graveyard. Now most people would never pay full price for a house sitting on top of a graveyard (the potential for ghosts and all!). But what is each house worth? Some people probably would not care much about the graveyard as long as they got $200,000 off the selling price. So, is $800,000 the Mark to Market price? On the other hand, some people would only buy one of the homes if it were substantially discounted, say to ¼ of the original price. So, is $250,000 the Mark to Market price?
Now lets add one more obstacle. Let's say – as is currently happening – it is very, very difficult to get a loan (mortgage). There is then the potential that NOBODY would buy one of the homes, because they could not get a mortgage, even though they may have been able to get a big discount. One financial quarter (3 months) goes buy and none of the homes sell. What is the Mark to Market value of these homes now? Without any direct comparisons (after all, this is like no other subdivision), the Mark to Market value would be ZERO. We know that is not true, but if the accountants assign an arbitrary value, say $700,000, they may get in trouble if later they are required to write-down the value of those homes to $250,000 each, when they find out very few people are comfortable living on top of a graveyard. So the problem is: What value should you assign to an asset that has no current market (no buyers)? By the letter of law you value them at current value – zero in this example – but as you can see that is hardly fair.
This is essentially the problem currently choking financial markets with MBS and other housing based instruments. Critics of the Mark to Market accounting rules say that they cause banks to undervalue assets that have a real value based on fire-sale prices in a frozen market.
"A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values," wrote Brian Wesbury in the WSJ.
Conclusion and Opinions
Tony - My personal recommendation is to keep the Market to Mark rule, but in cases where you cannot come up with a reasonable value – because of usual economic forces or a sufficiently liquid market – then guess conservatively and highlight the item to investors in the financial statements, so they can determine whether the value assigned is reasonable to them.
Andy - One point to note is that even if Mark-to-Market rules were suspended, it won't change the makeup of a company's balance sheet. If investors decide certain company's assets are toxic (like MBS nowadays) then it won't matter how a company accounts for them in its books - they will be assigned a zero or negative value by default. To get out of the current financial crisis, investors need to have confidence in the financial assets/instruments of these companies. That is what the government is trying to primarily do with the bailout bill – restore investor confidence by buying and creating a fair market value for these "bad" and illiquid assets. However, judging by recent market action it doesn't look to be working too well.
http://www.savingtoinvest.com/2008/10/financial-crisis-mark-to-market.html
written by Andy on Wednesday, October 8, 2008
Of late there has been a lot of negative press around the accounting requirements for companies and the methods by which they have to value their assets. Some critics and company executives have even attributed the accounting requirements, and specifically the Mark to Market valuation method, as a major cause behind the rapid failure of some of our largest financial institutions, because they were forced to value assets at unrealistically low levels. The Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) which sets accounting rules for companies, are being pressured by lawmakers, corporation and big investors to overhaul or suspend the current Mark to Market accounting rules that these companies have to follow. This type of accounting (like leverage), works great in boom times but can place a lot of pressure on companies and their stock prices when asset values fall. As an investor it is important to have a general understanding of how this type of accounting works in order to get a better of the state of the company's real financial health (and so you know what those pundits on CNBC are talking about!). Here, Tony Parker assists in breaking down Mark to Market accounting in an easy to understand format with examples and why it is causing so many headaches for companies.
What is it?
The act of assigning a value to an asset based on it current market value (what it could sell for today) as determined by the going "market price". For example, your house may have been worth $300,000 on 1/1/2007 but today according to the market it is worth $230,000. If you kept track of your assets like a company did, you would be required to "write-down" the value of your house by $70,000 to reflect the fact that if you had to immediately liquidate that asset (your house), it would not bring the kind of cash it would have about two years earlier.
Why was it implemented?
It was primarily intended to prevent shady accounting practices that hide underlying liabilities. The Accounting Standards bodies were concerned that companies were keeping "bad" assets on their books instead of "writing them down" to their real value (assigning a new, lower value to the asset). Mark to Market gives investors a much better "picture" of the health of the company if their assets are correctly priced (i.e. market price).
Example: Ford is holding 100,000 F-150 trucks on a storage lot. Ford originally valued these at $20,000 each. So, Ford books this as an asset with a value of $2,000,000 (100,000 x $20,000). But several months go by and Ford has not sold these trucks (high gas prices, economy, etc.). Now it is 6 months later and Ford must mark to market the value of those trucks for their quarterly reporting. Over the six months the true market value of trucks has dropped to $15,000 (based on what customers are currently paying). In this case, Ford should write-down the total value of the trucks to $1,500,000. This means Ford's assets (the trucks) have fallen in value by $500,000.
So why is this important?
To keep it simple, the most basic thing in accounting is the equation: Assets – Liabilities = Equity or, in common terms, Assets (things owned) minus Liabilities (debt) = Equity (value of the company - reflected in the stock price). If you reduce the value of the assets, then the value of the company must drop, thereby pushing down the equity (stock price). So continuing with the example above, Ford's share price will drop as the value of it's assets (trucks) are marked down. So do you see now how the falls in assets prices can quickly translate to stock prices drops under mark to market accounting?
Why is it causing so much controversy?
The Mark to Market rule works well until you cannot get a realistic price for an asset. Currently, many of the Mortgage Backed Securities (a combination of many mortgages pulled together as one security) that are behind the financial crisis have NO market and hence almost impossible to assign a fair value (unlike those of Ford trucks). Because of their perceived risk and unknown exposure nobody wants them and in many cases if there is no demand they become worthless ($0 value). This obviously is NOT true. Even if the value is 5 cents on the dollar, they still have a value. But the securities are so complex and the economic environment so uncertain, that nobody is willing to "stick their neck out" and try to pick the correct price.
Here is an analogy: Say there is a unique subdivision with 100 gorgeous houses. If these houses were any place "normal" they would be worth $1,000,000 each. But this subdivision sits on top of an old graveyard. Now most people would never pay full price for a house sitting on top of a graveyard (the potential for ghosts and all!). But what is each house worth? Some people probably would not care much about the graveyard as long as they got $200,000 off the selling price. So, is $800,000 the Mark to Market price? On the other hand, some people would only buy one of the homes if it were substantially discounted, say to ¼ of the original price. So, is $250,000 the Mark to Market price?
Now lets add one more obstacle. Let's say – as is currently happening – it is very, very difficult to get a loan (mortgage). There is then the potential that NOBODY would buy one of the homes, because they could not get a mortgage, even though they may have been able to get a big discount. One financial quarter (3 months) goes buy and none of the homes sell. What is the Mark to Market value of these homes now? Without any direct comparisons (after all, this is like no other subdivision), the Mark to Market value would be ZERO. We know that is not true, but if the accountants assign an arbitrary value, say $700,000, they may get in trouble if later they are required to write-down the value of those homes to $250,000 each, when they find out very few people are comfortable living on top of a graveyard. So the problem is: What value should you assign to an asset that has no current market (no buyers)? By the letter of law you value them at current value – zero in this example – but as you can see that is hardly fair.
This is essentially the problem currently choking financial markets with MBS and other housing based instruments. Critics of the Mark to Market accounting rules say that they cause banks to undervalue assets that have a real value based on fire-sale prices in a frozen market.
"A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values," wrote Brian Wesbury in the WSJ.
Conclusion and Opinions
Tony - My personal recommendation is to keep the Market to Mark rule, but in cases where you cannot come up with a reasonable value – because of usual economic forces or a sufficiently liquid market – then guess conservatively and highlight the item to investors in the financial statements, so they can determine whether the value assigned is reasonable to them.
Andy - One point to note is that even if Mark-to-Market rules were suspended, it won't change the makeup of a company's balance sheet. If investors decide certain company's assets are toxic (like MBS nowadays) then it won't matter how a company accounts for them in its books - they will be assigned a zero or negative value by default. To get out of the current financial crisis, investors need to have confidence in the financial assets/instruments of these companies. That is what the government is trying to primarily do with the bailout bill – restore investor confidence by buying and creating a fair market value for these "bad" and illiquid assets. However, judging by recent market action it doesn't look to be working too well.
http://www.savingtoinvest.com/2008/10/financial-crisis-mark-to-market.html
Saturday, 29 November 2008
Impairment Charges: The Good, The Bad and The Ugly
Impairment Charges: The Good, The Bad and The Ugly
by Rick Wayman
"Impairment charge" is the new term for writing off worthless goodwill. These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs (for example, AOL - $54 billion, SBC - $1.8 billion, and McDonald's - $99 million). While impairment charges have since then gone relatively unnoticed, they will get more attention as the weak economy and faltering stock market force more goodwill charge-offs and increase concerns about corporate balance sheets. This article will define the impairment charge and look at its good, bad and ugly effects.
Impairment Defined
As with most generally accepted accounting principles, the definition of "impairment" is in the eye of the beholder. The regulations are complex, but the fundamentals are relatively easy to understand. Under the new rules, all goodwill is to be assigned to the company's reporting units that are expected to benefit from that goodwill. Then the goodwill must be tested (at least annually) to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is deemed "impaired" and must be charged off. This charge reduces the value of goodwill to the fair market value and represents a "mark-to-market" charge.
The Good
If done correctly, this will provide investors with more valuable information. Balance sheets are bloated with goodwill that resulted from acquisitions during the bubble years, when companies overpaid for assets by using overpriced stock. Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for that stock. The new rules force companies to revalue these bad investments, much like what the stock market has done to individual stocks.
The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to impairment have not made good investment decisions. Managements that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality.
The Bad
The accounting rules (FAS 141 and FAS 142) allow companies a great deal of discretion in allocating goodwill and determining its value. Determining fair value has always been as much an art as a science and different experts can arrive honestly at different valuations. In addition, it is possible for the allocation process to be manipulated for the purpose of avoiding flunking the impairment test. As managements attempt to avoid these charge-offs, more accounting shenanigans will undoubtedly result.
It's doubtful that very many corporate managements will face reality and take their medicine. Compensation packages will incite managers to delay the inevitable as they hope for a stock market rebound that will boost fair value.
A delay, however, could backfire and adversely impact EPS in 2003. According to the rules, impairment charges that occur within the first year of adopting the new accounting rules (calendar 2002 for most corporations) are accounted for as a charge to equity. After the first year, impairment charges hit the income statement. Consequently, postponing may help results in 2002 but could reduce EPS in 2003.
The other bad thing is that investors will have a hard time evaluating how management is handling this issue. The process of allocating goodwill to business units and the valuation process will be hidden from investors, which will provide ample opportunity for manipulation. Companies are also not required to disclose what is determined to be the fair value of goodwill, even though this information would help investors make a more informed investment decision.
The Ugly
Things could get ugly if increased impairment charges reduce equity to levels that trigger technical loan defaults. Most lenders require companies who have borrowed money to promise to maintain certain operating ratios. If a company does not meet these obligations (also called loan covenants), it can be deemed in default of the loan agreement. This could have a detrimental effect on the company's ability to refinance its debt, especially if it has a large amount of debt and in need of more financing.
An Example
Assume that NetcoDOA (a pretend company) has equity of $3.45 billion, intangibles of $3.17 billion and total debt of $3.96 billion. This means that NetcoDOA's tangible net worth is $28 million ($3.45 billion of equity less debt of $3.17 billion).
Let's also assume that NetcoDOA took out a bank loan in late 2000 that will mature in 2005. The loan requires that NetcoDOA maintain a capitalization ratio no greater than 70%. A typical capitalization ratio is defined as debt represented as a percent of capital (debt plus equity). This means that NetcoDOA's capitalization ratio is 53.4%: debt of $3.96 billion divided by capital of $7.41 billion (equity of $3.45 billion plus debt of $3.96 billion).
Now assume that NetcoDOA is faced with an impairment charge that will wipe out half of its goodwill ($1.725 billion), which will also reduce equity by the same amount. This will cause the capitalization ratio to rise to 70%, which is the limit established by the bank. Also assume that, in the most recent quarter, the company posted an operating loss that further reduced equity and caused the capitalization ratio to exceed the maximum 70%.
In this situation, NetcoDOA is in technical default of its loan. The bank has the right to either demand it be repaid immediately (by declaring that NetcoDOA is in default) or, more likely, require NetcoDOA to renegotiate the loan. The bank holds all the cards and can require a higher interest rate or ask NetcoDOA to find another lender. In the current economic climate, this is not an easy thing to do.
(Note: The numbers used above are based upon real data. They represent the average values for the 61 stocks in Baseline's integrated telco industry list.)
Conclusion
New accounting regulations that require companies to mark their goodwill to market will be a painful way to resolve the misallocation of assets that occurred during the dotcom bubble (1995-2000). In several ways, it will help investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable. If the economy and stock markets remain weak, many companies could face loan defaults.
Individuals need to be aware of these risks and factor them into their investing decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that should serve as red flags indicating which companies are at risk:
1. Company made large acquisitions in the late 1990s (notably the telco and AOL).
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly since 2000.
Unfortunately, the above can be said about most companies.
by Rick Wayman, (Contact Author Biography)
http://www.investopedia.com/articles/analyst/110502.asp?viewed=1
by Rick Wayman
"Impairment charge" is the new term for writing off worthless goodwill. These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs (for example, AOL - $54 billion, SBC - $1.8 billion, and McDonald's - $99 million). While impairment charges have since then gone relatively unnoticed, they will get more attention as the weak economy and faltering stock market force more goodwill charge-offs and increase concerns about corporate balance sheets. This article will define the impairment charge and look at its good, bad and ugly effects.
Impairment Defined
As with most generally accepted accounting principles, the definition of "impairment" is in the eye of the beholder. The regulations are complex, but the fundamentals are relatively easy to understand. Under the new rules, all goodwill is to be assigned to the company's reporting units that are expected to benefit from that goodwill. Then the goodwill must be tested (at least annually) to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is deemed "impaired" and must be charged off. This charge reduces the value of goodwill to the fair market value and represents a "mark-to-market" charge.
The Good
If done correctly, this will provide investors with more valuable information. Balance sheets are bloated with goodwill that resulted from acquisitions during the bubble years, when companies overpaid for assets by using overpriced stock. Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for that stock. The new rules force companies to revalue these bad investments, much like what the stock market has done to individual stocks.
The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to impairment have not made good investment decisions. Managements that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality.
The Bad
The accounting rules (FAS 141 and FAS 142) allow companies a great deal of discretion in allocating goodwill and determining its value. Determining fair value has always been as much an art as a science and different experts can arrive honestly at different valuations. In addition, it is possible for the allocation process to be manipulated for the purpose of avoiding flunking the impairment test. As managements attempt to avoid these charge-offs, more accounting shenanigans will undoubtedly result.
It's doubtful that very many corporate managements will face reality and take their medicine. Compensation packages will incite managers to delay the inevitable as they hope for a stock market rebound that will boost fair value.
A delay, however, could backfire and adversely impact EPS in 2003. According to the rules, impairment charges that occur within the first year of adopting the new accounting rules (calendar 2002 for most corporations) are accounted for as a charge to equity. After the first year, impairment charges hit the income statement. Consequently, postponing may help results in 2002 but could reduce EPS in 2003.
The other bad thing is that investors will have a hard time evaluating how management is handling this issue. The process of allocating goodwill to business units and the valuation process will be hidden from investors, which will provide ample opportunity for manipulation. Companies are also not required to disclose what is determined to be the fair value of goodwill, even though this information would help investors make a more informed investment decision.
The Ugly
Things could get ugly if increased impairment charges reduce equity to levels that trigger technical loan defaults. Most lenders require companies who have borrowed money to promise to maintain certain operating ratios. If a company does not meet these obligations (also called loan covenants), it can be deemed in default of the loan agreement. This could have a detrimental effect on the company's ability to refinance its debt, especially if it has a large amount of debt and in need of more financing.
An Example
Assume that NetcoDOA (a pretend company) has equity of $3.45 billion, intangibles of $3.17 billion and total debt of $3.96 billion. This means that NetcoDOA's tangible net worth is $28 million ($3.45 billion of equity less debt of $3.17 billion).
Let's also assume that NetcoDOA took out a bank loan in late 2000 that will mature in 2005. The loan requires that NetcoDOA maintain a capitalization ratio no greater than 70%. A typical capitalization ratio is defined as debt represented as a percent of capital (debt plus equity). This means that NetcoDOA's capitalization ratio is 53.4%: debt of $3.96 billion divided by capital of $7.41 billion (equity of $3.45 billion plus debt of $3.96 billion).
Now assume that NetcoDOA is faced with an impairment charge that will wipe out half of its goodwill ($1.725 billion), which will also reduce equity by the same amount. This will cause the capitalization ratio to rise to 70%, which is the limit established by the bank. Also assume that, in the most recent quarter, the company posted an operating loss that further reduced equity and caused the capitalization ratio to exceed the maximum 70%.
In this situation, NetcoDOA is in technical default of its loan. The bank has the right to either demand it be repaid immediately (by declaring that NetcoDOA is in default) or, more likely, require NetcoDOA to renegotiate the loan. The bank holds all the cards and can require a higher interest rate or ask NetcoDOA to find another lender. In the current economic climate, this is not an easy thing to do.
(Note: The numbers used above are based upon real data. They represent the average values for the 61 stocks in Baseline's integrated telco industry list.)
Conclusion
New accounting regulations that require companies to mark their goodwill to market will be a painful way to resolve the misallocation of assets that occurred during the dotcom bubble (1995-2000). In several ways, it will help investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable. If the economy and stock markets remain weak, many companies could face loan defaults.
Individuals need to be aware of these risks and factor them into their investing decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that should serve as red flags indicating which companies are at risk:
1. Company made large acquisitions in the late 1990s (notably the telco and AOL).
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly since 2000.
Unfortunately, the above can be said about most companies.
by Rick Wayman, (Contact Author Biography)
http://www.investopedia.com/articles/analyst/110502.asp?viewed=1
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