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Saturday, March 29, 2008 2:44 PM

SEC Openly Invites Corporations To Lie

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The Securities and Exchange Commission sent out a Letter On Fair Value Measurements, (Financial Accounting Standards No. 157) that is tantamount to being an open invitation to lie. Let's take a look at what some are saying about that letter.

Floyd Norris at the New York Times writes If Market Prices Are Too Low, Ignore Them.

The Securities and Exchange Commission is out today with a letter to companies that own a lot of financial instruments whose current market value must be reported to shareholders. For more than a few companies, disclosing market values is neither easy nor convenient.

The issue is the application of SFAS 157, which governs the way companies compute fair value of assets. The rule sets out three categories of assets, with different ways to value them. Category 1 includes assets with easily observable market values. I.B.M. stock closed today at $114.57, and it is not easy to justify a different value if your quarter ended today. Category 2 is a little fuzzier, where there are observable markets that provide a good guide to prices of your asset, even though there is no direct market. And then there is Category 3, which is essentially mark to model.

But one part of the letter stood out to me, providing an excuse for companies to ignore a market value if they don’t like it (italics added):

“Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.”

That sounds to me like an invitation to fudge. Some people on Wall Street think that nearly every sale today is a forced sale. There are entire categories of collateralized debt obligations where most, if not all, of the trades, occur because a holder has received, or expects, a margin call.
Naked Capitalism wrote an excellent piece on this today called SEC Gives Permission to Fudge Mark-to-Market.
In the last couple of months, there has been increased worry that mark-to-market accounting leads to the operation of a destructive "financial accelerator." As prevailing values go down, banks have to lower the value of their holdings. This leads to a direct hit to their net worth, which will lead them to contract their balance sheets, either by withholding credit or selling assets. More sales in a weak market lead to further declines in the prices of financial instruments, leading to more writedowns and sales of inventory.

Funny how no one had a problem with mark-to-market when asset prices were rising.

But now the SEC has given banks and brokers a huge out. No matter how small or easily absorbed by the market a forced sale might be (think of a hedge fund hit by a margin call), a financial institution can ignore the price realized. In fact, they get to determine what trades constitute a forced sale.

Moreover, we've seen plenty of unintended consequences, or worse, backfires, as regulators intervene trying to alleviate the credit crisis. Banks have been reluctant to extend credit to each other precisely because they don't trust their creditworthiness. That's tantamount to saying they already don't trust their public financial statements, since according to their public filings, virtually all major financial institutions have more than the required statutory capital.

So this move, to stem the balance-sheet-shrinking impact of mark-to-market accounting in a falling price environment, may further undermine liquidity. Companies will less able to judge whether their published financials are telling the whole story, And where the numbers are in doubt, rumors are taken more seriously.

To paraphrase Winston Churchill, it has been said that mark to market accounting is the worst form of financial accounting except for all the others that have been tried. But it looks like we are going to try them anyhow.
Let's sum this all up. Corporations were happy to mark to market as long as asset prices were going up. This led to more loans on top of loans as corporations were making huge profits, at least on paper. Enormous bonuses were handed out based on those paper profits and corporations leveraged up loans.

Now we see those profits were nothing but a mirage.

Of course everyone knew those earnings were a mirage even at the time, but as long as the party was going on, no one wanted to spoil it, especially the Fed and the SEC. So the SEC looked away, and so did the Fed, and so did investors who were happy with everything as long as stock prices were going up.

In the asymmetrical world of the Fed and the SEC bubbles are never prevented, but everything is done to prevent them from busting. Now the SEC is openly inviting corporation to lie.

Disclosure that was fine on the way up is somehow not fine on the way down.

In the end all this does is create more mistrust and suspicion about what is real and what is imaginary. That suspicion may be more damaging than actual disclosure and may also create big temporary inequities between corporations that decide to come clean vs. those who keep sneaking more garbage into Category 3 assets, while pretending those assets are worth more than they are.

Nonetheless, if there was a futures market on pretending, "pretending futures" would be a screaming buy. To paraphrase Martha Stewart "That's not a good thing".

Mike "Mish" Shedlock
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