Monoline Death Watch

Felix Salmon discusses some recent JPM research on MBIA:

in a note issued this morning they said that MBIA’s tangible book value is actually negative, to the tune of about -$40 per share.

OK, the full article has some caveats. But the mere fact that a reputable investment bank (if that is not an oxymoron) can suggest that MBIA is insolvent should raise some warning signs about the extended historical fiction that is insurance accounting.

Moooo

In an article reminiscent of Cows accused of spending a lot of time in fields, Floyd Norris writes in the NYT:

Politicians Accused of Meddling in Bank Rules

He continues with more sound (if rather obvious) comment:

Accounting rules did not cause the financial crisis, and they still allow banks to overstate the value of their assets, an international group composed of current and former regulators and corporate officials said in a report to be released Tuesday.

The report, from the Financial Crisis Advisory Group, also deplored successful efforts by politicians to force changes in accounting rules and said that accounting standards should be kept separate from regulatory standards, contrary to the desire of large banks.

The report is here.

Cry havoc and let slip the dogs of war accounting

OK, the revised version is perhaps a touch less catchy. Bloomberg reports:

The FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month.

So the Americans are showing some guts. Good on them. This will be an interesting showdown. The FASB, in white hats, are holed up in a one horse town with the evil banker boys coming after them; their old allies, the IASB gang, have abandoned them, and they only have unarmed readers of financial statements supporting them.

39 Steps

No, not a (really rather good) novel by the 1st Baron Tweedsmuir, but rather the steps to revise IAS 39. For those of you who have not been following this slightly less gripping drama, this is the international accounting standard relating to the valuation of financial instruments.

The IAS 39 replacement project is proceeding in three phases:

1. Classification and measurement
   
2. Impairment methodology
   
3. Hedge accounting

We are at phase 1, but this is in many ways the most important one as it relates to the fundamental question what is a financial instrument worth?

The current proposals are a bit of a curate's egg. The good parts first.

• The available for sale category is eliminated. All instruments are either held at fair value or amortised cost.
  
• The treatment of embedded derivatives is simplified.
  
• There will be only one approach to impairment, and it will be used for all instruments in the amortised cost category.
  
• Only loan-like instruments can valued using amortised cost.

Much of the complexity of IAS 39 is eliminated, and the resulting accounting standard should be easier to apply.

The big problem, though, is the availability of amortised cost for some assets. Provided a financial asset is debt like, managed on a yield basis, and the institution's strategy is to hold it to maturity, then they will be able to use amortised cost accounting. This means that the ability to lie about what your assets are worth is preserved. It means that the same bond can be held at two different values by different institutions as one could use fair value and the other amortised cost. If a very firm approach is taken to impairment, and this approach is actually implemented by the audit firms, then perhaps this will not be a total disaster. But I still worry that the basic principle of true and fair has been obscured by the banks' desire to smooth earnings.

In their podcast -- even accountant standards setters make podcasts, -- the IASB say:

While fair value could provide useful additional information [for investors], the board believes that the cost of providing that information likely outweighs the benefits [in some cases].

I have to say that I don't share this belief. I think that the benefits of trying to estimate fair value are great both for the reader of financial statement and for the preparer. Of course, finding fair value can be as hard as finding an allicorn, and there can be considerable subjectivity in the process. But I still want to know what an institution estimates its assets are worth now, not what they might be worth if their strategy is successful.

Information based finance

Without good data, it is rather hard to do good analysis. Therefore if accounting standards are sensible, they become invisible: investors use the data, and take it for granted. But if accounting standards are bad - if they allow reporting companies to conceal material facts - then the users of financial statements are put at a huge disadvantage. Credit rating and securities analysis becomes a lot more difficult. This is why the basic test for accounts is still 'are they true and fair?'

I think the major accounting standards setters, the FASB and the IASB, have a very difficult job to do. They are subject to intense, well resourced lobbying from the financial services industry. Moreover, being accountants, they are not experts in all of the products they have to write rules for.

The recent news here is deeply depressing. On Sunday, the observer reported that the IASB may lose the power to make accounting standards in Europe. This is pure politics: the banks have lent on the European commission, and the commission is leaning on the IASB. The IASB is trying to hold the line, but the pressure to allow banks to lie about the value of their balance sheets is considerable.

In the US, things are just as bad. Today FT alphaville picks up a story from the WSJ that the FASB is coming under huge pressure to relent on the reclassification of off balance sheet vehicles. This comes after the shameful capitulation of the FASB on fair value.

The problem here is that one side - the issuers of financial statements - is well organised and the other - the readers - isn't. It would be a great shame if the result of the asymmetry was a permanent degradation in the quality of financial information. But right now, 'true and fair' seems further away than ever.

Update. Floyd Norris has an excellent post on the flexibility that the current loosened US rules give in the NYT. The key point is that if a sale is 'distressed', it can be ignored for the purposes of fair value. One fund bought more of a security that they already owned, and were marking at $98.93, for $9.50. They then

contacted the selling broker-dealer to determine whether the sale was “distressed” (and thus could potentially be disregarded for purposes of determining the fair value of the security). On May 28, 2008, the broker-dealer responded that the security was “not coming from a distressed seller, just one that wanted to get out.” Notwithstanding this response, the Ultra Fund’s portfolio management team informed the Valuation Committee that they believed the sale was distressed

(Quote from SEC litigation against the fund.)

Now, admittedly this is illegal and I am not claiming that the large banks would go this far. But it does illustrate how valuations can be manipulated once you are allowed to ignore current transactions.

Reading Wells' disclosures

Jonathan Weil has been over them carefully. Frankly, reading his article, one wonders (a) why the accounts were signed off and, (b) why anyone would want to buy any of the bank's securities given these tricks.

Something for you to do

Willem Buiter, reneging on his earlier negativity on the IASB, quotes from a statement made on April 2, 2009 by the Trustees of the International Accounting Standards Committee Foundation:

Sir David Tweedie, Chairman of the IASB, reported to the Trustees that at their joint meeting last week the IASB and FASB agreed to undertake an accelerated project to replace their existing financial instruments standards (IAS 39 Financial Instruments, in the case of the IASB) with a common standard that would address issues arising from the financial crisis in a comprehensive manner. Though the IASB is consulting on FASB amendments related to impairments and fair value measurement, the Trustees supported the IASB’s desire to prioritise the comprehensive project rather than making further piecemeal adjustments.

This is good. They are not being rushed into anything, and they are not following the FASB in giving in to the banks. However it does make it vital that the IASB gets sufficient informed comment on fair value during its consultative process. I would encourage anyone who cares about these issues to visit the IASB page here, download the consultative document, and comment on it.

Finite reinsurance: a strange and sometimes manipulative thing

Thanks to AIG, the weird and wonderful world of finite reinsurance has come under broader scrutiny recently. (You may recall that a finite reinsurance policy between AIG and Gen Re was the method used to inflate AIG's earnings in the case that came to the courts in 2008.)

Now, thanks to the Big Picture, further amusing documents have achieved more general publication. I don't agree with much of the thrust of the post - which frankly contains altogether too much credit derivatives related hysteria. But the extra light on finite reinsurance is welcome.

When is finite reinsurance a valid business tool, and when does it verge on fraud? This is difficult to answer because finite reinsurance is a very sophisticated tool that can be used in myriad ways. But let me illustrate a good and a bad situation.

Good finite reinsurance. Suppose a company has a liability with a known size but uncertain timing. Asbestos-related claims are a commonly cited example: the firms knows it will have to pay workers for past exposure to asbestos, and it can estimate the size of those claims reasonably well, but it does not know when the claims will be presented as the sickness has a long and uncertain gestation period. The uncertainy thus created weighs on the share price, even though the company has every intention of paying and the resources to do so. Therefore it purchases a finite reinsurance policy whereby it pays a premium equal to (roughly) the present value of the expected claims to a large, well capitalised reinsurer. The reinsurer takes two risks: one small (that the claims will be larger than expected: this is unlikely as typically the risks insured under finite schemes have rather little uncertainty in claims); and one larger (that the claims will be presented earlier than expected, and hence the invested premium will not have grown sufficiently for them to make a profit). From this we see that finite schemes are often about transferring timing or investment risk rather than the risk of uncertainty in claims.

Bad finite reinsurance. Consider the effect of the scheme above though. Before the reinsurance, the firm had a known hit to earnings in the future but with uncertain timing. Afterwards, it has a stream of expenses - the premium payment or payments on the policy - but no uncertainty. Earnings have been smoothed. Clearly we can extend that effect more broadly via policies which pay out money in the future for an appearance of risk reduction today (buying surplus for an insurer, i.e. flattering their capital position) but where all of the risk comes back in later years, or via policies which move current profits into later years, smoothing earnings. Accounting rules do not permit you to arbitrarily reserve whatever amount of current earnings you like against some future risk, especially a very unlikely and hard to quantify one, but finite reinsurance policies achieve the same effect.

Finite reinsurance can therefore be used, quasi-legally, to manipulate earnings for many companies. It can also be used to manipulate insurance companies' capital position. If ever there was an area of finance crying out for better regulation, I'd say it was insurance.

The FASB buckles

Narrowly winning the award for most depressing news of the week (the runner up being Gillian Tett getting an award - and not one for most ignorant commentator on credit derivatives in a mainstream newspaper), Bloomberg announces:

The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value rules... The changes to so-called mark-to-market accounting allow companies to use “significant” judgment when gauging the price of some investments on their books, including mortgage-backed securities.

This is just terrible news for readers of financial statements, investors, and financial stability.

Update. You have to love Willem Buiter sometimes. His latest is entitled How the FASB aids and abets obfuscation by wonky zombie banks. Zombies are scary enough. But wonky zombies? Are they going to explain the dynamics of the money supply to you before they eat you? Or would that be wonkish zombies? Seriously, though, it is a good post: I recommend it. My only remark is that Willem is not sanguine about the IASB, whereas I am slightly more hopeful that they will not fall further into sin.

But first, accountants embarrass themselves

This is so incredible, so bizarre that I have to blog.

The FASB has lost its mind. It is proposing that:

U.S. companies would be allowed to report net-income figures that ignore severe, long-term price declines in securities they own. Not just debt securities, mind you, but even common stocks

(Quotation from an excellent Bloomberg article by Jonathan Weil. This is a large, forceful slap in the face to the users of financial statements. As Weil says:

if these rules had been in place last year, a company that still owned shares of American International Group Inc. or Fannie Mae, for instance, could exclude those stocks’ price declines from net income entirely. It would make no difference that the companies were seized by the government last year, or that both are penny stocks.

Idiocy on this scale is deeply depressing. One can only hope that this proposal goes nowhere.

Accountants and other criminals

My apologies for an incendiary title. I don't really mean it of course. I think I have a slight case of hyperbole from Francine McKenna. Still, in this article at The Huffington Post, she points out that

The Big 4 public accounting firms haven't yet been asked the hard questions by governments, legislators, or regulators.

Which is true. She also points out that they share some of the characteristics of organised crime. Which, so far as the analogy goes, is also true. But the big issue is liability.

Governments all over the world are protecting and shielding the public accounting firms from failure under any circumstances, even in the face of repeated failure on their part... The firms and their partners ... are unequivocally self-interested.

As one would expect them to be. But the time for pandering to their self-interest is over. If they want to give opinions on accounts, then they should be liable for them. If they don't feel ready to take responsibility, then they should not sign off the accounts. Removing caps on auditor liability is a really easy way to dramatically improve the quality of audited financial statements.

AIG - Where did the money go?

(HT The Big Picture.)

What is interesting about this is the GIAs. I _think_ that these are GICs, i.e. guarantees of minimum investment returns, sometimes on variable balances. Obviously as rates have fallen, GICs have become more valuable to the holder and riskier to the writer. Insurers have conspicuously underpriced the implied puts in GICs for years, and now it seems that for AIG these have come home to roost.

Good bad/bad bank

Willem Buiter has a discussion of how good bank/bad bank separations might work in detail: the mechanics come from Robert Hall and Susan Woodward. I will simplify the argument a little, and discuss the issues.

Consider a bank with:

Assets		Liabilities
Good loans	1000	Deposits	1200
Bad loans	500	Bonds Issued	600
Other assets	380	Shareholder's funds	80

(Let's ignore the off B/S stuff for this post and assume that all of the other assets are good.)

The proposal puts the deposits and good assets in the good bank, and calls the difference between assets and liabilities 'capital'. Thus we have for the good bank:

Assets		Liabilities
Good loans	1000	Deposits	1200
Other assets	380	Shareholder's funds	180

Notice that the good bank is well capitalised under this proposal.

The bad bank owns all of the equity in the good bank. For it we have:

Assets		Liabilities
Bad loans	500	Bonds Issued	600
Equity in good bank	180	Shareholder's funds	80

It is fairly likely that the equity holders in the bad bank will be wiped out over time, which is right and proper. If the good bank makes money and declares a dividend, the bad bank will receive that income as it stands. Meanwhile the debt holders of the bad bank now have a claim on a rather worse quality institution, at least at first sight. This is a proposal with rather little moral hazard.

The issue comes when we consider the bad bank's position. It is not capitally adequate, not least because material holdings in credit institutions (i.e. its shareholding in the good bank) is a deduction from equity. One might argue that it does not need a banking license as it is now in run off, but still, it is so leveraged that its management will have to sell some of the equity in the good bank. Does a forced seller of bank equity (albeit good bank equity) really help financial stability?

Also notice that the bad bank would consolidate the good bank from an accounting perspective. Again, to get deconsolidation it would have to sell at least 50% of the good bank's equity.

The proposal in short makes sense from a moral hazard perspective, and transfers the taxpayer's deposit guarantee to a well capitalised institution. But it does force the bad bank to sell its position in the good bank almost at once, and that is a rather worrying side effect.

Accounting for the dead

I have a terrible confession. I have never liked Elvis. But aside from dead musicians, Bloomberg is doing a great job on chronicling the absurdities of accrual. David Reilly says:

Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co., meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank.

What are all those other assets that aren’t marked to market prices? Mostly loans -- to homeowners, businesses and consumers.

...investors already believe banks are underestimating just how bad losses will be on their unmarked loans. GE investors, for example, fled the stock due to concerns over its corporate loans and lending to Eastern Europe.

If investors could get a better sense of the losses actually facing GE, they might have more confidence in its financial strength. In other words, we need more mark-to-market accounting, not less.

Real Solvency and Fantasy Solveny

There is a `the banks are insolvent' meme going around at the moment. It's rubbish, but something close to it may be true.

The reason it is rubbish is that solvency means assets > liabilities under the firm's accounting standards. This is clearly true for all the large banks.

What the commentators mean by `the banks are insolvent' really, then, is `under my idea of what accounting standards should be, the banks would be insolvent'. Clearly this is a little different, however rational the particular accounting counterfactual concerned is.

Let's look at some of the choices in the space of accounting methods.

• Pure accrual accounting would value every asset and liability under accrual accounting, with whatever loan loss reserves the firm can get past its auditors being taken. Under this measure pretty much every bank is solvent.
  
• Pure rigourous fair value would use fair value for everything, with prudent valuation adjustments being taken wherever there is uncertainty. Under this measure, many banks would be insolvent.

Most banks definitions of solvency are closer to the first than the second of these at the moment, of course. I suspect that most commentators who say that the banking system is insolvent are implicitly thinking of something like pure rigourous fair value. In any event, there are many, many accounting standards between these two extremes, of which any given bank's choice is one.

Two more things to note.

First, insolvency implies that the bank is not capitally adequate, but capital adequacy is a stronger constraint. It implies solvency* plus capital > capital requirements**. Losses challenge both solvency and capital adequacy as they erode capital, but the capital adequacy test is hit before the solvency one.

Second, solvency or insolvency have nothing to do with liquidity. A bank can be insolvent and perfectly able to fund itself (if that fact is well enough hidden) and highly solvent but unable to fund.

For further reading, see a good if long post by John Hempton here.

*Actually this is not quite true as the regulatory notion of solvency is not quite the same as the accounting one. Regulators apply a few (typically minor, in the big scheme of things) valuation adjustments to GAAP.

**The definition of Capital is much more country specific than that of Capital requirements. The `Basel 2 capital requirement' is close to being the same everywhere (although there are some differences in national implementations). But the definition of capital varies significantly, especially in the treatment of things like deferred tax assets, goodwill, and unrealised gains on held to maturity positions.

Are there any solvent banks in Spain?

Creditflex's story (via Alea) that Spain's banks and cajas are negotiating on a one-to-one basis with the Bank of Spain to "fine-tune" their 2008 accounts in order to avoid taking catastrophic write-downs on loans makes me wonder if anyone knows the answer to this question.

The Barclays dilemma

This one is really hard. On the one hand, Barclays announced that they don't need more capital, and that their earnings are strong. (Bloomberg story here: Barclays letter to investors here.) And obviously one does not want to do a Peston, and spread irresponsible rumours. But there is still a nagging suspicion that there is something rank* about their balance sheet -- that they may have been less than honest about all their writedowns. I suppose this is yet another accounting problem: once suspicions arise that a bank might be abusing accrual, it is very hard for them to convince everyone that they are clean.

* But not as rank as a Durian, obviously

Update. Up 73% in one day. Wow. Just wow.

Accounting for bullies

The Washington Post has a nice article on the European Commission's bullying of the IASB.

In October, largely hidden from public view, the International Accounting Standards Board changed the rules so European banks could make their balance sheets look better. The action let the banks rewrite history, picking and choosing among their problem investments to essentially claim that some had been on a different set of books before the financial crisis started.

The results were dramatic. Deutsche Bank shifted $32 billion of troubled assets, turning a $970 million quarterly pretax loss into $120 million profit.

We already know that David Tweedie, chairman of the IASB wasn't happy about this and reportedly threatened to resign. But what is new is that the Americans are waking up to the implications of this bullying.

"Right now, there is no credibility," said Robert Denham, chairman of the Financial Accounting Foundation, which oversees the FASB. "If we are going to have global accounting standards, my view is that is not going to work if the IASB is going to be jerked around by the European Commission.

Over lunch on the 24th a leading member of the IASB suggested to be that the FASB was irrelevant and that IAS would soon rule the world. Perhaps the Americans won't go gentle into that good night.

MTM

MTM means for course `mark to me'. It appears that AIG has determined the most reliable source of fair values for some transactions is -- itself. Think of a number. Wow, the number I just thought of was ... the number I was thinking of. I must be right.

I exaggerate of course. Let Bloomberg take up the story:

AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe...
[These swaps] are different because they didn’t insure against losses... they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves.

The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps.

[AIG has] unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial-products subsidiary, said the company continues to “experience early terminations according to our schedule at par.”

As a result, Lewis [AIG risk officer] said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.

That’s because, as the insurer said in its third-quarter filing, it “estimates the fair value of these derivatives by considering observable market transactions.” And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing.

There is more to trouble an AIG investor, European bank regulators, the SEC, the FED, and AIG's auditors in this, if it's true, than you can shake a stick. Here are a few of the issues.

Firstly you would have thought that the Gen Re case had taught AIG that doing transaction purely for regulatory manipulation without risk transfer is a bad idea.

Secondly, what do European bank regulators think of this? (I'll leave Basel 2 being described as an accounting standard as a signal that this new item may not be entirely reliable. And while we are asking questions, where exactly in Europe hasn't Basel 2 been implemented yet? And what is a default swap that does not transfer losses, and how exactly does it qualify for capital relief?)

Thirdly, if both the transaction and AIG's accounting for it are correctly described, why on earth do their auditors, PWC I think, let them get away with this? Hasn't AIG had enough auditing issues at AIG FP already?

Fourthly does the FED really want an almost 80% state owned company doing this kind of transaction? And accounting for it this way?

The humbling of the actuaries, part 357,121

Bloomberg has a nice article on one of my favourite pieces of actuarial insanity, guaranteed annuity contracts. The basic story is that life insurance companies wrote long-dated equity index and basket puts in size and didn't price them properly, because their actuaries didn't understand derivatives. With the recent market falls, they are beginning to see just quite how stupid an idea this was.

It’s ending in tears. In September, the insurance raters A.M. Best and Fitch moved the life-insurance industry into its negative-outlook column. In October, Moody’s, and Standard & Poor’s did the same. A.M. Best has downgraded 30 life and annuity companies so far this year.

Of course, because all of this is in an insurance wrapper, there is no requirement to mark to market, so investors cannot see the size of the problem.

In the meantime, the industry is proposing to handle its problems the good, old-fashioned, American way: by putting lipstick on its books.

As the value of GMWB [guaranteed minimum withdrawal benefit] annuities tumbles, the carriers are required to raise the reserves they hold against these products, as a way of assuring that consumers will be paid. Raising reserves, however, could starve their working capital at a time when they’re also writing down toxic mortgage assets. The companies say they’re already holding plenty of reserves, so they’re asking the states, which regulate the industry, to loosen the rules.

Astonishingly, some of the state regulators seem sympathetic:

The National Association of Insurance Commissioners will discuss the proposed changes this month. Iowa insurance Commissioner Susan Voss calls some of the reserves “redundant” and suggests that NAIC will go along.

Short now, short in size. It is a very cheap way to get protection on an extended period of low equity markets.