Thought the subprime mess was bad? Wait till the accountants get involved By
Harry Koza | 10 November 2007 "Fasbie, that's gonna be the next big thing." My interlocutor pointed his chopsticks at me to emphasize his point, "You just watch." |
Since he was talking while chewing on a mouthful of General Tso's Chicken, it sounded to me like he had said Frisbee, and I was pondering how best to break the news that they invented the Frisbee, like, back in the sixties, when I realized he was talking about
FASB— the U.S. Federal Accounting Standards Board. You know, the guys who come up with the new accounting rules almost as fast as the Enrons and WorldComs find ways to circumvent them.
"What about FASB?" I asked, helping myself to the garlic prawns (I was lunching with an old friend, an ex-Grateful Deadhead who now trades, well, I'm not quite sure exactly what he trades, but whatever it is, it seems to be extremely lucrative). |
"Nov. 15. FASB 157 comes into effect." |
"The 'fair value' thing?" |
"That's it. Banks and dealers will have to either mark their Level 3 assets to market or write down their value." Our harried waiter appeared with a plate of Szechuan dumplings. |
"Okay," I said. "I barely made it through accounting class in biz school, so let's see if I get this. Fair value, for bean counters, isn't necessarily what an asset cost— though its cost could be its fair value— but rather, what it can be sold for at that moment." |
My friend had just stuffed a hot dumpling into his mouth and couldn't talk, but managed a nod, so I continued.
"Level 1 assets, then, would be like IBM shares or long bonds: There's always a bid for them, you always know what fair value is, and they are always marked to market.
"Level 2 assets would be less liquid stuff, like high-yield bonds, where you can't just hit a bid on screen, but you can still figure out fair value pretty easily with a couple of phone calls.
"And Level 3 assets would be instruments that nobody has the first freakin' clue what they're worth, stuff like subprime CDOs and SIVs— all that alphabet soup stuff." |
"Exactly. See, accountants have never been able to agree on what constitutes fair value before." |
"Yeah, it was one of those nuance-riddled grey areas for which accounting is so famous. Of course, that wasn't helped by the investment industry always insisting that determining the fair value of an investment isn't a science, it's an art, and one that can only be arrived at through the use of black-box models based on combustion thermodynamics equations, said results then being duly interpreted according to the learned assumptions of management." |
"Right, like the assumption that house prices can only ever go up. Anyway, FASB says that starting Nov. 15, fair value at any given moment is the price you can sell the thing for, period. So now all the banks and dealers have to disclose how much of what's on their books is crap that there's no bid for, and write down the value to what it's really worth, which, in some cases, may be bupkes. Needless to say, the previous valuations of those investments, using management's presumptuous assumptions, were much closer to par than the new ones will be." |
"Yow. That could get downright ugly. I mean, ABCP and SIVs are already on life support, and that new MLEC fund they're talking about to buy the SIV assets is dumb— solving a debt problem with more debt, yeah, like that'll work— and the markets for CDOs, CMOs, RMBS and CLOs are all similarly distressed, so either the banks and investment banks have to take the crap onto their own books and take big writedowns or sell it at a huge loss. Either way, it could be real nasty." |
"And the new rules mean that everyone will now know how much exposure everybody really has to subprime slime and the other crunchy credit products." |
"So I guess this means big losses for banks and dealers, which will beat up their capital ratios and their stock prices, plus they'll have to raise tons of new capital to shore up their balance sheets, and worst case, some firms may go belly up or be forced to merge." |
"There's already plenty of chatter about dealers' Level 3 exposure. Take Citigroup, for instance. In a recent SEC filing, they said they had $135-billion (U.S.) in Level 3 assets. They have an equity base of $128-billion, so their Level 3 exposure is 105 per cent of equity. Goldman has $72-billion in Level 3, or 185 per cent of their $35-billion in equity." |
"And a report from the Royal Bank of Scotland this week predicted the total losses from Level 3 writedowns will be somewhere between $250-billion and $500-billion." |
"Dude," said my Deadhead friend, "even in U.S. dollars, that's still serious gelt." |
Harry Koza is senior Canadian markets analyst at Thomson Financial and a columnist for GlobeinvestorGOLD.com.
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