FASB: The Dark Side Clouds Everything

The new FASB ruling is getting more play than it deserves.

I’ve written on mark-to-market many times. I’ve always felt it was a good concept but has been applied incorrectly. When the rules were written, it was never assumed that generalized risk aversion would ever rise to the extent that it has. Thus the rules assumed that a $30 decline in a bond price would always and every where indicate a security-specific problem. The rules (and/or the auditors) also assumed that securities that seemed similar at a glance could be used to value each other. They never assumed that various securities would ever become as granular as they eventually became. For example, a whole-loan RMBS with 15% California exposure suddenly was valued drastically differently than one with 25% CA exposure. But both were valued off the ABX as if they were the same, because the ABX was the only thing trading.

Anyway, the key thing that changes with this FASB guidance is the assumption of distress. Now any trade that occurs in an inactive market is presumed to be a distressed trade unless proven otherwise. I’d expect this means that most Level 3 asset prices will become more PV model-based and less trade based.

BUT…

I’d argue that this won’t result in banks writing up their asset valuations. Think about it. Say XYZ Bank announces some huge quarterly EPS figure, but when the analysts look deeper into the number, it turns out it was all paper gains on Level 3 assets. Investors would universally pan the earnings figure, claiming it was all phantom profits on marks to make-believe valuations.

Conversely, let’s say the same bank reports break-even earnings with no change in Level 3 and a healthy increase in loan loss reserves. Now what does the market think? Analysts would say that the bank has potential latent gains in their Level 3 portfolio that haven’t been recognized.

This market is all about imagination. If you are a bank (or any financial), the market isn’t going to just accept your balance sheet as reported. The market is going to try to imagine what your balance sheet is really. Since no one knows what it is really worth, investors are going to imagine. I argue that a bank is better off convincing the market that it is being too conservative, thus guiding the imagination to better times.

Otherwise the bank will only stimulate the imaginations of the “its all worthless” crowd, which I realize is the majority of the blogosphere. I don’t get this point of view, and I think its all rooted in some sort of visceral desire to see the banking system crash and burn. I think Jim Cramer said it well on TheStreet.Com today:

“The first side is the “it doesn’t matter and it is bad” camp. This is the camp that says it [the FASB ruling] is a mistake because it will give the banks too much latitude, and they don’t deserve it. “Deserves,” as they say in Unforgiven, “got nothing to do with it.” This is a completely worthless position that makes you no money. Who the heck cares whether they “deserve” it? What is this, some sort of civics lesson? We are now going to invest on whether someone should be punished? This is about money. I could care less about “deserves”. ”

Its similar to my position on politics. As an investor you need to forget about what “ought” to happen and worry about what will happen. That’s how you make money.

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