UPDATE: 09-15-08  FEDERAL RESERVE NOW CONSIDERING FAS 140 MODIFICATIONS

On September 15, 2008, the Federal Reserve published a news release: "Federal Banking Agencies Evaluating FASB's Accounting Proposals"

"The federal banking agencies are evaluating the amendments to generally accepted accounting principles proposed today by the Financial Accounting Standards Board (FASB)."

"These proposals would amend Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FAS 140), and FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities (FIN 46(R))."

"The FASB's proposed amendments would remove the concept of a qualifying special purpose entity (QSPE) from FAS 140.  This would require that variable interest entities previously accounted for as QSPEs under FAS 140 be analyzed to determine whether they must be consolidated in accordance with FIN 46(R).  The amendment also would revise the criteria for reporting a sale versus a financing." <Source>

Not only was this release timely, coming some eight or so hours after this blog entry was published, but it is believed that this is a pre-cursor to the combined Treasury-SEC-Federal Reserve Plan to use covered bonds to replace off-balance-sheet qualified special purpose entities and thus re-introduce a measure of transparency into the financial world.

Original Blog Entry ...

On the financial brink …

On the eve of an historic financial announcement concerning the potential bankruptcy filing of Lehman Brothers and the purchase of Merrill Lynch by the Bank of America, it might prove enlightening to examine the accounting practices that enabled these, as well as other financial firms, to hide the growing risk that was being assumed by those who were manipulating the markets for their own gain.

Lehman Brothers …

“Wall Street readied for a potential Lehman Brothers Holdings Inc. bankruptcy after Bank of America Corp. and Barclays Plc pulled out of talks to buy it and the government indicated it wouldn't provide funds to prevent a collapse.”

All day Sunday was spent by numerous financial institutions attempting to unwind the financial affairs of Lehman Brothers. "Trades are contingent on a bankruptcy filing at or before 11:59 p.m. New York time, Sunday, Sept. 14, 2008," the ISDA [International Swaps and Derivatives Association] said. "If there is no filing, the trades cease to exist." <Source: Bloomberg>

“The Lehman board authorized the filing of the Chapter 11 petition in order to protect its assets and maximize value, the firm said. In conjunction with the filing, Lehman intends to file a variety of first-day motions that will allow it to continue to manage operations in the ordinary course. Those motions include requests to make wage and salary payments and continue other benefits to its employees.” <Source: Wall Street Journal>

Merrill Lynch …

“In a rushed bid to ride out the storm sweeping American finance, 94-year-old Merrill Lynch & Co. agreed late Sunday to sell itself to Bank of America Corp. for $50 billion.” <Source: Wall Street Journal>

And in another Sunday news bulletin, the Federal Reserve announced

The Fed: Unlocking our national treasure …

The Federal Reserve Board on Sunday announced “several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities.” Basically, the Fed will be accepting equities (stocks) along with other types of collateral for its temporary “liquidity injection” loans. <Source: Federal Reserve> 

Represented by allegedly the best and brightest …

All of the major enterprises and financial institutions that have crashed and burned have had name-brand accounting and legal support.

Enron, master of the off-balance-sheet transaction, had Arthur Andersen (which did not declare bankruptcy and was not dissolved as commonly thought – but which lives on in the form of four limited liability companies ironically named Omega Management I-IV.)

An old accounting joke begins …

The president and the chief financial officer are interviewing the remaining big accounting firms to select their auditor. The president confesses that he has no idea what makes a good auditor as the chief financial officer reassures him that he knows how to select the best auditor from the sharp-looking and knowledgeable  candidates.

The CFO slowly walks up to each candidate and whispers in their ear. The CFO listens intently to what each person says in response. Suddenly, the CFO announces he has chosen the auditor and dismisses the rest of the candidates.

The president asks the CFO what he was whispering. The CFO replied that he had simply asked each candidate what the sum of two plus two was. Baffled, the president could not understand how such an elementary question could have an impact on the CFO’s decision. Professing disbelief, the president asked how this simple question could make a difference when the answer was know to all to be four.

“It wasn’t the answer that I was looking for,” replied the CFO. I just waited until one candidate exclaimed, “What do you need for performance this quarter?”

Purchased opinions …

And herein lies the cause of most financial debacles. A fudging of the numbers to meet the needs of the managements that hired them. A definite disregard and disrespect for the accounting profession in order to maximize the income of the accounting firm trying to overcome the blandishments of its competitors.

Aided and abetted by the rule-makers …

In many ways, the accounting profession is a mix of law and accounting rules which, like all endeavors involving licensed professionals, are complex enough to allow both sides to exert a position in order to allow the professionals on both side to collect their professional fees.

Enter the rule-makers: FASB …

“The Financial Accounting Standards Board (FASB) is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public's interest. The Securities and Exchange Commission (SEC) designated the FASB as the organization responsible for setting accounting standards for public companies in the U.S. It was created in 1973, replacing the Accounting Principles Board and the Committee on Accounting Procedure of the American Institute of Certified Public Accountants. The FASB's mission is "to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information” <Source>

Hiding the truth …

The goal of accounting is to provide a regulatory framework which allows enterprises to fairly and accurately present their financial information to their regulators, investors, management and others who may make decisions based on the information presented. In essence, the two-fold goals are accuracy and transparency.

FAS 140 …

Much of what has occurred in the recent financial debacle involves ENRON-like “off-balance sheet” accounting which allows companies, under a certain set of circumstances defined by FASB, to avoid reporting the full and complete extent of a company’s assets and liabilities on their balance sheets. 

While the description of FAS 140 is hyper-technical and would just confuse most lay readers, it is enough to know that this single accounting maneuver kept the ever-growing risk that was being assumed by the companies using this ruling from being easily seen and evaluated by the regulators, company board members, counterparties who do business with the company and the investing public.

Had this accounting technique not been employed, the risk would have more visible to all parties and, it is believed, not tolerated by the financial industry.

Sophistication is not a defense against these type of accounting maneuvers. Even sophisticated people may not have the time and energy to individually vet all of the off-balance sheet information  since each and every party that relies on the company’s financial information is often assumed to have vetted the financial information for discrepancies and

So why am I concerned?

Now that we can clearly see the damage caused by this type of accounting rule, it stands to reason that FASB would simply propose changes to FAS 140 to restore financial transaction transparency and the faith of the public and others in the accounting profession. And do it as fast as humanly possible to avoid a further loss in investor and counterparty confidence which resulted in a massive liquidity problem – requiring a massive intervention by the Federal Reserve and Department of Treasury. 

Delaying the inevitable …

In order to provide breathing space for financial institutions whose balance sheets would immediately take a major hit, the lobbyists have requested their political contacts to delay the implementation of the modified rulings.

Enter the politicians …

Which is exactly what Spencer Bachus (R-AL), Ranking Member of the House Committee on Financial Services, attempted to do with a July 22, 2008 letter addressed to FASB and the SEC.

“Since August 2007, the U.S. capital markets have been experiencing an extended period of stress and dislocation. Financial regulators, collectively and individually, have
taken steps to respond to the disruptions in the credit and capital markets, attempting to mitigate impacts on investors, consumers and the broader economy.”

“While expeditious regulatory action has been beneficial in many areas, I am concerned that your current timeline to amend FASB Statement 140, ‘Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,’ and Interpretation 46(R), ‘Consolidation of Variable Interest Entities’, by the end of 2008 may have serious unintended consequences. 

“Changes to securitization accounting could have a dramatic impact on the economy, the capital markets and consumers seeking credit. With capital and liquidity at a premium, the effect of these changes could be to prolong market dislocation.”

“In fact, as of December 31, 2007, the aggregate outstanding balance of potentially affected transactions included $7,210.3 billion in mortgage-related securities; $2,472.4 billion in other asset-backed securities (excluding asset-backed commercial paper); and $816.3 billion in asset-backed commercial paper.”

Notice the cuteness is not describing $7,210.3 BILLION as $7.2 TRILLION.

“The U.S. capital markets benefit when there is a deliberative process for accounting policy makers and affected constituents to fully consider all available options and work out the details for a smooth transition. Significant changes to the accounting rules should be made with careful consideration and preferably when markets are functioning with minimal stress and volatility. A more measured and realistic deadline for finalizing amendments to Statement 140 and Interpretation 46(R), such as January 1, 2010, would permit all stakeholders to have a full and fair opportunity to debate all policy alternatives and their consequences. In the interim, the SEC and FASB should work with market participants to develop temporary solutions to improve market transparency and disclosures.” <Source>

FASB Responds …

In the minutes of the July 30, 2008 Board, we see that the letter had the desired effect.

“At the July 30, 2008 meeting, the Board discussed the transition and effective date for the proposed Statements to amend FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest
Entities. The Board unanimously decided to change its tentative decisions reached at the June 11, 2008 Board meeting regarding transition and effective date to a single effective date for fiscal years beginning after November 15, 2009.” <Source>

Not exactly the January 1, 2o10 date, but close enough for government work.

Buying time …

The sole reason for delaying the implementation of accounting rules which would bring additional transparency to the financial community is to buy time for those organizations who would be declared insolvent should they be required to repatriate all of their off-the-balance sheet transactions back to their balance sheet. The Administration, the regulators and the financial community is hoping that the time granted by the delay would allow all of the affected enterprises to resolve their delicate positions by adding capital, merging or selling off troubled assets.

What now …

For regulated financial institutions, it is believed that Treasury Secretary Hank Paulson’s idea of using covered bonds will help ameliorate the situation by allowing for the restructuring of current financial instruments into covered bonds and thus repatriate them back to their parent’s balance sheet with minimal disruption – and might I say disclosure – to the parent organization and the financial world in general.

But unless the financial industry restores accounting transparency, renews faith in our financial institutions, removes the inflationary billions of dollars pumped into the economy to shore up failing financial institutions and allows market forces to stabilize housing values … it will only prolong the agony of those innocently trapped in the aftermath.

In particular, the government needs to implement a plan to restore the billions of lost values that were siphoned from retirement accounts and the savings of those who followed the prudent path and saved their money while avoiding speculative ventures. Trusting in institutions and individuals who betrayed that trust as they bought in to a lie: that derivatives with little or no liquidity when leveraged to imprudent levels could return a healthy rate of return for the institution – a minor portion to be shared with those who trustfully invested their money in what they believed to be a safe and sound manner.

As for FASB, they face two major problems: one how to deal with restoring transparency to accounting transactions and to either outlaw the use of illiquid derivatives or modify the present practice of “mark-to-market” which insures that financial instruments with long maturity dates are considered essentially valueless in their early life.

As for the Wall Street Wizards who borrowed additional money to leverage transactions to levels where a nominal ten percent decline in market value would wipe out the investors, they should face the loss of their multi-million dollar mansions, fancy cars and have their assets placed into a trust to help those who were deeply affected by their outrageous actions. Since we all know that this scenario will not come to pass with all of the political protection they purchased, perhaps the public disclosure and shunning of these individuals will sufficient. But somehow, I doubt this will affect people who fly on private jets to private resorts and who are normally surrounded by burly security guards to isolate them from the average man whom they screwed.

What can YOU do?

No matter how much they protest their innocence or portray their profession as being of service to the public, regard each and every accountant and attorney as a self-interested party interested in feathering their own nest at your expense.

As for politicians, throw out those who were complicit in the screwing of America and elect someone relatively worthy of trust.

Do not elect those who want to paper over this financial debacle or extend its effects by creating an even larger government bureaucracy and raising taxes to further damage the citizenry.

Be extremely careful in placing your money in a bank that offers minimal interest which will be eroded by inflation into negative yields and lessened purchasing power.

Consider the Better Business Bureau’s prime rule: Investigate before you invest.

In today’s environment, even financial institutions with brand-names may either be in an unsound condition or barely surviving. Do not buy the friendly public relations line – consider your investments carefully and use only those advisors who are trustworthy.

And for those who anticipate wholesale carnage on Wall Street when the market opens Monday, this too shall pass.

-- steve

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