In today’s Mad Hatter World, we might remember the Queen of Hearts, the mean-spirited sovereign created by Lewis Carroll in “Alice’s Adventures in Wonderland.” She sentenced her subjects to death for the slightest offense, ranting: “Off with their heads!”
Fast-forwarding to today’s topsy-turvy world, we find some eminent investment bankers such as Chairman Stephen Schwarzman and President Hamilton James of the Blackstone Group arguing that possibly the major culprits for the $1 trillion meltdown in the financial system are the bean counters — more commonly known as the accountants. According to Andrew Sorkin in an article, “Are Bean Counters to Blame,” James said that “FAS 157 is not just misleading: It is dangerous.”
The criticism of accountants centers on FAS 157. Bookkeeping rule makers created FAS 157 to provide some estimate for fair value of the billions of dollars of inventory held by Wall Street firms in order to make the market more transparent.
This rule requires the “marking to market” of certain assets held by financial companies whose real worth is not readily discernible by active trading markets. Some securities are so illiquid and unique that experts must “guesstimate” their value. FAS 157 require the auditors to assign a value that reflects a price one would receive if sold immediately on the open market. Critics of FAS 157 argue that accountants, to protect themselves from criminal and civil litigation, assign arbitrarily low values.
What are the major arguments by the proponents of FAS 157?
* FAS 157 stops arbitrary valuations. FAS 157 proponents say that if Schwarzman and his crowd get their way, financial companies might end up valuing investments based on market prices when it suits them, and just look the other way when it does not.
* Goldman Sachs’ trading track record success demonstrates that great trading firms can live comfortably with FAS 157. That is, Goldman Sachs insists that their traders mark to market.
What created the problem?
Middlemen financial institutions bulked up their balance sheets by more than 25 times their net worth without securing the appropriate long-term funding. This mismatch between long-term illiquid assets and short-term financing led to a classic “run on the bank.” Some investment banks and commercial banks violated a cardinal rule for financial solvency — ensuring appropriate liquidity to finance their businesses on an on-going basis.
Why did Wall Street firms take such enormous, reckless risks?
For many years, the financial community made enormous profits “carrying inventory” that offered much higher returns than their overnight borrowing costs.
In the “go-go era,” Wall Street successfully sold toxic ice to Eskimos. When the music stopped after “scorched” buyers demanded more plain vanilla securities, the Wall Street firms deservedly were left holding the bag.
Wall Street executives earned outsized bonuses by attaining short-term objectives. Financiers voted with their pocketbooks with the seminal economist John Keynes who said “we are all dead in the long term.”
Investment banks, commercial banks, and mortgage banks are not suitable repositories for highly leveraged balance sheets containing illiquid securities, given that most of their funding sources are short term.
Why do I support FAS 157?
My experience in the “trenches” as a trader for more than a quarter-century makes me a firm believer that marking to market is a necessary regimen. As a managing director of Morgan Stanley’s corporate bond department, I was responsible the valuing billions of dollars of securities from gilt-edge securities to “junk yard” dogs in a variety of currencies.
Let me highlight my observations:
* No sales ticket, no laundry! “The tale of the tape” for even small quantities provides valid evidence of value.
* A trading firm should only borrow against securities that can be sold in a reasonable time period.
* Proper valuation of the balance sheet is a sine qua non obligation to the public shareholders and creditors.
* Vulture investors have repeatedly purchased illiquid securities en masse at the appropriate price levels.
* Merrill Lynch stock rose after it unloaded more than $20 billion of securities at about 22 cents on the dollar because of its restored credibility.
In conclusion, while FAS 157 is not a panacea, its premise is financially sound.
Originally published in the Sarasota Herald-Tribune
