FAS 157 and the significance of distress versus bankruptcy

It wasn’t until I read about a massive writedown by a German bank associated with the bankruptcy of Lehman Brothers that I started to connect the dots. But, there is a hidden flaw in our accounting system which accounts for some of the distress associated with the Lehman bankruptcy. And it all leads back to marking to market.

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It wasn’t until I read about a massive writedown by a German bank associated with the bankruptcy of Lehman Brothers that I started to connect the dots. But, there is a hidden flaw in our accounting system which accounts for some of the distress associated with the Lehman bankruptcy. And it all leads back to marking to market.

As you may know, marking to market is a practice mandated under a rule called FAS 157 issued by the Financial Accounting Standards Board (FASB). This ruling has been fairly controversial as the fair value accounting instituted has meant large writedowns as asset values have fallen. FAS 157 is pro-cyclical. Basically, it says that any security which is freely traded in liquid financial markets must be accounted for on balance sheets at the price determined by the marketplace.

On its website FASB says:

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).

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What that should mean to you is that financial institutions have been and will continue to write down assets on their balance sheet as they fall in the free market except when prices are the result of a distressed/forced sale. That exception is significant because it gives an out to banks which would be writing down their asset values even more right now.

Back in March, the SEC said the following (my highlighting):

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Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale.

Translation: hide your bad assets in Level Three Assets that you are allowed to mark to make believe if you don’t want to mark to market.

But, what happens when a company is not just distressed but goes bankrupt? What happens to the debt issued by that company? What happens to the Credit Default Swaps associated to that company? A ha, this is the problem.

HSH Nordbank AG’s write-down of EUR450 million unveiled earlier this week is largely due to exposure to the collapsed investment bank Lehman Brothers Holdings Inc., a person close to HSH Nordbank told Dow Jones Newswires on Thursday.

A structured credit portfolio with a nominal value of EUR600 million is composed “mainly” of Lehman paper, the person said. On Tuesday the bank said that the value of the portfolio had to be written down to EUR150 million.

In November, HSH Nordbank said its losses from Lehman exposure amounted to EUR140 million.

You see where this is headed? We’re back to mark to market, essentially. Before Lehman went bankrupt, I’m thinking one could mark Lehman CDS paper to make believe. When they went bust, that game was over because the credit event meant it was time to settle and those writedowns came onto the books.

As I see it, this is another reason why Mssrs. Paulson, Bernanke, and Geithner erred in allowing Lehman to go bankrupt in the way they did. If any other company were to go bankrupt the way Lehman did — and if there is a huge volume of CDS paper associated with that company (think General Motors, Citigroup), then…..Bang!

Sources
HSH Nordbank EUR450 Million Write-Down Mainly Due To Lehman Source – CNN Money
Summary of Statement No. 157 – FASB Website
Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements) – U.S. Securities and Exchange Commission

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