Sunday, August 10, 2008

Rising Profits in FASB Wonderland... or Wimpy's Rule

10 August 2008

This new development seems so important that I simply must comment on it.

To my knowledge, two US companies - and probably many more - are now reporting blowout quarterly profits using a mark-to-market accounting rule under US Financial Accounting Standards Board (FASB) guidelines.

When I explain this to you, I don't think you're going to believe me. But it's actually not that complicated. It is loony. It's crazy. But it's not that complicated.

Radian Group is a bond and mortgage insurer. Their business is not going well, due to their exposure to collapsing assets. However, in May 2008, this company reported a quarterly profit of $195 million due to a single "fortunate" factor - the declining probability that the company will be able to pay interest or principle on its outstanding financial obligations.

Yes, you heard that right.

Radian is affected by the mark to market rule.

Wikipedia states: "In accounting and finance, mark to market is the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would fetch in the open market currently."

(Holman Jenkins, in the Wall Street Journal, refers to mark to market rules as a "fabulous failure." Read here for more information. And pay attention to the name Nouriel Roubini as you read the article, as Mr. Roubini is tallying probable credit losses in the current financial meltdown, with a present estimate in the $2 trillion range... and counting. Visit Nouriel Roubini's Global Economonitor blog here.)

The same principle (marking to market), of course, applies to the kinds of toxic assets that are exploding all over Wall Street these days, collateralized debt obligations, mortgage-backed securities, off-balance sheet structured investment vehicles, and so on - including, let us not forget, the financial instruments brought to you by the commercial banks, investment banks, financial services companies and insurers who have been holding these fantasy-based products as assets.

The purpose of the mark to market rule is to protect investors, who have a right to know what the assets of the companies they invest in are actually worth - for example, Merrill Lynch (whose assets have just taken a $24 billion writedown), to take a recent case in point.

Here's the latest FASB accounting trick for you, however.

Under these rules, companies whose financial liabilities and obligations are growing more rapidly than their income and assets now have a right to mark their own corporate bonds to market.

Yes, you heard me right!

If the company believes its bonds are declining in value because they probably won't actually be able to make payments on them, FASB rules allow the company to lower its liabilities by marking its own bonds to market prices.

Yes, Alice, you also heard that correctly; and, welcome to Wonderland!

Let's say, for example only, that Radian Group (or any other company operating under FASB rules) has issued $100 million in bonds to raise funds for the company's operations. This means that Radian is obliged to pay back all $100 million plus interest. So, the company actually owes $100 million plus something more in interest to trusting investors who have purchased their bonds.

Now, following FASB rules, Radian takes a look at the market value of the bonds that it issued.

Let's say that the market doesn't like Radian's balance sheet, due to the massive increase in payouts for faulty bonds and mortgages that they have insured in the course of doing business. For the sake of example only, let's say that the market is now valuing this particular set of bonds at $70 million.

Radian now processes that information on its balance sheet as follows:

Previously, the company was obliged to pay $100 million plus interest on this bond issue. But in the real world of the market, nobody believes that Radian will be able to repay bond holders fully, though perhaps 70% might be believed to be recoverable if the bonds were redeemed in this particular quarter (their value could fall further as the company continues to bleed assets).

Again, for the sake of example, Radian would now declare an obligation of only $70 million on the $100 million bond issue. The company "plans to pay" only what it can, due to its fully acknowledged financial distress. This now brings the $30 million decline in the value of the bond issue to the asset side of the ledger, and this is declarable on the profit statement in the quarter in which this particular FASB-approved financial manipulation is executed!!!

Again, in May 2008, Radian was carrying a quarterly loss of $215 million in their tanking bond and mortgage insurance business. However, based on the mark to market principle, they decided that in all probability (as recognized by the market in corporate bonds) they aren't ever going to pay $410 million of their obligations - money they borrowed from and originally promised to repay to investors.

As Wimpy in the Popeye cartoons was known to state, "I would gladly pay you Tuesday for a hamburger today."

Voila! The $215 million loss metamorphoses into a $195 million accounting gain, and Radian gets to declare a large profit for the simple reason that they now publicly plan to default on their obligations to their own bondholders!

Let me tell you, Radian Group is not unique. Only last week, Ambac Financial Group used the same rule to declare a $5.9 billion single-quarter gain!

Again, this means that Ambac has decided that the market expects it to "stiff" its bondholders to the tune of $5.9 billion - and, since the company has no plan to repay its financial obligations - they can take back the money they formerly owed and declare a hefty profit for their shareholders.

Bill Fleckenstein says it like this: "If you're capable of ruining your own credit, you can book that as a profit, or so FASB would have us believe."

(I hope you are now visualizing Wimpy clearly as he puts down his most recent in a succession of hamburgers for which he has no plan ever to make repayment, whether this Tuesday or next, or any other Tuesday of any future week!)

I could say more, but why add insult to injury?

Let me summarize:

Under FASB accounting rules, companies whose finances are so bad that they believe the market has no expectation they will ever repay their financial obligations are permitted to declare the money they no longer plan to pay as a single quarter profit in the quarter they decide not to repay their bondholders.

Or, if you will, under FASB rules, Wimpy is permitted to declare all the hamburgers he has ever eaten as profit derived from his business (in his case, and not so differently from our other examples, the business of being a bum) in the quarter in which he decides that no matter how many Tuesdays stretch out on the road of life before him, he will never repay anyone on any of those Tuesdays forever more.

Let's just call this Wimpy's accounting rule, shall we?
_

6 comments:

  1. Good post and summary of this accounting issue, and I really like the Wimpy analogy!

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  2. This one was irresistible. I could only think of Wimpy when I learned how this rule works. It is absolutely shocking that companies that decide to stiff their bondholders are allowed to write off their intended financial negligence as profit!

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  3. Have I got this straight?

    I decide I can't pay back my car loan. I tell everyone I can't pay back my car loan, everyone knows I can't pay back my car loan. Thus I get to write off my car loan and then declare the outstanding balance as part of my net worth?

    But really why isn't that okay? After all they STOLE the money from the investors doesn't that make them entitled to it. It's the same as if I STEAL a car and the police and courts don't charge me, I get to keep the car and the guy who owned it before well.... sucks to be him.

    I guess the police and courts said it's okay to steal cars.

    I liked the Wimpy thread too.

    ReplyDelete
  4. That's close. However, the abridgement of the bondholder repayment is actually a profit item.

    It may figure into net worth, but the low net worth is why you can't repay it.

    It's kind of like you took out a $300,000 bank loan (this is the analogue of the bond issue) to buy a dozen old beater cars.

    You paid $25,000 each for the junk cars. When you tried to resell them, however, you were only able to get $500 for them, so you have massive losses (only $6000 of the $300,000 you borrowed remains).

    Then you look at the money you borrowed to buy the old beaters, and discover that you can't pay it back. Now everything you don't repay is profit (in this case, $294,000 plus interest you also don't pay, which is also profit). However, you have already squandered your anticipated profits by wasting your borrowed money.

    So you have profits in that quarter, but your net worth is very likely negative (you still owe the bank, you have just written it down to the amount that you actually plan to pay them)!

    (The upside under FASB is that whether you have sold the cars or not, you can stop carrying them on your books as being worth what you paid for them. The profit is really a mitigation of your losses, and it is an incentive for you to admit that the assets are of little value, and that your promise to pay your bondholders is correspondingly of little value.)

    It is all very intricate.

    However, you are going to see a succession of financial analysts go out there and cite "strong earnings" in the S&P 500 as an argument that the economy is strong and that business is good. That is what will be really bizarre - and mark my words - it is already happening!

    Lies, damn lies, statistics, and the ultimate sin - accounting!

    ReplyDelete
  5. This is a great post Dmitry. I just had one of the ‘Doh!’ moments and ran back to correct my own site before publishing my comment. You see my own comment form did not match what I’m about to advise. I get less comments than you, so never noticed any problem. I’ve changed it now anyway so here goes.


    money and profit

    ReplyDelete
  6. This is a great post Dmitry. I just had one of the ‘Doh!’ moments and ran back to correct my own site before publishing my comment. You see my own comment form did not match what I’m about to advise. I get less comments than you, so never noticed any problem. I’ve changed it now anyway so here goes.


    money and profit

    ReplyDelete