A mythical creature is something that is typically said to have existed in ancient times. Often, folklore claims these creatures still lurk unseen at the margins of ordinary life.
Which sounds like a fitting description of what the Financial Accounting Standards Board is proposing to introduce onto the books of companies holding “distressed” assets. Today the FASB, which sets U.S. accounting rules, proposed allowing companies to exercise more imagination judgment in determining if a market for an asset is active and if a transaction is “distressed.”
At its heart, it’s not a crazy idea. If an asset can be fairly expected to spin off more cash than current market values imply, it makes sense to allow for accounting adjustments. It is possible that a bundle of mortgage backed securities, for instance, could suffer from an irrationally low price if a temporarily market dislocation was caused by a liquidity squeeze. Marking these to market could create a false impression of their underlying value.
Unfortunately, many firms have demonstrated that they have unrealistically high expectations of the cash flow from many distressed assets. The market has not been shown to have underpriced, mortgage backed assets. Instead, banks have been proven wrong time and time again when they have insisted on the accuracy of models based on historical long term average pricing or on models based on a calculation based on swap prices for assets.
So the main test for the FASB proposal will be whether it allows banks to continue to insist that past performance indicates future results. The greatest risk here is that companies will use the new flexibility in the rules to avoid realistically valuing assets across the board, rather than applying it to a narrow set of assets that may in fact be irrationally priced. In short, the risk is that companies will use the new guidance to boost their balance sheets rather than actually attempting to reflect underlying value.
Why is that so bad? Well, it’s bad because the longer we hold off on recognising shrinking asset values, the longer our crisis will continue. Banks holding assets that are less valuable will continue to underperform and new capitalisation problems will continue to be revealed. Banks, knowing that their publicly disclosed values are too high, will appear well-capitalised but will behave like zombie banks, hoarding capital and damaging the economy.
To put it differently, there’s a serious risk of moving from mark to market to mark to myth. Do we really want financial statements to end with: here be dragons? Or, more seasonally, do we think its a good idea to allow companies to bet that there will be a little man with a pot of gold at the end of the rainbow that will form once the storm has passed?