Fighting to Survive in a World of Changing Accounting Rules

As reported in today’s Wall Street Journal, financial firms just can’t catch a break from the folks at FASB. David Reilly writes in his Heard on the Street article “Assets Get Harder to Shake” that the FASB last week proposed new rules regarding assets that companies securitize and sell to other institutions. Currently, when the assets are securitized and sold off, they are removed from the books of the company that sold them. Unfortunately for the financial services firms, they often retain some interest of one form or another in the securitized assets. This retained interest, say in the form of mortgage servicing, could force the investment vehicle back onto the books if, under the new rules, the entity that sold the vehicle is deemed to have retained significant control over or liability for its assets. Mr. Reilly doesn’t cite any estimates of how much could come back on the books, but he does note that Lehman Brothers securitized more than $700 billion in assets between 2003 and 2007.

How FASB Caused the Credit Crisis

One of the most difficult aspects of the current economic malaise to explain has to do with complicated accounting rules dealing with a concept known as fair value. The Financial Accounting Standards Board, or FASB, issued two standards which radically changed the way certain financial transactions were recorded. Traditionally–with few exceptions–assets and liabilities were recorded at their historical cost. FASB Statements 157 and 159 allowed companies to record assets at their fair, or market, value. As early adoption of these standards took place, companies could determine their value based on what the market would pay for them. The problem with this idea is that the market for these securities was created by at least one party to any of these transactions, thereby impairing the independence of the transaction. For a while this method worked just fine, until the markets for securitized mortages and other complicated collateralized debt obligations (CDOs) siezed up. As soon as the market for the assets dispappeared, the accounting rules for them changed dramatically. Assets that were once considered Level 1, or based on “quoted prices in active markets,” were now downgraded to Level 3, where only “unobservable inputs for the asset or liability” exist (FASB Statement No. 157). Companies were forced to rely upon complicated, and often proprietary valuation methods, based largely on “black box” computer models no human could ever hope to understand or explain. Large writedowns result when the asset’s valuation method changes and the certainty of that valuation comes into question. While the market may have allowed for and even encouraged inflated asset prices (yes, we’re talking bubble), accounting rules do not. This is another cause of the substantial writedowns most banks have announced over the last year.

To recap: Bear Stearns announces is has pumped cash into two failing hedge funds. As a result, the market for mortage-backed securities and other CDOs evaporates. Thus, accounting rules for those securities change and massive writedowns ensue. Hence, accounting standards caused the credit crisis.

Where I Left Off

Last year, I suspended posting by saying I had just been assigned to a new client, which would be keeping my busy. Nearly a year later, I’m trying my hand at this again. The project that took me away from this last year was of the highest level of service (accountant speak for most complicated) offered in my industry: the audit. Audits are rare for my firm, largely due to the cost and relatlively little need among our clients. This year, I will begin this journey again with a new project, of a very different nature. Look for more on this new project in the coming weeks.

My Time to Shine

We’ve started work on a new client this week, and so I’ve been busy, hence the dearth of posts. More on that in the coming weeks. In the meantime, check out the August 20 & 27 issue of BusinessWeek, which focuses on “The Future of Work.”

Enron and the Insurance Industry

Executive Summary
Insurers suffered substantial losses following the collapse of Enron Corporation. Many insurers, particularly those specializing in life, not only wrote policies to Enron, these companies also invested heavily in Enron-backed securities. Suddenly insurers found themselves caught between servicing their clients and serving the needs of the bankruptcy court. Many important lessons would come from the industry’s experience with Enron, however. Life insurers learned whether or not their long-term planning and asset management programs functioned adequately. While sustaining heavy losses related to Enron’s demise, not a single insurer had its debt rating downgraded as a result of either investment losses or exposure. Surety bond insurers learned the consequences of not acting on a suspicion, as they guaranteed millions in fictitious energy trades used as a vehicle for major financial institutions to provide Enron with low-cost, off-balance-sheet loans. Insurers have learned the importance of carefully evaluating policyholders and their business relationships in today’s complex world of structured finance. The directors and officers’ liability insurance (D&O) carriers suddenly found themselves in a morass, weighed down by years of complacence and poor risk management. Caught in the middle of shareholder and creditor lawsuits, many settled rather than risk admitting guilt. In certain cases, this further damaged an already tarnished corporate image. Just as Enron executives learned there was a limit to their greed, so did insurers that blindly underwrote Enron’s activities. Thus, these carriers were faced with the unpleasant task of substantially increasing premiums, thereby pricing customers out of the market. D&O carriers, and the industry alike, did gain some sense from Enron’s demise, however, which was quickly tested by successive corporate scandals.

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