Spero Consulting

Archive for December 19th, 2008

It Doesn’t Add Up.

Accord­ing to The Wall Street Jour­nal, today S&P Cut Rat­ings on 11 Banks.

Depend­ing upon each institution’s account­ing poli­cies, indi­vid­u­als at those firms may have cheered their firm’s respec­tive down­grade because that action may have reduce the value of the firm’s out­stand­ing debt thereby allow­ing the firm to rec­og­nize an unre­al­ized gain on its income state­ment. (Yeah, it is per­verse and stupid.)

For exam­ple, by com­bin­ing the con­tents of this arti­cle about Mor­gan Stanley’s fourth quar­ter earn­ings and page two of this report, it seems that Mor­gan Stan­ley equity-​holders “gained” about $3.6 bil­lion because the firm’s debt – its promise to meet future long-​term oblig­a­tion – has become worth sub­stan­tially less to cred­i­tors than it was at the end of August. (We cal­cu­late the $3.6 bil­lion as $5.9 bil­lion of com­bined real­ized gains – from the actual repur­chase of its long-​term debt – and unre­al­ized gains – from writ­ing down the book value of debt – which are men­tioned in the arti­cle, minus about $2.3 bil­lion of real­ized gains men­tioned on the income state­ment, but we could be wrong, and its kind of besides the point; so, we don’t mind being wrong.)

Reg­u­lar read­ers will note that for quite some time, we’ve promised a rather long post on the nature of mark-​to-​market account­ing, but we’ve been busy, and it’s not the most excit­ing topic.

Our view is that there is noth­ing inher­ently wrong with mark-​to-​market account­ing for assets when mar­kets exist. 

Unfor­tu­nately, for many asset classes, there aren’t robust, active mar­kets; so, the exer­cise become mark-​to-​model (by def­i­n­i­tion an abstract, sim­pli­fied view of real­ity) or mark-​to-​quote (by def­i­n­i­tion an unful­filled wish or hope if no exchange took place). But we’ll save those issues for a longer and more detailed post when time is less pre­cious, but today we must fin­ish deck­ing the halls.

In our view mark-​to-​market for lia­bil­i­ties makes far less sense and cre­ates a per­verse sit­u­a­tion where a weak­ened firm may the­o­ret­i­cally ben­e­fit from that weak­ness; it’s not the same as loss carry-​forwards.

We’ll try to be clear. Take our esti­mated real­ized gains and unre­al­ized gains for Mor­gan Stan­ley as given, i.e., $2.3 bil­lion real­ized on retired debt and $3.6 bil­lion unre­al­ized on out­stand­ing debt.

Rec­og­niz­ing a real­ized gain on the early pay-​off on debt makes com­plete sense. If Mor­gan Stan­ley was able to repay $2.3 bil­lion less than the book value of its debt, then good for the firm and its own­ers. Note that such a sit­u­a­tion could occur if either base inter­est rates increased sub­stan­tially or credit spreads widened sub­stan­tially. (Those are actu­ally arti­facts, not rea­sons, but that’s how folks talk.)

In our mind, rec­og­niz­ing an unre­al­ized gain of $3.6 bil­lion is prob­lem­atic. Hold­ing base rates con­stant – and they’ve actu­ally decreased this fall – the only way for debt to lose such value is if the firm’s (per­ceived) cred­it­wor­thi­ness has deteriorated.

In that case and at some point, it would seem that the firm would not have the cash bal­ances nor the cash flow to real­ize the reduc­tion in out­stand­ing, con­trac­tual claims against it. To us, that means that the claim against the firm remains at the face value, and the resid­ual claimants – the share­hold­ers – would have to sat­isfy that entire claim (or some nego­ti­ated amount) before they would receive any­thing.

More­over, if the firm is uncred­it­wor­thy and can­not refi­nance the debt, then by the def­i­n­i­tion of a lia­bil­ity – an item of expected future sac­ri­fice from a past trans­ac­tion or event – the firm should record the lia­bil­ity at (1) its approx­i­mate face value (plus or minus any pre­mium or dis­count) or (2) its liq­ui­da­tion value in case of bankruptcy. In that lat­ter case, it is not clear whether the firm remains a going-​concern or not.

There­fore, if it is a going con­cern but it can­not pay-​off – say with cash or via refi­nanc­ing – at the deval­ued mar­ket value of debt, then we say that the expected future sac­ri­fice is not the “mar­ket value,” it is the face value. So, where is the gain? Nowhere; it doesn’t exist.

It seems that knowl­edge and its rarer cousin, wisdom, have no role at the FASB or the SEC. We derived our argu­ment from basi­cally one def­i­n­i­tion – a lia­bil­ity – and one assump­tion: the firm’s a going con­cern. Does it seem that our policy-​makers have lost sight of the prover­bial for­est because of the trees? Or are we wrong? If so, how?

In their attempts to become rel­e­vant, they’ve achieved the opposite.