Tuesday, August 26, 2008

Counting and double counting – a comment on losses and accounting standards esp FAS 159

Warning: Wonky accounting alert. Don’t bother reading this if you are not interested in wonky accounting issues

Last post I asked if anyone had a decent list of the losses so far realised. The problem was double counting – which is pervasive if you do this sort of thing. Aaron of the HF implode meter (who is usually acute about these things) made a comment which misses the point entirely – but it required a little thinking – and I admit I missed it at first. Here is his comment –

Then again, some gains aren't really gains, like the gains counted on the financial co's own collapsing bonds. Sure, they could buy those back, if of course they weren't already in hock for cash...

I will get back to Aaron’s comment later…

The gains from debt forgiveness in tax

In the US if you have a debt forgiven that is income for ordinary tax purposes. It sounds quirky – but its not.

If a bank lends company A $100 and they haven’t paid it back then the bank has clearly lost $100. Company A has lost $100 too – but that loss ultimately did not come out of Company A’s pocket – it came out of the bank’s pocket.

Unless you are very careful though the tax law is going to allow both company A and the bank to claim $100 in tax losses. That is a good way for the tax system to collapse because Company A could lend to Company B who could lend to Company C and so on and a single $100 loss could theoretically produce thousands of dollars in tax losses. Those losses could wipe out the tax base of any respectable country.

Fortunately (or unfortunately depending on your point of view) the people who draft tax law in most countries are not that stupid. [I started my career doing this stuff at the Australian Treasury – so it was once an area of expertise for me. We had terrible trouble in those days with cascading tax losses in trusts…]

What most countries do is that they have provisions against “loss cascading” or the like. They fix this up ultimately by taxing gains from debt forgiveness.

When it is finally clear that Company A in my above example will not have to pay back the said $100 it gets assessed on a “gain from debt forgiveness”. The idea is that if you borrow $100 and don’t have to pay it back that is a gain of $100. It offsets the loss of $100 above.

Gains from debt forgiveness in GAAP

The accounting rules do the same thing. When Conseco (a company I knew extremely well) completed its bankruptcy it compromised a few billion in debt (mostly preferred shares). The $2 billion or so it did not have to repay was a gain for accounting purposes – and the “New Conseco” published accounts reflecting that gain.

There were similar adjustments for the removal of Conseco Finance from the balance sheet.

Done properly these gains will remove double counting of losses from the accounting system. If you add up the losses made by Conseco and the losses made by the preferred stockholders without assessing the gain from debt forgiveness you get double counting.

Accountants rightly get concerned about double counting. But the accounting answers questions in a way that might be misleading to investors.

Typical question:

How much did company X lose doing that stupid lending:

Two possible answers:

(a). $2 billion dollars

(b). $500 million dollars [but we have ignored the $1.5 billion more borne by debt holders but ultimately forgiven].

The accounting answer is technically correct but doesn’t really get to the guts of why the lending was so stupid.

Now accountants are often pedants and investors should be practical people. And I have never seen a place of more vociferous disagreement than the disagreement over FAS 159.

FAS 159 says (roughly and in this context) that if a company is using mark-to-market accounting on its assets and its liabilities it should also use mark-to-market accounting on liabilities whose market value is affected by their own credit worthiness.

To take a real example, Ambac is a bond insurer which is showing in its accounts about 7 billion in derivative losses. During the last quarter they booked about a billion in gains because the market assessment of their credit worthiness went down and so the market value of Ambac’s derivative liabilities went down. Had the accounts been measured a month later Ambac would have booked over a billion in losses on the same transactions. The result was that during the last quarter Ambac’s profit was approximately equal to its market cap. It will reverse that profit this quarter.

That profit of course was meaningless for an investor assessing Ambac stock. [I own Ambac stock - purchased at $1.30.] I don’t think the FAS159 movements make any difference in assessing Ambac. I ignore them. I think Ambac’s results were not great but they showed stabilisation which was enough given the stock price.

David Einhorn – a man considerably smarter than me - put it this way in a speech (“FAS 159: Profiting From Your Own Demise”)

If your own credit spread widening counts as revenue...

... and you pay compensation as a percent of revenue ...

... the most profitable and lucrative day in the history of your firm will be...


Ok – so let’s ignore FAS 159 assessing Ambac, investment banks and the like. And the results are much worse than the headlines. The underlying of the investment banking industry sucks.

When you shouldn’t ignore FAS159

In once sense what FAS159 does is it brings forward the gains from debt forgiveness. If the price of repurchasing Lehman’s debt falls then Lehman has made a gain which it is hard for shareholders to profit from. If Lehman goes bust and has its debts forgiven Lehman has also made a gain – but it’s the same gain recognised on a mark-to-market basis as its credit worthiness collapses. [Its also hard for the shareholders to benefit from this gain.]

This is of course a problem with mark-to-market accounting generally. Mark to market accounting brings forward profits. It also brings forward losses. It’s a darn stupid way to run an investment bank when you pay cash on profits that are not realised but just bought forward. It’s a darn stupid way to invest when the profits being bought forward are the profits from total collapse and debt forgiveness.

But if you are adding up losses then the gains from debt forgiveness are a necessary part of ensuring that you don’t double count.

Likewise – in a mark-to-market world if you are adding up losses then the gains on FAS159 are a good thing to include.

Now let me bring back Aaron’s comment:

Then again, some gains aren't really gains, like the gains counted on the financial co's own collapsing bonds. Sure, they could buy those back, if of course they weren't already in hock for cash...

Aaron bought this up in the context of double counting. But this is the one context when those gains really are gains. Aaron is thinking like an investor – and I love him for it. But just for once I wanted someone thinking like an accountant.



Anonymous said...

I'm not an accountant, but I believe FAS 159 is completely nonsensical. The rationale stated above is not compelling.

The company's liabilities are still the par value. Just because the market thinks that there's a certain probability of insolvency and hence discounts the value of the liability to a holder of the securities doesn't change the underlying obligation of the issuing company.

I think that if they wanted to mark them down, they should either have to buy them or be released of their obligations by the holder (which of course could be imposed by a court).

Anonymous said...

FAS159 makes sense. Here's why.

(caveat: its dangerous to generalize with FAS159 but, like reckless others, I will anyway.)

Generally, a company's own debt credit spread does not widen in a vacuum. People frequently show these silly examples that isolate the impact of the spread widening on liabilities and show the company making money by marking liabilties to market when it is going bankrupt.

But in the general case, something else more fundamental, more real happens first like housing prices drop. As a result, in the general case, marking the liabilities is simply dampening a change in the net worth of the company. (value of common stock). The overall change in net worth (market value assets less market value of liabilities) is still a net negative.

If the primary user of GAAP accounting statements are common share holders, then the question for them is - is this dampening of the drop in net worth appropriate and useful.

I believe it is appropriate because in a limited liability company, you cannot have negative equity. The most you can lose is the value of your shares. Some call this the insolvency put option. Hence, the liability mark-to-market is reflecting the probabilistic expected share of the losses that may ultimately be borne by the debt holders. In an extreme example, for a financial institution, if the notional value of liabilities is 100 and the company has only 100 of assets, the common shares will trade and be worth more than zero. Why? Because the owners control the company and have the insolvency put option so they instruct management to take as much risk as possible with the 100 of assets in the hope that they beat the risk free rate. This option has value to the common shareholders and should be reflected in net worth. Afterall, it is reflected in stock prices (the ultimate exit price) every day.

Secondary users of the financial statements are debt holders and this method also has value to them as the mark on the liabilities represents that fair exit price of the debt, reflecting the likelihood of company default. Debt holders don't expect to receive par. What use it seeing par on a financial statement?

Anonymous said...

I am more familiar with IFRS than US GAAP - but IAS 39 is similar in this area to FAS 159. I still feel a bit uncomfortable with it, but the post does not contain the actual justification (at least not the IASB's). It is nothing to do with hypothetical possible future debt forgiveness/restructuring.

The credit spread of a company's bonds has always been included in the measurement - but at the historic issue rate which is then fixed for the life of the bond. Two parri-passu bond issues by a company at different times can therefore appear as completely different numbers on the balance sheet. Similarly, two companies that refinanced at different times (but are essentially the same in the market's view) will have different balance sheets.

FVPL of liabilities for own credit risk looks extremely odd on the Income Statement but it is essential to make balance sheets comparable so that all debt with the same characteristics will have the same value within and between companies.

If it helps at all, think of this. If you take a structural view of firm capital, then shares in a limited liability company do get more valuable as volatility and leverage increases, because they represent a call option on the firm's assets. FAS159/IAS39 is just reallocating the firm's value between equity and debt to recognise this.

A lot of people are still not comfortable with FAS159/IAS39 in this area, but the reasons given on popular investment blogs often seem to drift from the actual discussions in FASB/IASB minutes / papers.

advnet said...

I am also agree with u and I believe it is appropriate because in a limited liability company. great post.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.