FASB Update

The financial media often ignores accounting issues in favor of sexier stories about markets and companies. I thought my readers might benefit from a review of what the FASB (Financial Accounting Standards Board) has done lately and how these changes might impact investors. If nothing else, its interesting to see how the financial crisis has changed the attitude of the FASB:

New FV Guidance Planned

By far the most interesting development of the FASB recently comes out of their July 15 board meeting. During this meeting, the board agreed to a complete re-organization of fair value accounting. This is important for two reasons. First, it is a response to its previous move to ease fair value accounting, which was the result of government pressure for forebearance to troubled banks. Second, the guidance will completely change the pace at which firms recognize losses. The FASB wants companies to record almost all financial instruments at fair value, removing such designations as held for investment or held for sale. You can read more about the potential changes here. I see little point in discussing them, because I see little possibility of this being implemented in the near future. I think it is mainly a way for the FASB to maintain its legitimacy and explain the fair value rule change was due to special circumstances--in a way reaffirming its commitment to fair value accounting, though it is powerless to implement it at the present time. The real accounting authority, after all, is the SEC, which is still too concerned with bank's toxic assets to even consider such a change. I think the FASB will push for these changes eventually, and, when they do, it will be very interesting to see how the political power of the banking industry has weathered the crisis. (Banks are very opposed to stricter fair value rules, as it will cause them to recognize loans earlier.)

SFAS 166 and SFAS 167

The objective of FAS 166 is to ensure the transferor of a financial asset has surrendered control in conjunction with derecognition, meaning some institutions will have to bring assets they have derecognized back on their books. This abolishes the accounting loophole that allowed banks to exclude Qualified Special Purpose Entities (QSPEs) from consolidation accounting. It also prevents firms from using sale accounting for mortgage securitizations when a transferor has not surrendered control of an asset. Needless to say, this statement significantly changes off-balance sheet accounting.

This effectively destroys a large reason for the subprime debacle. SFAS 140 (which is amended by the new FAS 166) allowed firms to recognize a sale of an asset if the asset can be considered a QSPE. This enabled financial firms to leave entities holding mortgage securities off their books. FAS 166 has eliminated QSPEs. These ex-QSPE entities are subject to reclassification as VIEs and subject to consolidation (and disclosure). However, the language describing this process in FAS 167 is still vague and subject to interpretation, perhaps another example of forbearance towards banks. You can find a response from a structured finance group (among those most affected by this change) here.

FSP FAS 157-4

This is guidance about how to determine FV amongst decreasing volumes and fire sales. It shows ways to determine whether markets have low volume or forced selling.

FSP FAS 107-1

This guidance requires companies to disclose the fair value of their financial instruments, meaning companies have to disclose the fair value of their debt in the 10-Q footnotes.

FAS 168: Codification

The most drastic change recently is the new FASB Codification. FAS 168 is the last SFAS that will ever be released because it replaces the financial accounting standards with a new codification, organized by number in a manner similar to the tax code. The purpose of this is to simplify access to authoritative GAAP.

This is a big change, and not just aesthetically. First, it means everywhere you have previously seen FAS 157 you should now see ASC 820 (Accounting Standards Codification). Secondly and more importantly, it removes the hierarchy of GAAP. Previously, some FASB pronouncements superseded others, meaning a DIG is less authoritative guidance than a FAS. Now, all various kinds of pronouncements are incorporated into one code, meaning they are all equal. One byproduct of this is that the concept statements are no longer considered authoritative GAAP.

Codification doesn’t just mean financial statement references need to be re-done (they do, I have become intimately involved with this process after I recently translated the financial statements for the company I work for). It also means firms will have less interpretative power in choosing between vague language at the different levels of GAAP.

The Importance of Education in the New Normal

It is commonly accepted that we will have a “jobless recovery,” meaning unemployment will stay high even as output and markets rise. The last time we had a jobless recovery was after the early 2000s recession. As I mentioned in my last post, I think the massive decrease in demand from deleveraging has created a new economic reality characterized by substantially lower demand. We faced a similar reality after the 2001 recession but “kicked the can down the road” by increasing corporate, government, and consumer debt.

This is not necessarily a reason for despair. A bubble-free new normal gives us the perspective to re-evaluate our policies. Most of all, the new normal should underscore the crucial importance of maintaining our technology and knowledge advantage. One important aspect of maintaining this advantage is education.

The US has always been on the forefront of education, that is, until recently:

A recent McKinsey study titled “The Economic Impact of the Achievement Gap in American Schools,” delivers some troubling analysis on US education. This study demonstrates the cost of the education gap between the US and other developed countries. The study concludes that if the US had closed the education gap, US GDP would have been between $1.3 trillion and $2.3 trillion higher. Increasing the educational achievement of minority and low-income students is also estimated to raise GDP by hundreds of billions of dollars. The new normal may not be new, but its challenges—low growth and high unemployment—are new. The best way to overcome the malaise of the new normal might also be the key to maintaining American hegemony—more education.

The "New Normal" Is Not As New As It Seems

Mohamed El-Erian’s term describing the new economic reality, “the new normal”, has been widely adopted by analysts and the financial media. The reason for its popularity is the profound and intuitive truth it conveys. This recession is not just another recession. (That is why “This Time It’s Different” was the subtitle of this blog for the first few months of its existence.) This recession is not going to give way to the same dynamic economy we have grown used to because it is more than an inventory and monetary correction; it represents a fundamental re-orientation.

The financial crisis has revealed the unsustainable nature of US growth over the last decade. The US consumer can no longer rely on rising asset prices—whether equities or real estate—as their savings vehicle. US companies can no longer expect light touch regulation and low interest rates. The 2008 financial crisis was a shock that readjusted the global economic system. Not just Wall Street is re-evaluating its business model. China has realized it can no longer rely on Western consumption and that it cannot continue fueling US credit by buying treasuries. The US has realized the un-sustainability of consumer and import.

The term “the new normal” implies that the financial and economic crisis has significantly changed the economic structure of the US. This implies the 2% growth and 10% unemployment of the new normal is a result of the crisis itself, but this is misleading. The truth is the underlying trends driving the new normal existed even at the peak of the bubble—they were just masked by the bubbles themselves.

Let’s take a look at the real estate bubble. One consequence of rising housing prices was consumers could spend more and save less since they had security in the high value of their home. (Therefore, the stock and housing bubbles created another bubble—a consumption bubble.) Another consequence of rising real estate prices was a increase of mortgage equity withdrawals, which is when people treat their home like an ATM and give up equity for cash (perhaps to buy a new Escalade or Suburban). Below is a chart from Calculated Risk showing mortgage equity withdrawals by quarter:

This consumption bubble had a huge effect on GDP. The following chart, from John Mauldin, who has written about this topic a great deal, shows how GDP would have recovered without MEWs. As you can see, without MEWs, our GDP growth would have been about 1-2%, about the amount of annual growth expected in the new normal.

It seems plausible to say the new normal would have started after the 2001 recession if it hadn't been for the new housing, stock, and credit bubbles. This is further supported by unemployment figures. 2003 was the first "jobless recovery," many analysts are expecting the same kind of jobless recovery for this recession and, considering the unrelenting rise in unemployment, this is very likely. The new normal is not as new as it seems, the difference is we don't have any bubbles obstructing our perspective. (Or at least for now anyway. Considering the recent astronomical rise in stocks, which El-Erian described as a "sugar high", we might soon have another bubble.)

China: Turning Reserve Imbalances into Real Assets

This week, China revealed to the world what it already knew: China is using its foreign exchange reserves to fund foreign acquisitions by state-owned industrial giants. Premier Wen Jiabao said on Tuesday, "We should hasten the implementation of our ‘going out’ strategy and combine the utilization of foreign exchange reserves with the 'going out' of our enterprises." The "going out" refers to the efforts of large Chinese companies, such as Sinopec, Chinalco, and the Bank of China, to acquire foreign counterparts. However, the investment targets are no longer stakes in temporarily weakened western entities, but companies that will secure access to raw materials and energy.

Considering recent acquisitions (or acquisition attempts), this strategy has been obvious for quite some time. But it is a milestone to have a Chinese official publicly acknowledging the "going out" strategy for the first time. Jiabao's statements are also further recognition of China's dissatisfaction with the US dollar. This dissatisfaction has steadily increased and, over the past month, China has tried different avenues to address its reliance and vulnerability to the US dollar.

Early in July, China called for the G8 to discuss an alternative global reserve currency. Around this time, it also announced it would allow select Chinese companies to settle transactions in renminbi. A statement from the People's Bank of China stated, "Companies in China and neighbouring countries are facing relatively large risks of exchange-rate fluctuations because of big swings in the US dollar, the euro and other major currencies used for settlements." China's "going out" strategy is another way to address its reliance on the dollar. As the FT's John Authors pointed out in "the Short View" on July 23rd, China's strategy has shifted slightly from buying commodities to buying the companies that produce commodities. This is a good investment strategy as the rebound in commodity-based equities has far outstripped the rise in commodities. But there is also a strategic advantage: being a producer gives China more pricing power than being the biggest buyer. One interesting thing to watch in the future is what happens to the size of the "China premium", or the extra amount Chinese companies often have to pay to acquire foreign companies.

The "going out" strategy is also reflective of China's new geopolitical role. China's involvement abroad is based on trade rather than principles and politics. Its "going out" strategy means China will be a bigger player in places like Africa and Central Asia where there are abundant resources but less political opposition than places like Australia, where public opinion effectively blocked the 19.5bn Chinalco-Rio Tinto investment. In this sense, China is leveraging its currency differences in two ways. First, the low value of the renminbi drives export-oriented industries to China. Secondly, the suppressed renminbi supplies China with large reserves, which it now translates into real assets. The "going out" strategy, as well as China's efforts to have some Chinese companies use the renminbi, underscores that a weakening dollar will remain one of the strongest secular trends over the next decade. That is, unless there are stark structural changes in the US economy, which seems increasingly unlikely as appetite for reform is slowly seeping out of the political consciousness (best seen in the rising opposition to cap-and-trade and healthcare reform).

The Next Front

Last Friday, Japan released its annual military white paper, which outlines Japan's military operations over the past year. This white paper outlined continued expansion of the Self Defense Forces, which some see as a reaction to the Chinese military build-up and naval expansion. One interesting aspect of this white paper was a new focus on space, perhaps a reaction to the Chinese space program. Either way, it shows the increasing importance of space for the military.

Interestingly, the white paper describes Japan's new efforts in space in the same section that it describes Japan's new approach to its navy. Militarily, the two have a lot in common. For centuries, sea power has been the main determinant of international hegemony--an expanding Navy was, and still is, a sign of an emerging power. The most powerful navy almost always belonged to the global Hegemon--think Spain 1500s, Great Britain 1800s, and the US at present. This importance of the navy is best shown in Mahan's classic The Influence of Seapower Upon History.

Space is important for the military for the same reasons the navy is important. Both play indispensable roles in transportation, communication, and intelligence. Also, success in both relies on being at the forefront of technology. Having better satellites is now the equivalent of using oil engines in ships during World War I. As technology improves, the competitive advantage of being a space power will increase exponentially. Not that that is a new idea, NASA is mainly a military organization.

I wrote in April that Defense Secretary Gates' new defense budget is a step in the right direction considering the direction military conflicts are headed. Warfare is diverging into two distinct types. One focused on insurgency warfare, the kind of war seen in Iraq and Afghanistan, the US' unmanned aerial vehicle attacks in Pakistan, and even the Somali pirate operation. The other is about technology. This new front is about satellites and missiles. The fact that even Japan's self-defense force, which is constitutionally pacifist, is addressing this theater underscores its importance. One can envision a world where power is derived from powerful satellites as much as a web of bases and a strong navy.

The Curious Case of the PPIP

When Secretary Geithner first announced the Public-Private Investment Partnership, it was generally well received by the public. Many important commentators endorsed the program. PIMCO supported the program because it was effectively a stealthy government assistance for banks at a time when nationalization was not politically feasible. Ironically, banks, who were at first seen as the greatest benefactors, were eventually the greatest hindrance.

The PPIP has been completely marginalized since when it was announced. First, in early June, the FDIC cancelled a pilot sale of toxic assets that would have served as a test run. Then, it was revealed the program would continue but at 1/10th the size at only $30bn. This clearly indicates the Treasury no longer sees the PPIP as a necessary program. To account for this change, it is helpful to look at what has changed since the PPIP was announced.

The PPIP was announced in the middle of March, close to the low points of financial markets and investor expectations. Four months later, markets have rallied and outlook has improved. This could be an example of what George Soros called "reflexivity", where investor bias reinforce market trends and change perceptions of fundamentals. The PPIP created the idea that toxic assets would soon be removed from banks. Even though they were never removed, simply the idea that this would occur restored confidence. As one Goldman Exec described it in the WSJ, the PPIP was "the greatest program that never occurred... (because it) created confidence in the markets so banks can raise equity capital." The New Republic had a story on the PPIP that quoted a source from inside the Treasury:

I think there was a broad appreciation within Treasury that, even if [the big banks] were not insolvent, that capital was central. That it wasn’t just liquidity. If you were to caricature--the Paul Krugman caricature--there was a set of people who said we thought it was all liquidity, that there was free magic to be had. That if you get rid of the illiquid equilibrium and get to a good one, you'd fix things. ...

If you had asked--I don’t want to speak for the secretary--what’s problem number one? I think he'd say capital. Problem two? Capital. Problem three? Capital. Everything was in the service of that view. The legacy loans program was meant to help clean balance sheets. It was not an independent good in itself. It was seen as friendly to equity raising. Now people say the legacy loans thing is not gaining as much traction, so is that a failure? But because we had a good outcome in terms of raising equity, they [the banks] were able to raise equity without shedding assets ... you should be okay with that.

From this it seems evident the government's way of addressing banks' toxic assets is to have them earn their way out of their losses, as the PPIP will not take any significant portion of toxic assets off balance sheets. From a bank's perspective, ever since the FASB adjusted its guidance on fair value accounting a few months back (though after the announcment of the PPIP), it has been better not to participate in the PPIP. Selling only some assets to the PPIP would cause banks to have to write down many other related assets. As long banks can use mark-to-model to keep book values up, banks can recognize losses over the next few years while earning record profits due to monetary and regulatory forebearance.

(For this reason, I consider banks with few toxic assets, like JPM or Goldman, as strong buys. Regulatory and monetary forebearance will favor these firms as much as those who still bear the burden of toxic assets. These banks will benefit even more as capital market transactions continue at record rates. The kicker is these capital market fees will stay sky-high as long as large lenders like BofA and Citi carry toxic assets. These large lenders will not lend at their fullest as long as they carry toxic assets, especially as their capital ratios will be constantly scrutinized. This lack of lending will force companies to turn to capital markets and, therefore, GS, MS, and JPM investment bankers.)

As I mentioned earlier, a Goldman exec is quoted in the WSJ as describing the PPIP as "the greatest program that never occurred." It is obvious why a Goldman executive might have that opinion. However, a different approach, such as actually implementing the PPIP, might have been better for the economy, though maybe not as good for Goldman, Sachs.

Consider another time the Government chose forebearance before addressing toxic assets directly--the 80s Latin American debt crisis. During the Latin American debt crisis, American regulators allowed banks to postpone losses on their debt. This had the effect of stiffling capital flows into Latin America, causing their "lost decade." The toxic assets were finally addressed nearly a decade later through the creation of Brady Bonds. Recall also that the more famous "lost decade"--that of the Japanese during the 90s--was also caused by zombie banks holding toxic assets. Choosing forebearance over the PPIP does not mean the US necessarily faces a lost decade, but it greatly increases the risk. James Kwak from the Baseline Scenario writes, "as long as Banks can raise capital, everything is fine, no matter how many toxic assets they hold." However, if confidence and markets fall to March lows, we may regret passing over the PPIP when we had the chance.

Unemployment Risk

I wrote in my last post about the reversing of the expectations cycle. The expectations cycle is an interesting topic intellectually and also an incredibly useful investment tool. I wrote two weeks ago I expected an imminent reversal of optimism as economic data would come in worse than expected. No indicator demonstrates this better than the new unemployment figures from last week.

The unemployment rate is now up to 9.5% and looks set to break 10% for the first time since the early 80s recession. This data was worse than expected in the same way the May unemployment figures were better than expected. In May, unemployment was 100,000 people less than expected, sending markets higher into June. June's unemployment was 100,000 people more than expected. Ever since that data was released in early July, equities have fallen by about 1% a day. Most interesting however is the effect on commodities, especially oil. Commodity prices have decreased across the board and oil is down to $60 today (already a -3.4% change just for the day). (Oil was also affected by an announcement by the CFTC that it might place limits on positions for some market participants.) The decline in commodities is indicative of greater risk-aversion and negativity on the economy. Most of the upward pressure on commodities came from reasoning that an economic recovery would demand more raw materials and re-inflate commodity prices. In that sense, commodities can be seen as a call option on economic recovery. A good indicator of the new negativity is the marketpsych fear index (the line represents investor fear):


The rise in unemployment has significant political risk for the economy. As unemployment increases, policymakers will be under more pressure to stimulate the economy, especially since Obama said the stimulus package would keep unemployment at 8%. As unemployment surges, Obama will be under additional pressure to enact policies that can really mess things up in the long-run. A large part of this pressure comes from the fact that public opinion of Obama depends almost completely on a recovery. It is hard to imagine how Obama could be re-elected with unemployment above 10%. (A WashPost article from today titled "Obama Stands to Be Judged By the Economic Recovery" argues just that.)

Increasing the budget deficit is a grave risk, especially if you believe Morgan Stanley chief economist Richard Berner, who declared "America’s long-awaited fiscal train wreck is now under way."

"Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6 percent of [the gross domestic product] through 2019, contributing to a jump in debt held by the public to as high as 82 percent of GDP by then — a doubling over the next decade,” Berner writes on Morgan Stanley’s online Global Economic Forum.

"Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP. Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth," he adds. "And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service."

"Not only will those factors steadily lower our standard of living," Berner concludes, "but they will imperil economic and financial stability."

We have already heard talk about a stimulus II. Another stimulus would have more long-term negative repercussions than its worth. Sometimes, one simply has to buckle down and take the pain.