"Stock prices are down big-time. Just year over year, 12/31/07 to 12/31/08, 37.5% to 41%. You think there are not going to be big impairment hits coming up? You haven’t seen anything yet. You think first quarter of 2009 is not going to be a bloodbath? Because the first quarter of 2009 is when nonfinancial companies have to start measuring all of their assets at u2018fair value,’ and not just their financial assets. It is going to be a bloodbath." ~ Warren Miller (March 13, 2009)
This assessment comes from a man whose occupation is estimating the present value of future income streams. He presented this assessment at the Austrian Scholars Conference, sponsored by the Ludwig von Mises Institute.
His lecture was one of several that presented a gloomy assessment of the economy. His was unique, however. He spends his days working with heads of companies who have to predict the future. They have to know what their companies’ assets are worth in the competitive marketplace. This is not bean counting. This is assessing the present value of the beans in light of the future value of the beans. This is entrepreneurship.
Miller began his lecture with comments on "my accounting colleagues." (This reference led me initially to believe that he is an accountant. He later told me in an email that he is not. He calls himself an equity analyst.)
Accountants are conflict-averse, he said. They move very slowly. He says that the Financial Accounting Standards Board (FASB), the professional association of accountants located in Norwalk, Connecticut, is working on a revision of the guidelines for FAS 157. They are supposed to issue these guidelines in three weeks. "This is lightning speed," he said.
Given the fact they FAS 157 has been fully operational for less than 90 days, I would say that this is lighting speed indeed. Why the hurry? Because of the unforeseen consequences of FAS 157, the mark-to-market rule.
If you think banks are writing off large amounts of assets now, wait until new accounting rules take effect this month.
The Royal Bank of Scotland Group estimates that U.S. banks and brokers, already under massive losses caused by the collapse in the subprime credit market, potentially face hundreds of billions of dollars in write-offs because of what are called Level 3 accounting rules, according to Bloomberg.
The U.S. Financial Accounting Standards Board Rule 157, which is effective for fiscal years that begin after November 15, 2007, will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, the wire service reported.
"The heat is on and it is inevitable that more players will have to revalue at least a decent portion” of assets they currently value using “mark-to-make believe,” Bob Janjuah, Royal Bank’s chief credit strategist, reportedly wrote in a note published Wednesday.
This was the heart of Miller’s analysis. He said that "fair value" is fundamentally different from "fair market value," which has ruled in accounting circles for over a century. The difference is this: fair market value is an entry-price standard. Fair value is an exit-price standard.
FAIR VALUE: FIRE SALE PRICING
The lower you go on a balance sheet, he said, the more intangible the asset. Intangible assets are not easily priced. On the liabilities side, "we all have problems, especially these days, with sign-offs by auditors."
The auditor deals with the past. The valuation specialist deals with the future: "the seer’s, if you will, perceived present value of future benefits, however defined."
In Mises’ terminology, this is the difference between economic history and entrepreneurship.
The current crisis has revealed the weaknesses of FAS 157. Two fatal errors that in this crisis we’ve been dealing with for over a year now had the effect of essentially pouring kerosene on the avoidable bonfire that is clobbering all of us.
The first error is that the new rule puts "downward pressure in falling markets." The second error is that it ignores the subjectivity of valuing assets.
FASB overturned a hundred years of practice when they established something called "fair value," and it overturned something called "fair market value."
How did this come about? Miller pointed the finger at the Securities & Exchange Commission. The SEC told the FASB not to let another Enron take place. The FASB complied. Miller’s assessment was on target: "In the current circumstances, Enron is chump change."
Fair market value assumed the following: a willing buyer and a willing seller, neither of whom is under compulsion, and both of whom "having reasonable knowledge of relevant facts." He said this constitutes an entry price.
In contrast, fair value assumes that a price received takes place in "an orderly transaction by market participants at a transaction date." It is an exit price.
An exit price is not a problem when markets don’t seize up, he said. It is a problem when they do seize up.
Farther down the balance sheet, "the idea of market participants becomes a mirage."
Other companies must use prices established by a primary company. He offered this horror story.
Merrill Lynch last May sold $30-something billion worth of mortgages at 22 cents on the dollar. That laid down a pricing benchmark that everybody had to follow who was marking mortgages to market.
He said this, then said it again: "In a declining market, exit pricing is liquidation pricing."
Most value is done on what’s called a going-concern basis, that is, the assumption that the entity will continue to operate. When you assume liquidation, values fall precipitously.
He then gave another example of the new rule. If there is bidding at an auction for a Picasso painting, and it goes to $29 million, the final bid is $30 million. At this point, there were no longer market participants, merely a lone bidder — as in every auction. Under the new rule, the asset’s value is listed as $29 million. There is an immediate write-down of $1 million on the balance sheet. There is a loss of $1 million on the P&L statement. Miller then offered this insight:
I don’t know what they’re smoking in Norwalk, but I mean to tell you, it’s ugly.
As for value of good will, there are impairment charges. It was this context that led to his bloodbath prediction.
He sees this as the result of two factors. First, the demand of the SEC that no Enron ever take place again. Second, the accountants do not understand the nature of present value of future expected income. He warned against
those who have never done a purchase price allocation or impairment analysis or fair value accounting in general — that includes every one of the board members of the Financial Accounting Standards Board and every permanent staff member. There is nobody — nobody — in that population of over 200 who has ever spent one day doing what I do for a living. Not one.
Appraisals by competent appraisers can vary 10% to 15%. There is no way around this. That’s a lot of money in corporate balance sheets. As he said of FAS 157, "American shareholders of public interest are very ill-served by this." He closed his presentation with this: "No more Enrons. I hope the SEC is happy."
His lecture is available on-line. I strongly suggest that you listen to it. I have skipped over some amazing facts in his lecture, such as the fact that when Bear Stearns took a $225 million write-down, this required accountants to record a $225 increase in the P&L statement. The same was done with a $1.5 billion write-down of Citigroup’s balance sheet. As he said, the average guy cannot understand this. He said that the FASB didn’t, either.
To hear the lecture, click here.
MORE BAD NEWS
In addition to Miller’s speech, Peter Schiff delivered a scary speech on the implications of current bailout policy. The Mises Institute has posted both a video and an MP3 file of his speech. Get either here.
I spoke briefly on the nature of the crisis. My remarks are also available here.
THE GOOD NEWS
The Austrian Scholars Conference is not about Austrians, of course. It is about Austrian School economics. Every participant pays his own way to the conference, pays his own expenses, and pays $200 to attend. That is how good it is. Economists are notoriously willing to accept free lunches. The Mises Institute knows that it serves as a place where the clan gathers annually.
These people are aware of the crisis that we are facing. It is a major crisis. The government is responding as governments have ever since the Great Depression: with budget deficits and monetary inflation. The economists and analysts who spoke at the conference were never taken in by the boom. They are also not taken in by the bailout.
There was common agreement that inflation is coming. Schiff thinks the inflation will be very serious.
For those who want a very good summary of what price inflation was like in the great German inflation of 1921—23, there is an excellent article by Adam Fergusson that is now on-line. It is an excellent short introduction. Download it here.
A novel by Erich Remarque, The Black Obelisk, deals with day-to-day living during that inflation.
The continuing crisis in the economy has not yet produced panic. The malls are filled. There is a slowdown, but the politicians and Bernanke have calmed the voters. Bernanke’s appearance on 60 Minutes on Sunday evening was unprecedented for a Federal Reserve Board Chairman. The interviewer, Scott Pelly, asked only softball questions.
Bernanke said that the recession will probably end this year, but unemployment will continue to rise.
The average guy in the street does not care about the technical details of the National Bureau of Economic Research’s evaluation a year after the fact regarding when the recession ended. What he cares about is his job. The news on the employment front remains bad and will get worse.
Whether the FASB’s revision of the rule it laid down will reverse the present decline in asset values is problematical. I don’t think it will. The break in public confidence has been too great. The bonuses have been too large. The system, regulated to the hilt, created a license to loot. Even tighter regulation will now turn the capital markets into the Post Office.
The SEC’s lawyers thought a bunch of accountants could save the day. They couldn’t. They made the day a lot worse.