Just One Little Accounting Rule Word Change Will Bring Down Wall Street

Fair Game
A Window in a Smoky Market
new_york_times:http://www.nytimes.com/2008/07/06/business/06gret.html

By GRETCHEN MORGENSON
Published: July 6, 2008
EVERYBODY knows that the market for credit default swaps is one of the hottest investment arenas around. At the end of last year, according to the Bank for International Settlements, the fair value of credit default swaps outstanding totaled $2 trillion, up from “just” $133 billion three years earlier.
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Steve Ruark for The New York Times
Jack Ciesielski of The Analyst’s Accounting Observer.
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Columnist Page: Gretchen Morgenson
But when it comes to detailing how much of these instruments public companies hold, disclosure is mighty scant. That makes the credit default swap market also one of the foggiest out there.
This may soon change, if a rule proposed by the Financial Accounting Standards Board goes into effect as scheduled this fall. To help investors get a grip on the financial implications for companies that have sold credit default swaps, the F.A.S.B. has suggested a list of new disclosures to be effective in financial statements for fiscal years that end after Nov. 15, 2008. That very specific deadline may ensnare some of the nation’s biggest brokerage firms with fiscal years ending in November — Lehman Brothers, Morgan Stanley and Goldman Sachs.
Investors have flocked to credit default swaps in recent years, and there is no surprise why. These insurance contracts, known as C.D.S.’s, allow investors to bet on a company’s health or hedge against possible default by an issuer whose debt they hold. With all the bad loans made in the borrowing binge of the early 2000s, investors want to protect against the big climb in defaults that many think is surely around the corner.
The swaps also made it far easier for investors to protect against default risk; in the old days, hedging against such losses required borrowing the debt issues in question so as to be able to sell them short. What’s more, the borrower had to pay the buyer the interest rate generated on the bond.
NOW, thanks to C.D.S.’s, an investor worried about default simply has to find a counterparty to take the other side of the swap trade and pay a fee for the coverage. If a default occurs, the seller (the party providing the credit protection) must make the buyer (the party receiving the protection) whole on the amount of insurance purchased. Presto — the risk of absorbing the loss from a default shifts to the person selling the swap from the original debt holder.
“Credit default swaps are a great idea in context,” said Jack Ciesielski, an accounting guru and the publisher of The Analyst’s Accounting Observer, an accounting advisory service for investment professionals. “They make it easier to insulate against losses, but they may be too much of a labor-saving device. Maybe you don’t want to do the homework about your holdings so you buy the credit default swaps and think you’re insulated. It becomes almost like an addiction.”
The numbers show the swaps’ astounding popularity. The entire amount of insurance that has been written, also called the notional amount, is $62 trillion. The fair value of C.D.S.’s is a more meaningful figure, though, as it represents a more precise assessment of potential losses and gains. The fair value of these derivatives has had a growth rate far steeper than that of the notional amount in recent years.
With the market for these instruments so huge, and the parties agreeing to the terms of the insurance so intertwined, C.D.S.’s have become a grave concern for financial regulators. And for very good reason: Fears of so-called counterparty risk arising from credit default swaps on the books of Bear Stearns were central to the investment bank’s unraveling in March and the rescue engineered by the Federal Reserve Bank of New York and JPMorgan Chase.
Bear Stearns, of course, isn’t the only firm to have juggled a potentially explosive array of C.D.S.’s. The trouble is, it’s not currently very easy to know the exposure elsewhere on Wall Street — and that’s the problem the F.A.S.B. is trying to address.
What the standards board wants companies to do with their swap disclosure is unextraordinary. In fact, much of the rule change simply eliminates an odd inconsistency between two existing accounting standards, Mr. Ciesielski said. One of those rules, Interpretation 45, covers financial guarantees, which hold the same risks and rewards as credit derivatives. It requires extensive disclosure of contracts in which the buyer of the insurance owns the underlying instrument it is protecting.
But if the guaranteed party does not own the asset or instrument that is insured, the protection is classified as a derivative and falls under another rule, Statement 133, requiring no disclosure.
“Up till now we’ve had this weird dichotomy,” Mr. Ciesielski said. “If it’s a financial guarantee covered by one standard, you wind up disclosing a fair amount about your risks and potential payouts. But if it’s a credit derivative, you don’t. And yet the risks being undertaken by a firm under either of those kinds of instruments are the same.”
The F.A.S.B. proposal would cover sellers of C.D.S.’s, the entities that act as insurers. They would have to disclose such details as the nature and term of the credit derivative, the reason it was entered into and the current status of its payment and performance risk.
In addition, the seller would provide the amount of future payments it might be required to make, the fair value of the derivative and whether there are provisions that would allow the seller to recover money or assets from third parties to pay for the insurance coverage it has written.
These rays of sunshine in this shadowy world would be required every time a company publishes a balance sheet.
As the requirements of the new disclosure sink in among companies in the next few months, Mr. Ciesielski said he expects increased volatility to emerge in the C.D.S. market. Fearful of how investors will react to the extent of their swap holdings, companies may move to unwind them or offset them when they can.
“This is something that will change behavior,” Mr. Ciesielski said. “If you don’t want to look so bad, you’re going to have to be busy in the next few months to work these down, wriggle out of them or offset them.”
Mr. Ciesielski said he thinks the new rule goes only so far for investors truly interested in full disclosure. “It would be nice to put in a table saying here’s what we wrote, here’s what we bought, here’s the notional value, here’s the fair value,” he said.
For now, though, any increase in transparency where C.D.S.’s are concerned is a good thing. Of course, you can count on the usual caterwauling from executives and investors who like to blame accounting rules when the value of the assets they hold doesn’t go their way.
But for anyone interested in reality in financial statements, the new disclosure is a welcome step in the right direction. Let there be light.
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