Monday, October 19, 2009

The Debts of the Spenders: A Funny Thing Happened on the Way to the Market

Remember March when everyone said the banks were going to be nationalized and had huge debts on their balance sheets? Well, those losses helped push profits UP. Several months later, the same gains are recognized as losses.

The important thing to take away is that there are implications here for the other financials which are NOT the chosen of Wall Street (e.g. everyone else besides GS, JPM, and MS).

Matt Phillips of The Wall Street Journal discusses the double edged blade of mark to market changes to US bank balance sheets. This article is basically a look at the effects of FAS 166.

Under this accounting rule, banks can set a market value based on the debt they owe instead of the promised repayment amount. But ironically, when a company's finances improve, so does the value of its own underlying debt that others hold. Thus, the company's CFO has to register an actual or higher loss!

Prof. Duffie of the Stanford Business School summarizes these bizarre effects of accounting.
"Isn't that a little bit weird?" said Darrell Duffie, a professor of finance at Stanford Graduate School of Business. "The better you are, the more you've lost. But that's the way that it works." There are some advantages to these accounting rules, Duffie said, as they do seem to offer a clearer picture as to the actual value of a company's liabilities. However, these rules are "not useful for checking whether the bank is solvent or not."
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