• Robert Pozen on Fair Value Accounting

    In the November Harvard Business Review , Robert Pozen --former adviser to President George W. Bush and Massachusetts Governor Mitt Romney, and current chair of MFS Investment Management--weighs in on the debate over whether accounting rules bear some blame for the financial crisis. And he says that both sides in the argument over whether "fair value accounting" exacerbated the credit crunch a year ago may be wrong: We do not want banks to become insolvent because of short-term declines in the prices of mortgage-related securities. Nor do we want to hide bank losses from investors and delay the cleanup of toxic assets—as happened in Japan in the decade after 1990. To meet the legitimate needs of both bankers and investors, regulatory officials should adopt new multidimensional approaches to financial reporting. Before we can begin to implement sensible reforms, though, we must first clear up some misperceptions about accounting methods. Critics have often lambasted the requirement to write down impaired assets to their fair value, but in reality impairment is a more important concept for historical cost accounting than for fair value accounting. Many journalists have incorrectly assumed that most assets of banks are reported at fair market value, rather than at historical cost. Similarly, many politicians have assumed that most illiquid assets must be valued at market prices, despite several FASB rulings to the contrary. You can read his article here (subscription only). You can also watch Pozen discuss the issue, along with a brief introduction to some of the ideas he puts forward in a new book, Too Big To Save , in this video from Harvard Publishing:

  • Geithner says US Government has 'Great Obligation' to Lay Out Comprehensive Reform

    Treasury Secretary Timothy Geithner told Charlie Rose last night that the US banking system was not strong or resilient enough to respond to the fallout from the subprime mortgage crisis, and that the regulatory system "designed largely 90 years ago," did not adapt to new challenges: Later, Geithner told Rose that the Obama Administration needs to simultaneously fix the banks for the short term and build a better foundation for the whole system: You saw that in the campaign layout, a set of very ambitious proposals for reform. And in some ways, we face these two critical obligations today. One is to get the economy back on track, fix this system, get credit flowing again, arrest this deepening recession, but at the same time we have this great obligation to lay out for the American people and the world a commitment to the kind of comprehensive reform so that the crisis like this never happens again. And we’re going to move as quickly as we can on both those fronts. The president had the leadership of Congress in the Oval Office two weeks ago to start that process on building consensus on a reform. You’re going to see him lay out to G 20 to the leaders of the world a very comprehensive framework. You know, people talk about this a lot, but not much was done frankly in the run up to the crisis, and we have to take advantage of this opportunity, where we’re living with the acute damage caused by those judgments to put in place a set of reforms that will prevent this from happening again. And the president believes deeply in this stuff, and you’re going to find us very aggressive and creative and ambitious in the scope of change we’re going to try to bring about. You can watch the full interview here . And Greg Mitchell of Editor and Publisher provides a transcript here .

  • The weak get weaker: Corporate liquidity, asset sales, and the extensive use of bank lines of credit at lower-rated firms

    Each quarter the Duke University / CFO Magazine Global Business Outlook Survey polls thousands of chief financial officers around the world. The most recent survey concluded February 27 and reflects the views of 1,268 CFOs in the U.S., Europe, and Asia. This entry by John R. Graham of Duke University's Fuqua School of Business draws on the February 2009 and November 2008 surveys. The credit crisis of late 2008 has spilled into 2009, and the lack of funding has hampered the ability of many corporations to make the ideal operating and investment choices. We recently completed an in-depth study of how tight credit is affecting corporate activity. When a company is able to invest in positive net present value (NPV) projects, this means that the project returns more than the company's cost of capital, thereby increasing firm value in the long run. When credit is tight, as it is now, companies are not always able to obtain the necessary financing to pursue positive NPV projects. Due to the current credit crunch, more than half (55 percent) of U.S. companies tell us that they have recently had to cancel or postpone positive NPV projects. European and Asian companies are in a similar situation. This is bad for the economy in the long run because it spreads the effects of the current credit crisis into the future - less cash flow will be produced one or two years from now due to the cancellation of good projects today. Limited liquidity can hurt any company, but the problems are most acute among firms with poor credit ratings. For these firms, credit markets have nearly shut down. When external borrowing is limited, a company must rely more on internal funds, such as profits, asset sales, or cash on the balance sheet. For low-rated firms, profits are often poor, further limiting options. In our analysis, we found that struggling U.S. firms started 2008 with cash and marketable securities on the balance sheet equal to about 15 percent of total assets but ended the year with cash and marketable securities amounting to only 12 percent of assets. These financially constrained firms burned through a startling one-fifth of their cash holdings in just one year's time. Again, similar patterns are observed in Europe and in Asia. On the bright side, companies that are stronger financially were able to maintain cash of about 15 percent of asset value. Ironically, this indicates that most financially strong firms should not need to borrow extensively from credit markets, even though these are the only firms for which credit markets remain fairly open. In contrast, low-rated firms are burning through their internal reserves, while at the same time finding limited access to external sources of funding. What can a poorly performing firm do if it has limited profits, shrinking cash reserves, and little access to external capital? One option is to sell assets in order to obtain funds. Among firms that tell us they have experienced problems accessing credit markets, an astounding 56 percent indicate that they have sold assets in order to free up funds for other uses. While it is possible that some companies are finally shedding underperforming divisions (which would be a good thing), when you consider the depressed state of asset markets, it is likely that many of these recent asset sales have occurred at fire sale prices. Thus, asset sales have provided little relief. Firms that are struggling to access new capital can also rely on previously established lines of credit. Normally, credit lines are used for temporary "bridge" loans or as a short term substitute for cash. Today, we find evidence that lines of credit are instead serving as a "last resort" source of funds. U.S. firms have lines of credit with maximum borrowing capacity equal to about 23 percent of total asset value on average. We also find evidence that credit lines do in fact substitute for cash in that firms that have less cash on the books have a tendency to maintain larger credit line capacity. What is most astonishing about our credit line analysis is the degree to which they are currently drawn down. The typical U.S. company has drawn about 38 percent of the maximum allowable borrowing on its credit line. Companies with credit ratings of A or higher have drawn down less than 30 percent of maximum on average, while companies rated BBB or BB have drawn nearly 40 percent of the maximum allowed by their credit lines. Notably, companies rated B or lower have drawn nearly 70 percent of their line of credit capacity. This is alarming because it indicates that poorly rated firms have nearly used all available debt capacity. This draw down on credit lines among poorly rated firms has been exacerbated by a "just in case" phenomenon at some companies. That is, many poorly rated companies are drawing on their credit lines now as a precaution, fearing that their banks will eliminate their credit lines in the future (if, for example, the...