Would-be Jeff Skillings, Take Note

On of the key tricks that Enron played with its accounting was creating a variety of vehicles thruogh which it could “bet” on its own stock price continuing to rise. If they won the bet, they would be able to generate earnings from nothing more than appreciation in their own stock price. If, as of course they ultimately did, they lost the bet, it would turn out that a substantial percentage of the firm’s assets consisted of nothing more than shares of itself.

Well, Statement 159 plays a similar game allows firms to play similar games – entirely above board – with their debt. This could turn out to be a problem.

What 159 basically lets you do is mark your debt to market. Since debt is a liability, if the value drops, and you mark to market, you recognize a gain.

This sounds reasonable at first. After all, if you owe 100 dollars, but earn money in euros, and the dollar drops against the euro, you’ve made money. Similarly, if you owe 100 dollars, and projected inflation goes up, and your earnings are expected to move up with inflation, you’ve made money. There are lots of circumstances where a drop in the value of your debt really is a projected gain for you.

Moreover, mark-to-market accounting is generally favored as a way of making sure that losses aren’t hidden from view, that an accurate, up-to-date financial picture is presented to the markets. And if an issuer doesn’t mark its liabilities to market, and an investor does, then looking at the market as a whole value is created and destroyed every time the market moves. Imagine a world with two firms, firm A and firm B, each issuers of debt. Firm A invests some of its cash in a portion of firm B’s debt, and firm B does likewise with firm A’s debt and a portion of its cash. Now assume both firms’ bonds trade down 10%. Each would show a 10% loss on its assets. But they could simply trade their respective debt positions, and thereby make the 10% loss disappear. Marking liabilities to market would, presumably, achieve the same goal, whether or not the debt was actually retired. And that’s a good thing. Right? We want transparency, and we want consistency. Right?

But under 159, firms are now able to book accounting gains because their bonds have dropped in value due to fears about the firm’s own creditworthiness. And that creates a pretty obvious problem. After all, unlike the currency and inflation examples above, there’s pretty much no way a deterioration in your creditworthiness means it’s going to be cheaper for you to pay off your debt in the future. The only way you can realize the “gain” from the drop in your bond price is by buying back the bonds . . . but if you had the cash to do that then your debt probably wouldn’t be trading at depressed levels.

It is genuinely difficult to design accounting standards that give an accurate financial picture and that are impossible to arbitrage. But this is a pretty big potential hole that’s been created, and the stated justification – that it offsets asset losses (and gains), and thereby mutes volatility – is inadequate. After all, financial firms haven’t been taking losses from each others’ debt; they’ve been taking losses from securities whose value ultimately derives from the real estate market. There’s no way to reverse that loss after the fashion of the hypothetical bond trade between firm A and firm B above. There’s been real value destruction. Allowing financial firms to mark down their own liabilities because of the credit fears created by the sub-prime crisis is just deferring the impact on earnings into future years, and if we’re trying to achieve that why not drop mark-to-market accounting on the asset side and go back to the way things used to be?