It is earnings season and many banks will be reporting their earnings. What are we to make of these earnings? In usual circumstances, it is hard to decode earnings. Today, it is next to impossible.

By the way, why did Goldman Sachs and Morgan Stanley change their status to bank holding companies? One major factor was the flexibility they got to report their earnings.

The key to a basic understanding is FASB 115 :

 “Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders’ equity.”

This became effective on December 15, 1993.

The assets of Morgan Stanley and Goldman Sachs as investment banks were classified as “hold for trading” and, hence, subject to the “mark to market” or “fair value” accounting.

By reclassifying to as bank holding company, they get to largely dodge the “mark to market” bullet.

One supposed culprit in the credit crisis, is FASB 157 which establishes rules for “fair value” accounting. The TARP legislation suspended this rule in certain situations. However, the 157 foresaw the possibility of illiquid assets and the need to use “the entity’s own assumptions” in valuing assets:

“This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, this Statement establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.”

[I added the bold face.]

This came into force on November 15, 2007.

What does this all mean?

To me, any suspension of 157 means that market information is being ignored. It means that some assets are not being valued at fair prices.

Consider the following reasonable question to be posed to any financial institution:

“What is the value of your assets if they were valued at ‘fair value’?”

It is reasonable to assume that a large number of financial institutions – if fair value were imposed – would have assets worth less than their liabilities.

Put it this way. What if traditional banks were forced to use the same accounting treatment as Morgan Stanley and Goldman when MS andn GS were investment banks?

Hence, the earnings numbers that are about to be released are not really that meaningful. The more important question is: Do you have positive net worth if market prices were used to value your assets?