Madoff (with the money)

The ingenuity of lawyers is always amazing. The New York Law School is suing a firm of auditors (BDO Seidman) not because they were the auditors of the fund run by the fraudster Madoff, but because they were the auditors of a fund that invested in Madoff's fund.

Presumably the auditors verified the value of the investments by looking up the price in a list and didn't think it was up to them to enquire about the substance of the Madoff fund. The Madoff fund had been audited, but by a rather insubstantial firm. Perhaps this is one of the disadvantages of over-reliance on market prices. If theory tells you the market can't be wrong, then the market price is conclusive evidence of value.

I wonder how the case is going to turn out and whether the law school is also suing its investment advisors.

Procyclicality

The most damning charge against fair value accounting (FVA) is that it promotes volatility in the financial markets. The link in the title is to chapter 3 of the IMF's October Financial Stability Report. I had high hopes of this chapter but the analysis is woolly at times. The authors spend some time showing that FVA promotes volatility in financial reporting. That much is obvious. They provide some useful data on what proportions of banks fair-valued items are based on market values (level 1 - 25%), what are influenced by market values (level 2 - 69%) and what are 'marked to model' (level 3 - 6%) They then go on to simulate the impact of fair value on banks balance sheets through an economic cycle. They find that fair value is indeed procyclical, except in the case of the property cycle where falls in property values have the effect of increasing American investment banks' equity due to the fall in the fair value of their own debt. (Very counter-intuitive - fair value shows the banks getting better off because their creditworthiness has fallen.)

The authors don't conclude that fair value should be abandoned but rather than banks need to be regulated in a way that builds up reserves in good times to prepare for worse times to come.

The analysis is very partial because it fails to model the moral hazard inherent in fair value profit measurement. While it acknowledges that fair value can lead to instability in the system the authors take as given that financial reporting standards are directed at individual organisations and can ignore systematic effects. My own view is that financial reporting is all about increasing the economic welfare of society and refining the value of securities in second-hand markets is secondary to stability of the system and providing an environment where economic actors can contract efficiently with each other.

What the G20 really said

The title link is to the text of the G20 Declaration on sound financial markets. The G20 had been urged to make financial stability a goal of the IASB, but funked it. Instead G20 said

With a view toward promoting financial stability, the governance of the international accounting standard setting body should be further enhanced, including by undertaking a review of its membership, in particular in order to ensure transparency, accountability, and an appropriate relationship between this independent body and the relevant authorities.'

Which seems to mean that the IASB had better make itself accountable to regulatory authorities such as the EU and the SEC. It is to hoped this will help the IASB ground itself in reality rather more than its wilder flights of fancy about fair values suggest that it is currently grounded.

Credit Crunch Humour

Here is a selection of current internet humour ...


Q. What's the capital of Iceland?

A. About £3.50.

Q. How do you define optimism?

A. A banker who irons five shirts on a Sunday.

Q. Why have estate agents stopped looking out of the window in the morning?

A. Because otherwise they'd have nothing to do in the afternoon.

Q. What's the difference between an investment banker and a large pizza?

A. The pizza can still feed a family of four.



As a surprise, a chief exec's wife pops by his office. She finds him in an unorthodox position, with his secretary sitting in his lap. Without hesitation, he starts dictating: '. . . and in conclusion, gentlemen, credit crunch or no credit crunch, I cannot continue to operate this office with just one chair.

Q. What's the difference between a merchant bank and Katie Price?
A. Both are institutions whose reputation is built on assets that, on closer inspection, turn out to be entirely artificial, vastly over-inflated and in danger of going through the floor at any moment. But at least Katie Price is still worth something.

Q. What's the difference between an investment banker and a pigeon?

A. The pigeon is still capable of leaving a deposit on a new Ferrari.


A lobbyist on his way home from Parliament is stuck in traffic. Noticing a police officer, he winds down his window and asks: 'What's the hold-up?' The policeman replies: 'A group of bankers are so depressed they've stopped the traffic and are threatening to douse themselves with petrol and set themselves on fire. 'They say they are bankrupt and no one believes we can get through the credit crunch. So we're taking up a collection for them.' The lobbyist asks: 'How much have you got so far?' The officer replies: 'About 40 gallons, but a lot of people are still siphoning.'

The credit crunch has helped me get back on my feet. The car's been repossessed.

Latest news: The Isle of Dogs bank has collapsed. They've called in the retrievers.

Q. What do you say to a hedge fund manager who can't sell anything?
A. Quarter-pounder with fries, please.

Bradford & Bingley employees are concerned they were given no notice of the takeover by Santander Bank.
A Government spokesman said: 'No one expected the Spanish acquisition.'

You know it's a credit crunch when...
* The cashpoint asks if you can spare any change.
* There's a 'buy one, get one free' offer - on banks.
* The Inland Revenue is offering a 25 per cent discount for cash-payers.
* Gordon Brown has stopped chewing his nails and started sucking his thumb.
* Your builder asks to be paid in Zimbabwean dollars rather than sterling.
* Highgrove has been repossessed.
* Victoria Beckham is pictured shopping in Primark.
* Alistair Darling's eyebrows have turned white.

With acknowledgements to Andy Thorpe, the man who made cow flatulence newsworthy.

As predicted, auditors now being sued for bank collapse

An earlier post suggested that one of the reasons the big firms of accountants are desperate to maintain the legitimacy of fair value accounting is the likelihood of being sued as a result of financial collapses. News in the title link that the process has started.

If there is official acknowledgement that fair value accounting promoted risky behaviour by banks, then it will be a lot harder for auditors to defend allegations that their financial statements were misleading, or that they were negligent in assessing whether clients were going-concerns.

Stand by for a rush of going concern qualifications on the financial statements of financial institutions.

Procyclical Accounting

Following up on my post labelled 'the most hated accountant in the world'[1], if you stick with the videos of the interview with Sir David, near the end of part 3 of the interview he admits that regulating banks on the basis of financial statements 'would be pro-cyclical', and another way needs to be found. As I understand it, banks have been regulated on the basis of financial reporting so this amounts to an admission that accounting in its current form, ie using fair values, is promoting cyclical behaviour, which is another way of saying causing financial instability. Since the remit of IASB includes some general economic objectives, as well as providing information for financial decisions, it would appear that current standards are not meeting those objectives.

[1] Sir David styled himself thus after debate on the IASB's pensions standard, which has itself contributed to a certain amount of financial misery and transfer of risk to those least able to bear it, pensioners, as well as having its own procyclical effects.

Financial Stability

To understand what is going on in standard setting at the moment seems to require an advanced knowledge of the politics of both accounting and the EU. According to Accountancy Age (see title link) the world's top 20 nations discussed the internal politics of accounting at their recent summit. It is not surprising that they fudged the issue. The French, in their rational, Gallic way, were pressing that the IASB should set accounting standards taking into account financial stability. The Americans and Brits and the IASB, it seems, wanted to avoid that and there was the usual talk about 'transparency', as if it wasn't possible to both disclose the values of assets at the same time as incorporating a value in the financial statements that would promote stability - ie a prudent one. The conclusion was that the IASB would promote stability via a review of its governance. How changing the governance will change the standards set is a bit of a mystery.