Dallas Fed Omits FAS 157 Effects In Study

Dallas Fed Omits FAS 157 Effects In Study by Todd Sullivan, ValuePlays

Longtime readers know I am not a fan of FAS 157. I understand the reasoning behind it post Enron but in practice I think it did more harm than good 2008-’10.

The reason is simple, in a crisis (or entered your own description) it is the distressed buyer that sets the prices for securities for all participants in the market. The problem with this is they set prices for securities other entities may not have any intention or need of selling. This then forces valuation markdowns on those securities (many are just income related and not impaired) causing mythical “losses” on their value which then, for leveraged institutions (ie. every entity in the financial sector) causes entities that ordinarily would not be sellers to then be forced sellers (to “raise capital”) causing further price reductions in the market.  It is a vicious spiral. Look below:

FAS 157

Look at the unprecedented collapse in S&P earnings in 2008 and then the subsequent unprecedented rebound in 2009-’10. The core operating earnings of the S&P did not actually fall or rise by either amount. What we saw was a distortion in “losses” due to FAS 157 writedowns in ’08 and then the subsequent rebound in “earnings” as those writedown were reversed. This is not healthy for markets as huge earnings swings caused by unnecessary valuation changes only exacerbate panics or manias. While I’ll admit Eron’s fictitious earnings were a problem for that particular company and its investors, I think the market wide earnings distortions caused by FAS 157 are even worse.

“Davidson’ submits:

Interesting study, but they miss the point that sub-prime substantially lowered underwriting standards which created illiquidity in all securities when forced to mark-to-market under FAS 157.

Fed Study

So, which came first? First it was govt imposition of bad underwriting standards and then, second, govt imposed FAS 157 due to Enron.

The first created a house of glass and the second was the rock they threw through it.

Society as a whole still has no clue what they did. The only ones they blame are the banks (XLF).