From those SEC lackeys, known as the FASB, comes the latest attempt to force mark to market accounting on us all.  FAS 159 provides the option to report investments at fair value (using FAS 157 as your valuation guide).  Initial implementation will allow a debit or credit to retained earnings for the unrealized loss/gain, while subsequent periods would effectively move the investments into the ‘trading’ bucket of FAS 115 and mark any change in unrealized loss/gain through the GAAP income statement.  Normal adoption would be for accounting years beginning after Nov 15, 2007.  Early adoption would require an insurer to elect by the time their first financial filing is due for Q1, 2007.  (Read about FAS 159 in its accounting-speak text at www.fasb.org/pdf/fas159.pdf)

And the wolves of Wall Street are telling financial institutions to take advantage of early adoption and dump low yielding securities now for higher yielding ones, showing the debit in retained earnings and not as a drag on income…while pumping up net income with higher yielding securities.  Alas, a wolf does not understand time too well, only what to do now.  And certainly insurers who follow the wolves may eventually become dinner.

First, future changes in securities value under FAS 159 will significantly increase earnings volatility.  Try explaining that to your friendly Wall Street analyst when they compare your company’s results to a peer who has not adopted 159.  These are the same folks who give little or no credit for realized gains despite this item being important in judging overall investment performance.

Second, insurer regulatory accounting will remain unchanged and that means 159 will do nothing to hide the realized loss you might take from following the recommended Wall Street strategy.

Third, if enough insurers go down this path, our friends at the NAIC will start grumbling about how this might impact their latest stance on investment accounting, including OTTI, with unknown consequences. (Of course OTTI for GAAP disappears when using 159.)

We are not alone in continually stating the need to mark BOTH sides of the balance sheet to market, but little seems to happen in this respect.  (In fact, certain insurance contracts will not be marked to market under current International Accounting Standards.)

With 159, FASB has added a Sword of Damocles over our heads.  Who will adopt the fair value option?  When?  What will it mean for insurers?  What will it mean for statutory accounting?   How do we accurately compare our company’s results to others? 

Something tells me this will be a close shave.

Since we expect to comment quite abit about this trend, we thought it wise to number our posts on this subject.  Thus, here is part 1…

Deleveraging, or the gradual disappearance of liquidity in financial markets, can take several forms.  Here are two of those forms:

1 - The unwinding of the ‘carry trade’, the most popular of which is long higher yielding government bond/short lower yielding government bond.  The typical ‘carry trade’ format might be long US Treasuries/short Japanese Government Bonds.  It produces a ’spread of 300-400 basis points for the investor (hedge funds or even Japanese consumers) without the nasty regulatory requirements of reserves, capital, financial reporting and all of those other hurdles to unfettered risk.  However even hedge funds must manage risk, and an unwinding of the ‘carry trade’ can mean a reduction in overall fund risk (remember, this trade is usually executed with miniscule margin).  If hedge funds are unwinding risk in the ‘carry trade’, they are probably doing the same elsewhere.  And, what is a prototypical ‘risky asset’?  The S&P 500 can be used as that ‘risky asset’ in getting our arms around the question of current hedgie risk stance.   

In other words, as the carry trade gets unwound, Yen bonds are bought back, strengthening that currency.  If hedgies are taking risk off the table, one would expect the SP500 to fall as the Yen strengthens.

Until the events of Feb 27 (the possible beginning of delevering), the correlation between the Yen/Dollar exchange rate and the SP500 was practically zero.  However, since that fateful day, the correlation has been approximately +0.70 (on a scale of -1 to +1).  Of course, over the last two weeks of that period, the correlation has been closer to +0.20.  However, the conclusion can be that we are in a deleveraging trend as indicated by the relationship of the carry trade to the US equity values.

2 - The Return of the Regulators.  Take a look at this from Chris Whalen’s newsletter, Institutional Risk Analytics (http://us1.institutionalriskanalytics.com/pub/IRAMain.asp) - recommended reading for those interested in the view from the banking sector:

"For over a year, we have been getting reports from former auditors and federal bank regulators about quiet appeals emanating from Washington asking them to come out of retirement. Why lure a retired bank examiner with 25 years bank audit experience back into service? To consult for small and medium size institutions facing internal controls problems. One case involved a community bank newly involved in C&I lending. Another involves a regional bank with a case of toxic derivatives poisoning. But all of these triage samples involved one common malady: financial innovation.

More recently, subscribers to www.fbo.gov have witnessed a flurry of proposals to enhance the flow of data and other resources available to federal bank examiners. In at least one case in 2007, a request for proposal came out of the Treasury that was intentionally structured to attract former regulators in a consulting capacity to act as advisors to their former colleagues. The new regulatory advisories regarding exotic mortgages, etc., fall into this category as well."

The banking regulators are starting to sweat bullets over subprime mortgages and other similar ‘innovations’…a true contradiction to Chairman Bernanke’s "What Me Worry?" stance.  Subprime mortgages and repricing ARMs will indeed have an impact on residential real estate values over the next two to three years…and the result must be further deleveraging in the US economy.