Not so fast, Johnathan Weil: Citigroup & the fair value illusion

by Kurt Schulzke on December 4, 2008

Johnathan Weil called on Citigroup today to “properly confess” the “rot on Citigroup’s $2.1 trillion balance sheet.”  Weil is sure the rot is there because if it weren’t Citigroup “wouldn’t have needed last week’s government rescue [including] a new $20 billion investment by the Treasury Department, plus a guarantee covering about $306 billion of the bank’s assets against most losses.” I beg to differ.

The “rot” may well be an illusion created by poorly-drafted accounting principles applied in draconian fashion by auditors spooked by the specter of ruinous lawsuits.  Citigroup’s request for government assistance may well be an appropriate strategic response to the illusion.  In the market place, a good illusion beats a bad reality most any day.

Weil assumes facts not in evidence and arguably misapplies SEC regulations in demanding the Citi book losses now.  Under SEC rules, Citigroup would be obligated to “confess” losses on Form 8-K only if Citi’s board concludes that a material charge for impairment is required under generally accepted accounting principles.  If the board either has concluded that such a charge is not required or has not yet concluded that one is, no Form 8-K confession is called for.

Weil wants Citi to confess “other than temporary” losses on, among other things, its mortgage-backed securities portfolio. Yet, if Weil had watched the roughly eight hours of recent SEC hearings on mark-to-market accounting — held October 29 and November 21 — he would know that there is wide disagreement among accounting professionals about how to apply FASB Statements 115 and 157 to Citi’s situation.  It is anything but clear that Citi is obligated to record permanent write downs at this moment in time.

Citi’s board, accountants and auditors could justifiably conclude, under applicable accounting standards, that the markets for the assets in question are “inactive” under FASB 157 and FSP 157-3 and, therefore, the assets should be valued using so-called Level 3 inputs.  Level 3 assets can fairly be valued using discounted cash flow models rather than “marked” to hypothetical or isolated, distressed actual market transactions.

If the assets are classified as Level 3, then Citi could say, “We have the ability and intention to hold these securities to maturity and our DCF models reflect the assumption that we will do so.  Therefore, no write-down is warranted at this time.”

From what I can tell, Citigroup has a fair shot at Level 3 treatment.  If not, Citi’s board should be given some time to decide how much, if anything, to permanently write down.  Things are not always as simple as they appear.  Weil’s call for “confession” is premature and — like so much of the negative noise currently in the blogosphere — does a disservice to the markets by unnecessarily hyping down-side risk.