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04/26/2010

The Unfair Attack on Fair-Value Accounting


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Illustration by Mark Andresen The blame game for the financial crisis has no limits. In an effort to divert attention from their own culpability, bankers who took risks they did not understand and politicians who encouraged mortgage lending to people with shaky credit have pointed the finger at the accountants. Banks faced with severe losses on their structured debt portfolios and other securities pressed regulators to suspend accounting policies that oblige the banks to record these holdings at fair value, which usually means the current market price.

Frustrated bankers complain that many securities prices have fallen to distressed levels that do not reflect the discounted present value of expected future cash flows. If banks have to mark their securities portfolios down to rock-bottom prices, executives say that regulatory capital rules will oblige them to sell assets, turning paper losses they consider temporary into real losses. They allege that forced selling creates renewed pressure on prices and depletes regulatory capital in a self-reinforcing downward spiral that prevents the banks from extending credit to help revive the moribund economy.

The bankers’ argument fell on deaf ears at first. The FASB (Financial Accounting Standards Board) provided guidance last fall on how to calculate fair value in dysfunctional markets, but refused to alter mark-to-market principles. Then the politicians weighed in and threatened to legislate relief if FASB didn’t back off. The pressure proved too much: in early April, the FASB gave banks more leeway to substitute fantasy for fact.

Why did the banks pick a fight over an accounting principle in the first place? Although the primary purpose of financial statements is to give investors periodic reports on the companies in which they invest, the statements are used for many different purposes by other parties—analysts, rating agencies, and regulators—who don’t always take the numbers at face value. Bank regulators, for example, ignore OCI (other comprehensive income), a component of shareholder equity, when they calculate regulatory capital because the temporary fluctuations in market value recorded in OCI do not affect the safety and soundness of the regulated entity.

Banks desperate to shore up their regulatory capital want to shift the discrepancy between discounted cash-flow values and allegedly distressed current market prices into OCI. “The bankers wanted to apply the valuation discount that would apply in a normal market,” says Jay Hanson, a partner and national director of accounting at McGladrey & Pullen, the fifth-largest US accounting firm. “That denies the reality of what is happening today.”

FASB’s revised rules let banks pretty up their published financial statements, but tinkering with fair-value accounting might make matters worse. Investors thrive on transparency; the more information they have at their fingertips, the better price discovery is likely to be. If investors and creditors cannot trust the numbers on a bank’s balance sheet, they will either demand a wider bid–offer spread to compensate for the increased risk that the bank may not be able to meet its obligations, or they will refuse to do business with the bank altogether.

“Look at Wachovia,” says Zach Gast, head of financial sector research for the financial research and analysis unit of RiskMetrics Group, a leading provider of risk management software. “The assets that people were concerned about were the option adjustable-rate mortgage loans, which are valued at historical cost. Loss estimates were all over the place and people were not sure how to treat the institution. That played a big part in the crisis of confidence.”

THE EXTREME CENTER

Financial institutions run the gamut from investment companies and broker–dealers (for which everything is a trading asset that they may sell at any time) to insurance companies (which typically buy assets and hold them to maturity). Commercial banks fall somewhere in the middle. Investors and regulators expect accounting standards to apply across the board, however, so FASB has adopted mixed-attribute accounting, which classifies financial assets into three categories according to the intent of the purchaser at the time an asset is acquired.

If securities are held for trading purposes, commercial banks must mark them to market and report any changes in value through the income statement, just as investment companies and broker–dealers do. Banks also hold “assets available for sale”: securities that could be sold at any time but aren’t part of the normal trading book. For those assets, fluctuations in value bypass the income statement but show up on the balance sheet in OCI. The final group, securities the banks intend to hold to maturity, appears on the balance sheet at amortized historical cost, although banks do have to disclose the fair value in a footnote.

“It makes sense to hit the income statement if it’s a trading security,” says Ray Beier, a partner and leader of the national technical services group at PwC (PricewaterhouseCoopers). “If it’s not, then I like the notion of hitting OCI and leaving it there until they sell the security or it matures. In this view, profit and loss should not reflect temporary fluctuations in market value because the business model is to hold for the long term.”

Running unrealized gains and losses through the income statement does make reported earnings more volatile, however. Critics argue that, under fair-value accounting, earnings give investors a less useful measure of economic performance, a measure that tends to accentuate cyclical upswings and downswings. Supporters claim it’s a more realistic picture than historical cost. “It’s a trade-off,” says McGladrey & Pullen’s Hanson. “Would you rather have a historical-cost number that is precise but irrelevant, or an approximate fair-value number that is much more relevant?”

How relevant that number is depends on how the underlying assets are valued, of course. Nobody disputes that securities for which an active market exists—those traded on an exchange, for example—should be valued based on recent transactions: at last sale or best bid for long positions, and at best offer for shorts. That’s the easy part. At the opposite end of the spectrum, illiquid assets like loans are valued at cost unless they become impaired. While people sometimes disagree about whether a loan is impaired and by how much, these assets present relatively few problems.

The tough stuff lies between the extremes. In that zone are derivatives, which present a particular problem because the historical cost is often zero. “It doesn’t cost anything to get into the contract, but it can become a huge asset or liability very quickly depending on how the markets turn,” says Hanson. FASB tackled this in 1998 when it issued SFAS (Statement of Financial Accounting Standards) 133, which requires companies to mark derivative instruments and hedging transactions to market.

Then there is structured debt, which had limited liquidity even before the credit crisis. In today’s market, many tranches never trade at all, and for good reason. The junior tranches in a private-label mortgage-backed security or a collateralized debt obligation—anything rated lower than AA—tend to be relatively thin slices of a capital structure in which a particular tranche receives payment only after any senior tranches have taken their shares. This cash-flow waterfall means that a small difference in the default rate on the underlying pool of mortgages or in the percentage of principal recovered in foreclosure can make the difference between a junior tranche being money-good or worthless. With house prices still falling and subprime mortgage defaults at record levels, nobody wants to bet on a coin toss.

In the absence of a market price, banks have to use a model to value their assets. But models are only as good as the assumptions on which they are based and the quality of the data fed into them. Hanson says the banks lobbied hard last fall to be able to value securities as if the markets were still functioning. They were willing to take a hit to the income statement if a discounted cash-flow model threw up a value less than par, but they wanted to take the difference between that value and any recent transaction price indications into OCI on the grounds that current prices were temporarily depressed by forced sellers.

FASB still hasn’t swallowed the banks’ Kool-Aid wholesale. Although the initial draft of FASB Staff Position 157-5 presumed that a transaction price in an inactive market was distressed—a reversal of FASB’s previous position—an uproar among accounting experts forced FASB to retreat. Banks must now consider “the weight of evidence” in determining whether a price is distressed, which gives them some wiggle room but not a free pass.

NOT GUILTY

Despite the sound and fury directed at FASB’s latest pronouncements, fair-value accounting isn’t a new concept. Neri Bukspan, managing director and chief global accountant at Standard & Poor’s, points out that inventories have been valued at the lower of cost or market for decades. The requirement that financial institutions record their debt and equity securities portfolios at fair value springs from SFAS 115, which took effect in 1993.

Under normal conditions, market prices represent the appropriate value, but in turbulent times, when liquidity dries up for some securities, banks have to find other measures. “The value is less precise because there is no market,” says Bukspan. “But it is no different from writing a building down to net realizable value, a concept that has been embedded in accounting practice for decades. It’s a bunch of assumptions in either case.”

SFAS 115 was in part a reaction to the savings and loan debacle of the late 1980s, when failing lenders were able to keep questionable assets on the books at historical cost, deferring their day of reckoning, because they were in technical compliance with regulatory capital requirements. SFAS 157, issued in November 2007, neither introduced nor altered the basic fair-value framework; it merely provided guidance on how to implement the concept in an attempt to make financial reports more consistent. “There was some misinterpretation in an environment where there were no real bids,” says RiskMetrics’ Gast. “Auditors and others thought they had to use fire-sale prices.”

While auditors may have been too conservative, some financial institutions were in denial as the credit crisis unfolded. Gast recalls that in 2007 people scoffed at the “absurd” prices of subprime mortgage-backed securities rated BBB or A when it was clear to them (at the time) that losses could never reach a level at which those tranches would be affected. “Guess what?” says Gast. “Today, those securities are in default.”

Unexpected credit losses drove prices to bargain-basement levels—but the brave investors who went bottom-fishing early got burned as prices sank even further. As a result, Gast says, the smart money is waiting on the sidelines until the storm blows over and investors have a better handle on values. Now that buyers have vanished, banks and other leveraged investors that have to sell keep pushing prices down.

Although depressed prices do affect bank balance sheets, the impact is muted because banks don’t have to use fair-value accounting for the majority of their assets. In a report to Congress mandated by the Emergency Economic Stabilization Act of 2008, an SEC (Securities and Exchange Commission) study of 50 representative financial institutions found that fair-value measurements were used for 45% of assets, and the resulting changes in value flowed through the income statement for a mere 25% of assets. The SEC also concluded that fair-value accounting “did not appear to play a meaningful role” in bank failures during 2008, which were instead attributable to “growing credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.”

As a consistent supporter of fair-value accounting, the SEC may not be the most impartial judge, especially when the agency is under attack for failing to protect investors against either the market turmoil or Bernard Madoff’s colossal Ponzi scheme. Accounting experts nevertheless agree that the collapse in prices was driven by market dynamics rather than by how the books were kept. “If an asset goes from par to 40 it’s tough to handle in any leveraged business model,” says Justin Burchett, manager of economic advisory services at public accountants Grant Thornton.

It has happened over and over again, after all. Leveraged investors push the envelope too far and get caught when the market turns against them. The current crisis is the third instance in little more than ten years, including the 1998 Russian debt default (which brought down Long-Term Capital Management) and the 2001–2002 Internet and technology bust.

The expansion of credit that preceded the collapse owed nothing to fair-value accounting, either, although Ben Neuhausen, the Chicago-based national director of accounting at public accountants BDO Seidman, suggests that a related accounting rule may have played a part. When a bank repackages loans and sells them as securitized debt, the proceeds raised from the bonds typically exceed the aggregate cost of the loans in the pool. The transaction qualifies as a sale of assets by the bank, which records the arbitrage profit on its income statement.

Neuhausen believes the banks’ ability to generate those incremental earnings may have contributed to the credit bubble. “It created an accounting incentive for originating, packaging, and selling these loans. The gains from securitization probably did help power the expansion.” If Neuhausen is right, the accounting rules do bear some responsibility for the current mess—but fair-value principles weren’t the real culprit.

Fair-value accounting isn’t a one-way street. It applies to both sides of the balance sheet, and changes in value can go in both directions, except for assets subject to “other than temporary impairment.” (Banks carry impaired assets at the written-down value until they are sold, when they record a gain or loss equal to the difference between the proceeds realized and the impaired value.) The symmetrical application of fair-value accounting rules to assets and liabilities has theoretical appeal, but it can entail unexpected consequences. For example, PwC’s Beier points out that several monoline insurance companies reported significant gains in 2008 after their credit ratings soured and the market value of their debt plummeted.

“It’s important to report the information,” Beier says. “But if you mark liabilities to market through the income statement you send messages to investors that some say could be misleading.” The reported gains will never be realized if the decline in liabilities stems from faltering credit quality because a company under financial duress isn’t likely to have spare cash lying around that it can use to buy back its own debt. Beier suggests that the gain or loss on liabilities could run through OCI just as temporary fluctuations in certain assets do, although he acknowledges that fair-value purists might disagree.

Grant Thornton’s Burchett says that even ardent supporters of fair-value accounting acknowledge that marking liabilities to market can produce counterintuitive results if the gains flow through the income statement. Purists advocate additional disclosure to avoid any confusion, but while Burchett believes investors could adapt, he still harbors reservations. “We don’t want investors to mistake higher earnings attributable to a one-time change in the valuation of a company’s own debt for an improvement in the company’s economic performance,” he cautions.

RISKY REGULATION

Burchett finds that the thorniest valuation problems often arise when liquidity dries up. Banks may change their intent and decide to hold a distressed security to maturity, but the rules prevent them from shifting assets into a different category at will. It makes no sense to let banks tweak their balance sheets by switching assets available for sale into their held-to-maturity portfolios, thereby eliminating losses that would otherwise be recorded in OCI. Burchett warns that “you don’t want institutions making strategic decisions about when to sell an asset or what category to use. The accounting standards limit movement between the buckets as much as possible.”

Impaired securities present another challenge for accountants. Write-downs tend to be a significant percentage of the original value, and losses that flow through the income statement contribute to earnings volatility. Banks and other opponents of fair-value accounting argue that one-off gains and losses make it harder for investors and analysts to track the underlying trend in earnings. “It’s such a binary decision,” Burchett says. “The asset is either okay and held at cost, or else you take a large impairment.” Accountants must also try to ensure that different clients use the same values for identical assets.

PwC’s Beier points out that marking down impaired assets can cause distortions in subsequent periods if they are still money-good. Suppose a fixed income security that has a yield of 8% based on historical cost is written down from par to 40 based on price indications from an illiquid secondary market. As long as it continues to pay coupons on time, it will generate a yield of 20% based on the new book value, which flows through the income statement and inflates the apparent interest margin and return on assets. “I’m not sure that makes sense,” says Beier. “The question is, what do you do with the mark? Does it hit the income statement or do you keep it in equity?”

A charge against OCI hurts banks far less than a hit to the income statement, but the distinction has nothing to do with accounting principles. Financial statements designed for investors don’t always fit the bill for other users. For example, bank regulators charged with maintaining the safety and soundness of the financial system as a whole focus on solvency and capital adequacy rather than trends in earnings. To them, financial statements prepared in accordance with GAAP (Generally Accepted Accounting Principles) represent nothing more than a convenient starting point.

The regulator’s primary concern is risk: either the risk that a particular financial institution will fail, or the risk that the entire system will collapse. Fluctuations in market value don’t affect those risk assessments as long as the price changes are temporary, so regulators ignore movements in OCI when they compute regulatory capital, the cushion that banks must maintain against potential losses. The income statement is sacrosanct, however. Regulators don’t eliminate gains and losses on the trading book because the securities could be sold at any time. Nor do they add back impairment charges, which are assumed to be permanent.

A bank therefore has a huge incentive to keep mark-to-market fluctuations off the income statement. That’s why the banks proposed that if a security purchased at par is trading at $20 but is valued at $70 by a discounted cash-flow model, they should take a $30 hit against their capital to reflect a permanent impairment—and treat the difference between $20 and $70 as a temporary liquidity discount. “They claim the markets are out of whack,” says Wayne Landsman, KPMG professor of accounting at the University of North Carolina’s Kenan–Flagler Business School. “But why force a rule that makes arbitrary distinctions between trading prices and permanent losses just because the banks don’t like it?”

At an SEC roundtable discussion of mark-to-market accounting in November 2008, Landsman suggested that rather than tinkering with accounting standards that apply to all companies, bank regulators could make their own adjustments—as they already do for OCI, goodwill, and certain other items. His idea received a cool response from bankers, who weren’t sure the regulators would give them the relief they sought.

FASB did cave, however. In April, it substituted a requirement that a bank assert “it is more likely than not that it will not have to sell an impaired asset before it recovers the cost basis” for the bank’s firm commitment that it has “the ability to hold an impaired security until recovery.” And while the credit component of any “other than temporary” impairment must flow through the income statement, the remaining portion—including any liquidity discount—will go to OCI.

The fierce debate over fair-value accounting may be misdirected anyway. Bank behavior is arguably affected less by how the numbers are put together than by how the financial statements are used. Landsman explains, “The procyclical effects on banks derive from regulatory requirements that force banks to sell assets to reduce their leverage in response to a fall in their capital. That is a bank regulatory capital issue. It doesn’t come from fair-value accounting.”

Bukspan of Standard & Poor’s draws a clear distinction between the goals of accountants (to convey information about asset values) and those of regulators (to control risk). If investors have to choose one of three sealed boxes, each certified by a major accounting firm to be worth $1,000, they will select indifferently, making no distinction between the three because they know nothing about the associated risks. On the other hand, if regulators get to look inside the boxes and find that the first box contains US Treasury bills, the second contains Alt-A interest-only mortgage-backed securities that never trade, and the third contains a royalty interest in a Venezuelan oil field that is not yet in production, they’ll be far from indifferent in making their choice. The boxes have the same value but markedly different risk profiles. “If you are a regulator,” asks Bukspan, “can you address them in the same way from a safety and soundness perspective? Fair value is a red herring in that discussion. The variables that go into regulatory capital calculations go way beyond accounting and penetrate not the value but the risk.”

It’s far easier for regulators to play around with the calculation of bank capital or the amount banks are required to have than to wait for changes in GAAP, according to David Larsen, a managing director in the San Francisco office of Duff & Phelps, a financial advisory and investment banking services firm that does a brisk business in providing third-party valuations to private equity funds. Accounting standards go through a rigorous process of review and comment before they take effect, but regulators can act in real time. For example, the Spanish banks have survived the credit crisis in better shape than most because local regulators forced them to squirrel away excess capital during the go-go years in anticipation of the inevitable rainy day.

Accountants don’t like the idea of cookie jar reserves, which have turned up time and again at the heart of corporate accounting scandals. Neither does the SEC, which brought a case against SunTrust in 1998, alleging that the Atlanta bank built up excess provisions for bad debts, in order to dip into those provisions during tough times to smooth out earnings. (In the end, SunTrust had to restate three years of financial statements.) Nevertheless, a more flexible approach to bank regulation may serve the public interest better than rigid adherence to accounting principles. “The regulatory system has a great deal of flexibility that could be used if regulators want to,” says Larsen. “They could ease capital ratios for a period when credit gets tight.”

THE BAD NEWS BEARERS

To some extent, the regulatory regime has clung to historical cost while accounting standards have shifted toward fair value. Regulators favor a fixed framework that doesn’t require them to make judgments about whether and when to change the rules over the economic cycle—they don’t want to play God. If they grant regulatory relief to a bank that later fails, the Monday-morning quarterbacks will second-guess their decision. “Historical cost makes the regulators’ lives easier. Mark-to-market accounting forces regulators to make more transparent decisions for which they can be held accountable,” says BDO Seidman’s Neuhausen.

But accounting standards are supposed to serve investors’ interests, not to give regulators a cushy life. Fair-value accounting isn’t perfect, but it portrays the value of assets available for sale or trading to investors in a more relevant and timely manner than figures based on historical cost. “It’s like the freshness date on a carton of milk,” says Larsen. “It may stay fresh a day or two longer, or it may spoil earlier if the refrigerator gets too warm. But if you take away the freshness date, who is going to buy the milk?” The more financial statements become divorced from economic reality, the less investors will be willing to trust the underlying institutions.

To auditors, the accusations against their fair-value accounting methods have come as an unwelcome, illogical surprise. When we typecast parts for the worst economic disaster since the Great Depression, who makes the most plausible villain? The politician who espoused misguided housing policies? The hot-shot Wall Street banker who created what Warren Buffett described as “financial weapons of mass destruction”? Or the bean counter in the green eyeshade who checks the numbers?

Politicians and bankers are trying to shoot the messenger. If information about the fair value of securities portfolios appears in the footnotes rather than on the balance sheet, even an inexperienced securities analyst will know enough to roll the difference between cost and market value into shareholders’ equity. Anyone who believes that changing the way financial statements are compiled will hoodwink investors and restore confidence in the banks has a tenuous grasp on the workings of efficient markets.

–Neil A. O’Hara brings 29 years of experience in the financial services industry in London and New York to his second career as a freelance writer. His work has appeared in Institutional Investor, Alpha, FTSE Global Markets, and the New York Times, among other publications.

Illustration by Mark Andresen.

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Comments

This article is such an amazing great. I have to commend you on standing up for mark-to-market accounting.

Have a good day.

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