DJIA Drops 778 Points as Bailout Bill Fails; House to Reconvene Thursday

The Dow Jones Industrial Average dropped a record 778 points yesterday (Mon. Sept. 29), as the U.S. House of Representatives narrowly defeated the proposed financial markets bailout legislation. As reported by AP’s Julie Hirschfeld Davis yesterday in “Shocking defeat for econ bailout; record stock dip,” the bill was defeated by a vote of 228 to 205, with 65 Republicans joining 140 Democrats in voting "yes," while 133 Republicans and 95 Democrats voted “no.” Hirschfeld added, “Bush huddled with his economic advisers about a next step. The House was to reconvene on Thursday instead of adjourning for the year as planned," and plans will be underway to workout a bill that can pass. See also “European Official Says U.S. Has ‘Special Responsibility’ to Pass Bailout” in RTT newswire, in which European Commission spokesperson Johannes Laitenberger called the failure of the House vote "disappointing," and said: "The U.S. must take its responsibility in this situation, must show statesmanship for the sake of their own country and for the sake of the world."

EESA To Be Voted On Today Would Require SEC Study Mark-to-Market (MTM) (Fair Value) Accounting; Reiterates SEC Can Suspend MTM

The Emergency Economic Stability Act of 2008 (EESA) (see Discussion Draft of the bill) to be voted on by the House this morning, with the Senate reportedly to vote later this week, includes two provisions related to mark-to-market (MTM) accounting, also called fair value (FV) accounting, particularly as set forth in FASB Statement No. 157, Fair Value Measurement (FAS 157).

Section 132 of the Act reiterates the SEC’s authority to suspend FAS 157 for any issuer, or with respect to any class or category of transaction, if the SEC determines that it is in the public interest and consistent with investor protection to do so.

Section 133 of the Act requires the SEC, in consultation with the Federal Reserve and Treasury, to conduct a study and report to Congress within 90 days on the impact of MTM accounting on financial institutions, including the effect of MTM on financial institutions’ balance sheets, the impact on bank failures in 2008 and the impact on the quality of information to investors. Additionally, the study must address FASB’s standard-setting process, the advisability and feasibility of modifications to such standards [presumably, the fair value standards and related standards]; and alternative accounting standards to those provided in FAS 157.

For further details, see FEI’s summary of Sections 132, 133 of EESA based on discussion draft of bill posted by House Financial Services Committee Sept. 28.)

A discussion of the mark-to-market accounting provision in the bill can be found at the end of the article, “Broad Authority, Lots of Money and Uncertainty,” by Binyamin Appelbaum, David Cho and Neil Irwin in today’s Washington Post. Separately, Floyd Norris posits that the crisis leading to the bailout was caused not so much by overregulation or deregulation as ‘unregulation,’ and comments on EESA’s accounting provision, in his article in today’s New York Times, “After The Deal, The Focus Will Shift to Regulation.”

FASB Drafts Guidance on Fair Value As Congress Agrees On 3 R’s of Rescue Bill, the EESA

In an article slated for publication Mon. Sept. 29 in BNA’s Daily Report for Executives, Steve Burkholder, considered by many to be the Dean of accounting journalism, breaks the story that: “FASB Staff Crafting Guidance to Help Gauge Fair Value in Inactive Markets.” This is a significant escalation of action by FASB, following last week’s meeting of its Valuation Resource Group formed to advise the standard-setter on implementation issues arising from FAS 157, Fair Value Measurement.

The U.S. accounting board is acting at a time when debate is swirling in Washington, D.C. and elsewhere over whether fair value (mark to market) accounting has played a role in the credit crisis, amid requests for further guidance from the SEC and FASB, as noted in our earlier coverage, We Didn’t Start the Fire (Sale) and Other Than Temporary Impairment (OTTI).

Three R's of the Rescue Bill
Lawmakers were literally burning the midnight oil last night to reach consensus on enhancements to Treasury’s proposed $700 billion bailout package, with the New York Times reporting that “Congressional leaders and Treasury Secretary Henry M. Paulson emerged from behind closed doors to announce [a] tentative agreement at 12:30 a.m. Sunday.”

According to the "Summary of the Draft Proposal to Rescue U.S. Financial Markets," issued by House Speaker Nancy Pelosi’s office last night (posted on the Wall Street Journal website earlier today, replaced with updated material - see UPDATE, below), the plan tentatively agreed to by Congress (to be formally voted on Monday) revolves around three main themes: reinvest, reimburse, and reform. Specifically: “Reinvestment in the troubled financial markets … to stabilize our economy and insulate Main Street from Wall Street, Reimburse the taxpayer … through ownership of shares and appreciation in the value of purchased assets , and Reform business-as-usual on Wall Street … strong Congressional oversight and no golden parachutes.”

UPDATE 9PM SUNDAY: The WSJ reports this evening: “U.S. Seals Bailout Deal.” The article, by Deborah Solomon, Damian Paletta and Greg Hitt, says: “The Bush administration and congressional leaders agreed on a deal to authorize the biggest banking rescue in U.S. history.” The bill is entitled The Emergency Economic Stabilization Act of 2008, and the preceding link takes you to a copy of the draft bill and related summaries of its provisions, as posted by the House Financial Services Committee. As to timing, the WSJ reports “The House plans to vote on the measure Monday, with the Senate likely to follow later in the week…. Passage is seen as likely, despite the measure's unpopularity. Support from House Republicans, who staged an 11th-hour revolt on Thursday, will be vital, as will the backing of the Democratic leadership.”

FASB's Potential Guidance
Congress and the administration apparently are not the only ones burning the midnight oil. BNA’s Burkholder reported that a FASB staff director told him that “[FASB] staff …. is working on guidance intended to help companies apply the board's two-year-old rules on fair value accounting in situations in which there is little or no market activity.” As to timing, Burkholder quotes FASB’s Russell Golden saying: “The staff believes this is a priority. We expect to go to the board in the near term."

It is not yet known entirely what the scope of FASB’s guidance will be, or whether the board will necessarily approve its release. At a minimum, Burkholder writes, citing Golden, the guidance is likely to include some examples of when it is appropriate to apply ‘Level 3’ inputs in inactive markets. Level 3 inputs are defined in the FAS 157 ‘hierarchy’ as ‘unobservable’ inputs such as model-based inputs including cash-flow derived models. FAS 157 emphasizes use of ‘level 1’ inputs (including market prices for identical assets) or ‘level 2’ inputs (market prices for similar assets) with ‘level 3’ unobservable inputs being more of a fall-back position when there is a lack of level 1 or 2 inputs. However, in the current environment of illiquid markets fraught with ‘fire sale’ prices that differ substantially from fundamental valuation models, there have been calls for more guidance to specify when ‘level 3’ inputs can be used.

In a related move, FASB announced on Friday it has postponed its webcast on Application of FAS 157, originally scheduled for Mon. Sept. 29, to take place some time “within the next few weeks.” The announcement notes: “In light of recent events in the financial markets, and the legislation under consideration by the Administration and Congress, the FASB plans to redesign the webcast to provide real-time insights about the role of accounting standards in providing transparency to investors. Postponing the webcast will give auditors, preparers, users of financial statements, and regulators an opportunity to consider the application of FASB Statement No. 157, Fair Value Measurements, and other applicable generally accepted accounting principles (GAAP) to financial reporting issues that may arise from the pending legislation and recent market conditions.”

Given that companies are looking for immediate guidance to apply to their Sept. 30 quarter-ends, it will be interesting to see what form the FASB staff guidance will take, whether it will be discussed by the board at a public meeting, and whether it will be issued in final form immediately, or in draft form for public comment. Normally discussion at a public board meeting and a comment period would be provided if the guidance were to come in the form of a proposed FASB staff position (FSP), and it is possible FASB could conceivably propose guidance this week with, e.g., a 10 day comment period, but indicate companies would be able to adopt the guidance as of the date of the initial proposal if no changes are made in the final guidance.

Alternatively, perhaps due to something akin to ‘emergency’ circumstances, FASB probably could, particularly if it has the backing of the SEC, issue final guidance immediately in the form of examples or implementation guidance without having to go through a notice and comment period. We will update this post to add links to any further info posted by FASB on this matter (sign up here if you’d like to receive our blog by email), and keep an eye on www.fasb.org, www.sec.gov and www.pcaobus.org for further developments.

Separately, FASB announced on Friday the appointment of Marc A. Siegel as a new FASB board member, succeeding George Batavick whose term ended June 30. Siegel, a forensic accounting specialist, officially starts his board duties on Oct. 20, leaving his current job as head of the Accounting Research and Analysis Group at RiskMetrics Group. He served in a similar capacity with the Center for Financial Research and Analysis or CFRA, founded by Dr. Howard Schilit, which was acquired by RiskMetrics. Siegel has also served on FASB’s Investors Technical Advisory Committee (ITAC).

OTTI

OMG, have you heard about OTTI? It’s not on this list of IM abbreviations so we’ll try to explain. OTTI, or Other Than Temporary Impairment, is a term found in FASB and SEC literature to denote when a loss in market value of an investment in debt or equity securities must be written off. Key considerations include current market conditions as well as conditions of the issuer of the security, and the intent and ability of the investor to hold the securities until recovery. Existing guidance (written before the credit crisis) includes:

• SEC staff speech by Ashley Carpenter, PAF, Dec. 2007 AICPA National Conf. on Current SEC and PCAOB Developments – see section on Other Than Temporary Impairment of Securities, which references SEC SAB Topic 5-M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities,
• SEC Corp Fin Current Accounting and Disclosure Issues (last updated Nov. 2006), Section H: Investments, covers (1) Other Than Temporary Investments, (2) Government Sponsored Enterprises, and (3) Auction Rate Securities. References parallel FASB guidance set forth in FAS 115, Accounting for Certain Investments in Debt and Equity Securities, EITF No. 03-01, Other-Than-Temporary Impairments, FSP Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, which amends certain portions of EITF 03-01.
  

More recently, questions have been raised over the application of OTTI guidance in light of recent events:

• “Regulators and Bankers at Odds Over GSE Seizure,” By Rob Blackwell and Emily Flitter, Sept. 11, on FinancialPlanning.com, originally published in American Banker.
• “Top Accounting Firms Crack Whip,” by Chelsea Emery, in Reuters, Aug. 28. This article cites comments of various analysts, with one saying: "There has been a large degree of variability …as is often related to the approach of the auditors. In many cases, certain auditors, such as KPMG, have been more aggressive at requiring banks to take OTTI marks on such securities," and another analyst saying: “Fitch believes weak guidance on OTTI recognition by accounting standards has resulted in significant inconsistencies among companies on what is/is not written down in their financial statements.”

As has been widely reported, representatives of the American Bankers Association (ABA) met with SEC staff on Sept. 25 to discuss fair value (mark to market) issues generally, including OTTI. Last week, we provided links to ABA’s letter to the SEC, as well as letters from the Financial Services Roundtable (FSR) and CFA Institute.

We asked Donna Fisher, ABA’s Senior Vice President for Tax and Accounting, if she could share any insights following her meeting with the SEC. According to Fisher, attendees included SEC, FASB, and PCAOB staff, the chief accountants from the four federal banking agencies, and representatives of the eight largest accounting firms.

“Our goal was not to suspend fair value,” said Fisher, “rather, it was to identify the problems with the complex issues in the existing accounting standards.” She continued, “Specifically, we focused on determining fair value in the current economic environment for the purpose of estimating ‘other than temporary impairment’ [OTTI]. We had a frank discussion of the issues and believe that the SEC understands the need for guidance as soon as possible.”

Fisher told us she is not certain what form any potential guidance may take as a result of the meeting. However, she shared with us the topics which ABA posed for discussion:

• What is an “inactive market”, what represents an “orderly transaction,” and how should they be considered in determining fair value? [NOTE: According to the Summary of Discussions to Date as of July 1, 2008 of the FASB Valuation Resource Group (VRG), Issue 2007-4: “The VRG agreed that any definition of active market must be principles-based and that it would be difficult to develop any additional principles-based guidance that does not include bright-line rules. Accordingly, the staff does not believe that any Board action or further action from the staff is warranted at this time. The staff will continue to monitor this issue.”
• How do you define a “market participant” in a dysfunctional market?
• How should cash flow projections and illiquidity premiums be considered in determining fair value and impairments?
• What are the appropriate recovery periods to be utilized for under water securities?

According to Fisher, ABA provided the SEC staff with their views on possible answers to these questions. She added, “We reiterated the importance of providing timely guidance as quarter-end approaches.”

I’d like to close with a cite to an article in the current issue of The New Republic: “Bailing Upward - Why Congress needs to suck it up and act--and then go even further,” by Larry Grafstein and Jim Millstein, who write: “[T]he Treasury bailout, however necessary, should merely be a prelude to systemic reform. Consider the three very fragile links in a chain of risk that many observers recognized years ago: high financial leverage; accounting-rule arbitrage, inducing the purchase of credit insurance; and a reliance on a relatively narrow array of counterparties to underwrite those credit guarantees... TARP [Treasury’s proposed Asset Relief Program] addresses none of these issues.”

“There is no question that one immediate factor exacerbating the solvency crisis for banks has been the application of fair value or "mark-to-market" accounting rules to the balance sheets of the troubled institutions,” continue Grafstein and Millstein. “These rules, put into effect over the past 15 years by the Financial Accounting Standards Board and the SEC, have pegged the valuing of assets to wild (often panicked) fluctuations in the market, rather than at a value justified by the assets' fundamentals. Heavy markdowns coupled with extreme leverage have proved a lethal combination, making it difficult to survive the possibly temporary impairment of asset values in the absence of further accounting flexibility. At the same time, the fair value rules themselves would not have sparked anywhere near the financial damage were the relevant institutions not so heavily indebted.”

As I’ve written before (reminding readers the views in this blog are my own, not those of my employer, its officers, members or other staff), I concur with President Bush’s and Treasury Secretary Paulson’s assessment that “extraordinary times call for extraordinary measures.” @TEOTD, will it remain BAU for FV and OTTI? IANAL, so DYOR, and T+. GTG, TTFN. Sign up here if you'd like to be on our email list.

Treasury ACAP Issues Final Report:Over 30 Recs; No Consensus On Litigation; Q's On Fair Value, IFRS, XBRL Raised in Press Conf

Earlier today, the U.S. Treasury Department’s Advisory Committee on the Auditing Profession (ACAP), co-chaired by former SEC Chairman Arthur Levitt and former SEC Chief Accountant Don Nicolaisen, voted 14-1 to release its Final Report . The one member voting no was Lynn Turner, former chief accountant at the SEC. Here is a link to the Draft Final Report that was voted on by the committee, a Fact Sheet summarizing the recommendations, and a related press release. Separately, a PCAOB statement issued today says “The PCAOB welcomes the Treasury report and will carefully consider those recommendations that may have an impact upon the Board’s oversight of the auditors of U.S. public companies.” See the list of ACAP members.

U.S. Treasury Secretary Henry M. Paulson, called in briefly at the beginning of the meeting to thank the committee, its chairs and observers from the SEC, FASB and PCAOB.

Alluding to the efforts underway with Congress and the Administration to reach a deal on Treasury’s proposed $700 billion bailout plan, Paulson said, “I so much wish I was in person with you there today, because this is something very important that I have been looking forward to, but as you know I’ve been spending my time differently these days.”

Noting his call for this committee to be formed took place in 2007 as part of Treasury’s capital markets competitiveness initiatives, Paulson said ACAP’s work “is very important, this industry [the audit profession] is terribly important.” Once again alluding to current events, Paulson said, ““As I looked at my schedule this morning, I remember … 2007 seems a long time ago… I remember [former Treasury Secretary] George Schultz telling me the days would be long and the years would be short… for me, the days have been long and the years have been long.”

He stated that in discussions about competitiveness last year, “all of us thought accounting was right in the center” of capital market competitiveness, adding, "the lifeblood of capital markets are the financial statements, and the sustainability of the auditing profession is critical to investor confidence in our capital markets. Since that time, this has only become clearer, given some of these developments.”

“I very much welcome and am eager to receive your final report after you vote today,” said Paulson, adding, “I hope and believe what you do is going to contribute to, shape the necessary work to improving confidence in the financial markets.” Paulson also noted, “I know you’re going to vote on several very significant recommendations, including a market stability recommendation, and I think that’s very important.” [NOTE: The ‘market stability recommendation’ which Paulson alluded to would appear to be related to 2 of ACAP’s recommendations, summarized in the Fact Sheet as recommendations that

• “the PCAOB monitor potential sources of catastrophic risk at auditing firms to prevent reduced auditor choice and significant market disruptions,” and for
• “Creation of a mechanism for the preservation and rehabilitation of troubled larger public company auditing firms to prevent reduced auditor choice and significant market disruptions.”]

Paulson closed, “I really appreciate what you’ve done, [and I] thank you for your service to the United States as the best place in the world to do business. We’ve got a lot of work to do in a lot of areas to get us back to where we should be, your work is an important part of it.” The ACAP cochairs thanked Paulson and Treasury staff that supported the committee, led by Kristen Jaconi.

ACAP’s recommendations are organized in three areas, as developed by its three subcommittees: (1) human capital , chaired by Prof. Gary Previts, immediate Past President of the American Accounting Association, addressing issues relating to education, recruitment, and retention, (2) firm structure and finances, chaired by former NASD Chairman and CEO Robert Glauber, and (3) concentration & competition chaired by AFL-CIO Associate General Counsel Damon Silvers . At today’s meeting, the subcommittee chairs said changes in today’s draft report vs. the earlier (July) draft were minor except for the following changes:

1. The final report makes no formal recommendation regarding litigation/liability reform, since the subcommittee charged with that task (Firm Structure and Finances) was unable to reach consensus. However, the divergent views of members of that subcommittee are included in the report, and a separate section of the report includes ACAP co-chairs (former SEC Chairman Arthur Levitt and former SEC Chief Accountant Don Nicolaisen’s) views on this and other topics. The manner in which the litigation issue was handled may be the basis for Turner’s dissent from the final report; although he did not elaborate during today’s meeting, he expressed concern on this point at prior meetings.

2. ACAP’s earlier recommendation to form a new national fraud center (to study and issue best practices on fraud prevention and detection) has now found a ‘home’ in the PCAOB, which has agreed to house the new fraud center.

3. Some additional language has been added to the report to facilitate the relationship between predecessor auditors, successor auditors, and client companies when there is a change in auditor. Levitt thanked in particular Ken Goldman [note: Goldman is CFO of Fortinet, Inc. and is an FEI member] and KPMG Chairman Tim Flynn for working out this language.

At a press conference following the meeting, ACAP co-chairs Levitt and Nicolaisen were asked about the committee’s deliberations on the litigation reform/liability issue.

Levitt responded, “There was certainly an awareness and sensitivity on the part of the accounting firms and other members of the committee that felt the threat to the firms coming from catastrophic liability claims could kill [a] firm and create… [a] very serious [situation] for our capital markets. He continued, “The issue is very easy to catalogue and talk about, but [reaching] consensus very difficult; rather than forcing compromises which represent relatively meaningless effort, we opted to have those having a particular view about litigation protections or caps or federalizing the supervision of accountants [to have] those views presented as their adherents wanted it presented.” Additionally, he noted, “Whatever happens to this report as it is used in terms of rulemaking or legislation… the positions are stated as clearly as I’ve ever seen before; although the committee as a whole did not vote yes or no [on the issue of litigation reform], the cochairs presented their view, and I think that will be noted as well.”

Asked if any firm is currently at risk of catastrophic loss, Nicolaisen replied, “We don’t think so, the firms are all here,” but added, “the concern is that firms can have difficulty for a number of different reasons.” He added “it would be hard to see a firm, one of Big 4, disappear, and be able to reallocate that in an orderly manner; it would be critical to keep our markets operating efficiently, important that regulators [be] very aware of those things that could threaten a firm’s existence.” He added the regulators need to pay attention to solvency and strength of the large audit firms going forward.

The co-chairs were also asked about audit firms' reaction to ACAP’s recommendation that audit firms provide the PCAOB with GAAP financial statements for their own firm, on a confidential basis (although, the report is silent as to whether or not the PCAOB could subsequently release the reports to the public, or if the firms could choose to publicly release their own GAAP financials.) Levitt responded, “Don [Nicolaisen] and I both in our letter voice strong support for the profession to present audited financials to the public, and I think that within a very short period of time some of the firms will do just that., and once one firm does it, the rest of them will.”

Questions About Fair Value, IFRS, XBRL Raised At Press Conference
Among other matters raised at the press conference with Levitt and Nicolaisen following ACAP’s meeting related to Fair Value Accounting, IFRS and XBRL. We’ve excerpted the Q&A on those issues below.

Q: Was fair value accounting addressed in the report/what are your thoughts on this issue?
Nicolaisen: “We have kept this [committee/report] focused on the auditing profession… [e.g.] does the auditor have training, background, are they equipped to deal with these issues… You’ll see recommendations [in the report] about increased need for more training, more experience with things like mark-to-market, as well as international accounting standards, as the world moves forward; we’re not taking any view on accounting in this document.

Levitt: “There were enough divisive issues in terms of [the auditing] industry and what its paradigm should be in the future… “ He later added in response to a different question, “There’s been a general improvement in the industry, trying to understand their public responsibilities, and I think they’re doing better than they’ve done prior to the [post-] Enron changes.”

Q: What about calls from the American Bankers Association (ABA) to suspend Fair Value accounting/mark-to-market rules… how should auditors deal with that?
Nicolaisen: “That is an issue we have not entered into within this committee, I don’t think it would be appropriate for us to comment on it, we were focused on the audit side, not accounting, didn’t view that as within the charge [of this committee]. The Treasury Secretary focus[ed] us on the audit profession, viability, quality, acceptability of work product [of the audit profession].

Q: Are we on track for a move to IFRS, are we on target to make decision by 2011 timeframe? [NOTE: SEC’s proposed IFRS roadmap discussed at SEC open meeting earlier this year set forth 2011 as date by which SEC would determine whether to mandate IFRS, and if so, that they would contemplate mandating it be effective in 2014.]
Nicolaisen: “I believe that the firms, the academic community can in fact get up to speed on IFRS. It’s important that the U.S. contribute to really good accounting standards around the globe, I believe we have the resources, intellect and capability to do that. It will be difficult and it will be more of a challenge to converge this capital market from one system to another, I think the SEC is right in having a very extended timetable - and also the opportunity for a time out if they need to, before it would be required, if it will be required.” He added, “You need a timetable to keep things moving, like everything else in life, it can be moved if it needs to.” A followup question was asked: is the message clear to universities they need to start developing IFRS programs. Nicolaisen responded: “I think it is very much coming across, universities today are also global… I serve on a board of advisors [of a university], I’m always impressed by the diversity of the students, number of countries, interests they bring; I think youthful interest combined with intellectual challenge, [will take the] next year or two to move this forward, to help get it done right, we don’t want to make mistakes.”

Q: Will XBRL place additional burdens on auditors, [e.g. if there is a] discrepancy between XBRL and the financial statements?
Nicolaisen: “XBRL is just data tagging, identifying data; it’s much like moving into the laptop age from ledgers that may have been prepared more rigidly with less flexibility to be able to analyze information.” He continued, “From what I understand of the technology, it’s good, it’s available, it can be very helpful in the long-run to better detailed information about financial data in income statements and balance sheets. Like any other technological change, you introduce it, a vast majority of people - particularly younger people - say it’s good stuff, let’s move with this; it has the potential to improve the quality of data.”

If you received this blog post from ‘a friend’ and you’d like to get the FEI blog by email, send an email to blogs@financialexecutives.org and write in Subject line: Sign up.

We Didn't Start The Fire (Sale)

With the WSJ reporting Thursday afternoon “Agreement Reached on Bailout Ahead of High-Level Meeting,” [UPDATE: Friday morning: "Bailout Negotiations in Disarray"] what about related accounting issues - specifically, application of fair value or mark-to-market accounting in illiquid markets? Presumably, accounting matters won’t be part of the legislation, but some are wondering if relief from fair value accounting will be addressed through separate action by the SEC.

Earlier today, SEC staff reportedly met with representatives of the American Bankers Association (ABA), the Center for Audit Quality (CAQ - affiliated with the AICPA), and senior FASB and PCAOB staff, as reported in today's BNA Daily Report for Executives (“Bankers Seek Immediate SEC Guidance On Proxies for Fair Value in Illiquid Markets,” by Steve Burkholder and Susan Webster.)

What could the outcome of such talks be? Is it realistic to think some action may be taken to modify current accounting rules in light of the credit crisis? After listening to Fed Chairman Ben Bernanke’s testimony at the Senate Banking hearing earlier this week, the President’s remarks last night, the SEC’s Fair Value Roundtable in July (see our related post on Deconstructing Fair Value) … and looking at the American Banker’s Association (ABA) Sept. 23 letter to the SEC, the CFA Institute’s Sept. 23 letter to the SEC, the Financial Services Roundtable (FSR) Sept. 24 letter to the SEC, materials published by FASB’s Valuation Resource Group (July 2 Summary of Decisions to Date), the IASB’s Expert Advisory Panel (Sept. 16 draft guidance on Measuring and Disclosing the Fair Value of Financial Instruments in Markets That Are No Longer Active), and other articles on Fair Value, here’s what I think. (NOTE: I remind you of the Disclaimer posted on this blog that these views are my own and not necessarily those of my employer, its members, officers, directors or other staff.)

It boils down to this:

• Some, like the ABA, have argued, “The fair value accounting rules are problematic in the current market… and are having a strong pro-cyclical impact in the marketplace.” Therefore, ABA states, “We recommend that, given current market turmoil, the SEC provide immediate guidance that intrinsic value or economic value are appropriate proxies for fair value.” Similarly, the FSR states: “Companies should not be required to rely on an illiquid market to price long term, non-trading assets or to create an educated guess of such an asset’s value. As such, the Roundtable urges that in illiquid market conditions, rather than a blanket application of fair value exit pricing, investors should be able to use alternative definitions of fair value that focus on the value to the investor if the security does not require immediate liquidation. In our previous letters to the Commission, the Roundtable has provided details on this proposal.”
  
• Others, like the CFA Institute, argue, “Investors are interested in the value that a company could sell the asset for today. In this context, management has flexibility to not be bound solely by some distressed, fire-sale price. If management believes that an alternative measure is also relevant to investors, we agree that the information described by the SEC in its March 2008 letter as to why a range is appropriate, its key drivers, and how assumptions were developed, is an appropriate and acceptable practice to investors. However, the fact that there are few, if any, transactions or prices to benchmark a specific financial instrument is a reality that must not be ignored. “ Further, CFA cites from the IASB EAP Sept. 16 draft guidance, which states: “Entities sometimes place undue emphasis on the distinction between active and inactive markets …Even when markets are inactive, a current transaction price for the same or a similar instrument normally provides the best evidence of fair value … distress sales are rare and evidence is needed before it is determined that a transaction has not taken place at fair value.”
  

As we noted earlier this week, Fed Chairman Bernanke explained in his Senate testimony earlier this week how ‘fire sale’ pricing in today’s illiquid markets is driving down capital levels and in turn constricting credit. For all intents and purposes, he made a plain English plea for some sane reference point to be established by Treasury’s proposed auction process, to move the ‘fair value’ (fire sale) reference point closer to as an estimated ‘hold to maturity’ (HTM) amount. The theory behind the HTM amount is broadly akin to the intrinsic value, economic value, or fundamental value approach which the ABA letter supports, and the CFA Institute and IASB EAP dispute, in terms of complying with the current fair value accounting requirements. (Under current accounting rules, lest HTM be the actual transacted price, it would not receive the same consideration as an actual transacted price, even in illiquid markets.)

Complicating this further, as noted in recent press reports, (“Economists Look at Ways to Structure Auctions” in the WSJ, “Plan’s Mystery: What’s All This Stuff Worth?” in the NYT) is the fact that some parties are concerned about the federal government potentially paying something in excess of the ‘fire sale’ price that private participants are willing to pay (if willing to transact at all) in today’s illiquid market.

This leads to the question - unless there is some relief in the application of the fair value accounting standards as currently constructed (which were written with the express assumption of relying on market prices in active markets, with willing buyers and willing sellers, and not distressed sales) – is there a risk of the tail (accounting) wagging the dog (the auction process, and more broadly, the economy)? Your view of which is the tail and which is the dog is probably based on whether you believe fair value accounting contributes to procyclicality.

Faced with seemingly opposing views as encapsulated in the ABA (FSR) and CFA letters, what’s the SEC to do? Here’s my observation: As President Bush and Secretary Paulson said on Sept. 18, “extraordinary times call for extraordinary measures.” The SEC and FASB have taken actions akin to emergency measures in the past when warranted by events or related legislation; here are a few examples that may illustrate paths that could be taken, if they choose to take any action in this regard.

• Letter from SEC Chief Accountant … concerning the American Securitization Forum’s Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans. (January 8, 2008)
• “Commission Amends Compliance Dates for FASB Statement No. 123R on Employee Stock Options.” SEC Press Release, April 14, 2005
• “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” FASB Staff Position (FSP) FAS 109-1, Dec. 21, 2004.
• “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” FASB FSP No. 106-2, May 19, 2004.
  

In light of the current status of guidance issued by the private sector (IASB’s EAP and FASB’s VRG), I wouldn’t be surprised if the SEC (or one of the banking agencies?) does choose to issue some form of guidance on application of fair value in the current (illiquid) market. Only time will tell. (Maybe in time to mention on FASB’s Sept. 29 webcast on fair value.) [UPDATE 9/26: FASB announced today they have postponed the Sept. 29 webcast, and will reschedule it within the next few weeks. FASB states: "Postponing the webcast will give auditors, preparers, users of financial statements, and regulators an opportunity to consider the application of FASB Statement No. 157, Fair Value Measurements, and other applicable generally accepted accounting principles (GAAP) to financial reporting issues that may arise from the pending legislation and recent market conditions. ] But, I wouldn’t necessarily place any bets on it; I’ve been raked over the coals before by people I respect like Re: The Auditor’s Francine McKenna when I raised the question a couple of months ago that if markets aren’t rational, can market values really be ‘fair.’ If you’d like some background music while you contemplate this subject, here’s a link to “We Didn’t Start the Fire “ by Billy Joel. (Note: link is to video by Scott Allsop of Kings College in the U.K, illustrating historical events in the song.) If you received this blog post from ‘a friend’ and you’d like to receive our blog by email, sign up here.

FASB Extends Effective Date of Proposed Changes to FAS 5, Contingencies; Adds Project On FIN 48 and Private Cos

At its board meeting earlier today, FASB agreed to conduct field tests this year, and hold a roundtable first quarter 2009, on its proposed changes to FAS 5, contingency disclosures. In light of comments received from the preparer and legal community (including FEI comment letters) on its earlier Exposure Draft, the staff has developed an alternative disclosure model to be included in the field test. Accordingly, FASB agreed to extend the effective date of the final amended standard to be effective no sooner than fiscal years ending after Dec. 15, 2009. FASB is looking for volunteers for the field test.

Among the concerns identified by the legal community mentioned today was that communications of attorneys regarding litigation reserve estimates and related disclosures could be discoverable. FASB board member Tom Linsmeier asked if a suggestion made earlier this week by Ralph Ferrara, Managing Partner of law firm Dewey & LeBoeuf LLP and a member of FASB’s Financial Accounting Standards Advisory Council (FASAC) had been considered; FASB staff said they would look into it. Staff emphasized the disclosures subject to the field test would encompass ‘closed cases’ so as not to divulge confidential information, they also noted they would be careful to try to avoid causing any problems with compliance with SEC’s Reg FD.
In other FASB action, Chairman Robert Herz announced an ‘agenda decision’ had been reached to add a project to FASB’s agenda to consider a potential deferral or modification to FIN 48, Uncertainty in Income Taxes, with respect to nonpublic companies. He added, “In the next few weeks we will discuss [this project] at a board meeting." If you're new to our blog and you'd like to receive emails of our posts, enter your email address here.

Bernanke Tells Senate: Auction Will Help Facilitate Held-To-Maturity Vs. Fire Sale Price

During testimony before the Senate Banking Committee on Sept. 23, Federal Reserve Board Chairman Ben Bernanke advocated against suspending mark-to-market (also called fair value) accounting, but stated that determination of ‘hold to maturity’ estimated valuations through the U.S. Treasury Department’s proposed reverse auction process would provide banks with “a basis for valuing those assets” and so the banks “will not have to use fire-sale prices,” and “their capital will not be unreasonably marked down.” (Thus, while not supporting a move away from ‘fair value’ being defined as a ‘market to market,’ Bernanke implied that the ‘hold to maturity’ price, if offered at auction by Treasury, would establish a new reference point or baseline for ‘fair value’ vs. the current ‘fire sale’ prices offered in the current illiquid market.)

Bernanke also referenced hold-to-maturity pricing as follows: “taxpayers [w]ould own assets at prices close to hold- to-maturity values, which minimizes their risk.” Other benefits of the auction plan, he said, would be increased liquidity, a reduction in uncertainty as these assets are removed from bank balance sheets when sold into the auction, an influx of new private capital, and a thawing of frozen credit markets.

Speaking like a former college professor – indeed, later noting as much in response to a question about potential conflicts of interest, saying: “I’m a college professor, I was criticized for taking the job [of Federal Reserve Board chair] without having been on Wall Street, my interest is solely for the recovery of the U.S. economy” – Bernanke opened his remarks: “Let me start with the question, why are the financial markets not working.”

He explained, “Financial institutions and others hold billions in complex securities, including many that are mortgage-related.” He continued, “I'd like to ask you for a moment to think of these securities as having two different prices. (1) The first of these is the fire-sale price. That's the price a security would fetch today if sold quickly into an illiquid market. (2) The second price is the hold-to-maturity [HTM] price. That's what the security would be worth eventually when the income from the security was received over time.”

“Because of the complexity of these securities and the serious uncertainties about the economy and the housing market, there is no active market for many of these securities, and thus today the fire- sale price may be much less than the hold-to-maturity price. This creates something of a vicious circle,” said Bernanke.

Describing in essence the fair value measurement requirements of FAS 157 (note: similar requirements exist in IAS 39), which emphasizes reference to a current transaction price as generally best evidencing ‘fair value,’ Bernanke said: “Accounting rules require banks to value many assets at something close to a very low fire-sale price rather than the hold-to-maturity price, which is not unreasonable in itself, given their illiquidity. However, this leads to big write-downs and reductions in capital, which in turn forces additional sales that send the fire-sale price down further, adding to pressure. Meanwhile, private capital is unwilling to come in because of uncertainty about the value of institutions and because of the prospect of more write-downs.”Bernanke noted: “One suggestion that's been made is to suspend mark-to-market accounting and use banks' estimates of hold-to-maturity prices.” He added, “Many banks support this. But doing this would only hurt investor confidence because nobody knows what the true hold-to-maturity price is. Without a market to determine that price, investors would have to trust the internal estimates of banks.””So let me come to the critical point,” said Bernanke. “I believe that under the Treasury program auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets.”

He continued: “If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits. (1) banks will have a basis for valuing those assets and will not have to use fire-sale prices. Their capital will not be unreasonably marked down. (2) liquidity should begin to come back to these markets.(3) removal of these assets from balance sheets and better information on value should reduce uncertainty and allow the banks to attract new private capital. (4) credit markets should start to unfreeze. New credit will become available to support our economy. And, (5) taxpayers should own assets at prices close to hold- to-maturity values, which minimizes their risk.”

Bernanke concluded his opening remarks, “I believe that under the Treasury authority being requested, a program can be undertaken that will help establish reasonable hold-to-maturity prices for these assets. Doing that will restore confidence and liquidity to financial markets and help the economy recover without an unreasonable fiscal burden on taxpayers.” Bernanke then “urge[d] [the Senators] to act as soon as possible.”

Also testifying at hearing were U.S. Treasury Secretary Henry Paulson, U.S. Securities and Exchange Commission Chairman Christopher Cox, and Federal Housing Finance Agency Director James Lockhart.

On the topic of fair value accounting, Cox noted, “Both the U.S. and international accounting standard setters are very focused on the need to provide timely guidance.” He added, “Today, FASB’s Valuation Resource Group (VRG) is meeting to address these very application issues in the context of [generally accepted accounting principles or GAAP] with the goal of providing timely guidance to companies.” In related news, the IASB’s Expert Advisory Group published a draft paper on Sept. 16 summarizing its views on Measuring and Disclosing the Fair Value of Financial Instruments in Markets that are no longer Active.

All written testimony and a link to CSPAN’s video coverage of the hearing is posted here. We post additional highlights on Wednesday in this FEI summary (FEI members only.) See also our related post on Tuesday, "Fair Value Accounting, Liquidity, and Treasury's $700 Billion Bailout." If you received this blog post from 'a friend' and you'd like to get FEI's blog by email, sign up here.

Fair Value Accounting, Liquidity, and Treasury’s $700 Billion Bailout

The use of fair value or mark to market accounting has already come up in opening statements of Members of the Senate Banking Committee at its hearing taking place right now on Turmoil in the U.S. Credit Markets. In related news, the American Bankers Association and Financial Services Roundtable are reportedly trying to get relief from fair value or ‘mark to market’ accounting requirements written into Treasury’s $700 billion bailout bill, or alternatively to have the SEC provide this relief outside the bill (see BNA and Bloomberg articles below.)

The concern with fair value accounting relates to FAS 157 (and its sister standard internationally, IAS 39) which at their core include an explicit presumption that actual transaction values are the best measure of fair value measure when there are active markets and sales are not ‘forced’ or ‘distressed.’ Although the accounting standards allow for traditional valuation methods or models like discounted cash flow to be used to value items in illiquid markets, there is terminology used in the standards, interpreted further in guidance issued last year by the Center for Audit Quality (CAQ), affiliated with the AICPA, and in material included in a draft document posted last week by the IASB’s Expert Advisory Panel (EAP) on valuing in illiquid markets, which emphasizes that market prices for transactions taking place - even in illiquid markets - cannot be ignored. The particular guidance provided by CAQ and IASB’s EAP - in depth and breadth - pose a practical if not theoretical conundrum in deciding how much emphasis the standard-setters implied, and auditors may require, in use of a current market price obtained in a psychologically panicked or illiquid market to dial back or ‘recalibrate’ (to use the IASB EAP’s term) the ‘fundamental value.’ Akin to IASB’s EAP is FASB’s Valuation Resource Group (VRG), although VRG’s published decisions to date do not address the issue of illiquidity.

There are at least two sides to the fair value (also called mark-to-market) argument: those that say fair value accounting has provided a dose of reality and transparency on what some in the press are referring to as ‘toxic’ debt, including certain subprime mortgages, mortgage backed securities and credit default swaps, and those who say that fair value accounting as currently constructed under FAS 157, IAS 39, and various interpretations or related guidance thereof has exacerbated the crisis. The latter school of thought cautions that potential fire sale prices which the government may pay under the reverse auction process proposed by Treasury could have a dire effect in pushing down the prices of related securities held by those companies and others, triggering a further downward spiral in capital shortages and tightening of credit. Similarly, Jerry Bowyer, (whose blog we linked to last week), noted on Larry Kudlow’s show last night, “Let’s talk about all the regulations that put the hole in the boat, not just bai[l] out the boat.”

Below are links to recent speeches and articles on this topic. I particularly like Jeff Miller’s post, “Understanding Cause and Effect: The Implications” which cautions against oversimplifying the core issues in the financial crisis, including fair value accounting, and Vinny Catalano’s post on “The Imperative of Logic.” If for some reason you want to read just one item on each side of this debate, I would suggest you read FASB Chairman Robert Herz’ Sept. 18 speech, and former FDIC Chairman William Isaac’s Sept. 19 OpEd in the WSJ, which are the first two items listed below.

Lessons Learned, Relearned, and Relearned Again from the Credit Crisis— Accounting and Beyond, speech by FASB Chairman Robert Herz, Sept. 18

How to Save the Financial System, OpEd by William Isaac, Former Chairman, FDIC, in WSJ Sept. 19.

Bankers Seek Alternative to Fair Value Accounting in Pending Financial Bailout Bill, by Steve Burkholder, BNA Daily Report for Executives, Sept. 23.

Banking Groups Seek Suspension of Fair Value, by Ian Katz, Bloomberg news, Sept. 22.

The Pending Fair Value Fracas, by Jack Ciesielski, in his AAOweblog, Sept. 21.

Witnessing History, by David Merkel, CFA in The Aleph Blog

All’s Fair: The Crisis and Fair Value Accounting, The Economist, Sept. 18.

Understanding Cause and Effect: The Implications, by Jeff Miller. Miller is president and CEO of NewArc Investments, and said in his blog, A Dash of Insight, Sept. 20. Highlights: “Many issues in the current investment discussion are incorrectly portrayed as "black and white." Here are some examples: (1) “Short selling. Amateurs see short-selling in financial stocks as a cause. Professionals understand that the ability to sell short is one of many market influences. They understand that short sales are often done against long call options, that they may hedge other positions in pair trades, and that the analysis done by those selling short may expose major problems at specific companies. It is not black and white. (2) “Accounting. Amateurs see accounting rules like FAS 157 as forcing companies to reveal the truth. Experts know that the securities cited are difficult to value, and that FAS 157 uses a simplistic method. There might not be a single good method, but the pros try to figure it out, not accepting illiquid distressed sales as the ultimate answer. (3) “Bailouts. The popular media analyzes everything in terms of the potential cost to the taxpayer. That is the theme that sells papers and it is easily understood. The pro considers a more difficult calculation. When do societal effects become so great that it is time to act?”

Miller: Dump the Mark-to-Market Rules. By Jeff Miller (same Jeff Miller as above) posted on RealMoney.com and TheStreet.com Sept. 18. Highlights: “The mainstream media have covered only one side of this debate. It is easy to champion free-market pricing and point to the hazards of Japan. It is more difficult to draw a distinction between normal trading and distressed and illiquid markets. The result is that few followed our lead over the last year, when we pointed out the dangers in letting accountants -- unelected and with little oversight -- form our public policy.
From Chaos to Sanity: The Imperative of Logic, by Vinny Catalano in his blog, Musing on the Markets. Highlights: “Rules Matter. If the NFL changes its rules of play, does that not have an effect on the game? So, why would a rule change by the FASB or the SEC or a law by Congress not have the same game changing effect?” Read Catalano’s suggestions regarding FAS 157, disclosure and more.
The Anti-Fair Value Lobby Has a Point (Even if They Don't Know It), by Prof. Tom Selling, in his blog, The Accounting Onion.

Betting on Financial Armageddon, by John Mauldin, Millennium Wave Advisors

What a Week! Explained in Plain English (and Chinese)

Fair Value Concept Prompts Cries of Foul, by Jenifer Hughes, FT Sept. 18

Paulson bailout would worsen contagion-spreading accounting rules, John Berlau, Director, Competitive Enterprise Institute, in their OpenMarkets Blog, citing among other items Berlau’s Sept. 20 WSJ OpEd, Maybe the Banks are Just Counting Wrong

Idea, Hub, Phoenix and Radar --- and New Info on SEC's 21CDI

If we were playing Jeopardy, and I said “Idea, Hub, Phoenix and Radar,” and you said, “What are the names of the SEC’s four new tech initiatives?” you’d be right. Read more about these terms, and find out about an update posted yesterday by the SEC on its 21st Century Disclosure Initiative below.

One of the earliest cites to HUB and Phoenix were in SEC Chairman Christopher Cox’ remarks at PLI’s SEC Speaks conference in February this year. Next, the Idea of IDEA, or Interactive Data, Electronic Application, was announced at a press conference on Aug. 19. IDEA was described as a filing system that would be based on interactive (rather than static) data, and would one day replace the Edgar filing system. (See our Aug. 19 post.) The other terms described by Cox on Aug. 19 were: HUB is the SEC’s new enforcement case tracking system, PHOENIX is the SEC’s new system “that helps us track and distribute billions of dollars to injured investors,” and RADAR “is the SEC’s “state of the art risk analysis system.” You can see logos for all four terms in the IDEA ‘style guide’ (Visual Entity Guidelines) posted on SEC’s website Sept. 11. The shared tagline for the 4 logos is: “Better Data, Stronger Markets.”

IDEA was described by Cox on Aug. 19 as ‘the flagship in our fleet of new enterprise software.” A patch of rough sailing may be ahead if a firm called Caseware follows through on its threat to potentially sue the SEC for trademark infringement on use of the name “Idea”, as recently reported in webcpa.com and accountingweb. (Here is Caseware’s statement.) Dominic Jones of IR Web Report included a link to SEC’s application filed with the U.S. Patent and Trademark Office (USPTO) in his post: “Software firm ‘dumbfounded’ by SEC’s use of its IDEA trademark.” He notes the info was provided by SEC Spokesman John Heine, who pointed out the USPTO stated: “The Office records have been searched and there are no similar registered or pending marks that would bar registration under Trademark Act Section 2(d), 15 U.S.C. §1052(d). TMEP §704.02.”SEC Posts New Info on its 21st Century Disclosure Initiative

In other SEC news, starting with their newly revamped homepage, there is a bit more visibility now of the Spotlight pages which gather information on a number of special topics. New at the top of the list is the 21st Century Disclosure Initiative (I’ll call it 21 CDI).
A number of key documents relating to 21CDI were posted by the SEC yesterday (Sept. 16), including the 21CDI Strategic Plan, 21 CDI FAQs, and a brief blurb about the previously announced Oct. 8 roundtable on the 21CDI. According to the strategic plan, 21CDI will be conducted in 3 phases: (1) the staff of the Commission, led by Bill Lutz, Ph.D., J.D., will prepare by December 31, 2008, a high-level plan to help the Commission to make the transition to an interactive company file system. (2) the Commission will be asked to establish a Federal Advisory Committee [FACA] in early 2009. The Advisory Committee would review our plan and make recommendations to the Commission for implementing it. (3) in the final, multi-year phase, the Commission would consider and begin acting on the Advisory Committee's recommendations, engaging the Commission's normal notice and comment rulemaking process.

The core proposal at the heart of the 21CDI is described in the above documents as “A Company File System,” described by the SEC as: “A company file system would collect core information about a company or fund in a centrally and logically organized interactive data file. Companies would supplement that information with the current, periodic and transactional information that is currently required by Commission disclosure regulations.” Further details can be found in the 21CDI docs linked above.

Idea Postscript: A highly credible source sent me a comment recently saying I guessed wrong in my original Aug. 19 post on IDEA, as to who did the voiceover on the IDEA video intro that pops up when you click on IDEA on the SEC website; the correct answer, they said, is Ethiopis Tafara, Director of SEC’s Office of International Affairs. This seems fitting, since the term ‘convergence’ employs some aspects of convergence of technologies, accounting standards (e.g. IFRS and U.S. GAAP), and XBRL taxonomies (e.g., the taxonomies issued by XBRL-US and XBRL-International).

Fallout Boys

No, this isn’t about some rock band, but about the potential fallout from the failures, rescues, failed rescues, and everything in between, that rose to a crescendo in the past six months – particularly in the past ten days – with respect to the financial markets. (By the way, I don’t mean to be sexist by saying ‘Fallout Boys,’ FEI is hosting its “Women in Financial Leadership” conference today in NYC, and clearly women will be impacted in every aspect of this crisis.)

Beginning with the government assisted takeover of Bear Stearns by JP Morgan Chase in the spring, and continuing with the FHFA’s takeover (technically, conservatorship of) Fannie Mae and Freddie Mac earlier this month, followed by the bankruptcy filing of Lehman Brothers earlier this week (not to mention the purchase of Merrill Lynch by Bank of America), and now, the $85 billion secured lending facility offered by the Fed to AIG, the situation seems to have deteriorated. Announcing the AIG loan agreement last night, the Fed said its action was taken “with the full support of the Treasury Department,” and that “The [Federal Reserve] Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.” In light of the turmoil in the markets, Members of Congress, Presidential candidates, and others are asking for answers (or at least, explanations).

The Washington Post’s Lori Montgomery reported in her article yesterday, “Crisis Prompts Calls for Federal Rescue Entity,” that Rep. Barney Frank, chair of the House Financial Services Committee, indicated the market has "gotten into such terrible shape that specific interventions haven't helped,” and that he asked, “Are we at the point where there needs to be some federal intervention?" Her report continued: “’I think that's probably the next question we'll have to debate,’ Frank said, referring to the possibility of an entity similar to the Resolution Trust Corp. ‘The president-elect may be asking us to take a look at this.’ Frank said the assets of many troubled financial institutions are ‘probably undervalued by the panic,’ suggesting that the federal government could ‘hold them’ without saddling taxpayers with excessive costs.”

Numerous times, U.S. Treasury Secretary Henry M. Paulson has referred to the need for some mechanism to deal with the ‘resolution’ of (or the need to ‘resolve’) troubled institutions, as recently as Sept. 15, in his remarks at a White House press conference. Talk of a need for a resolution type entity was taking place earlier this summer –as reported in “Is There A Resolution Trust Corp. in Fannie or Freddie’s Future,” by Marine Cole, published in Financial Week on July 11, 2008 (prior to the September actions taken on Fannie and Freddie.)

Also in the ‘fallout’ category - other potential actions in response to the crisis could include: “Scope of Regulatory Revamp Is Likely to Widen - Derivatives Market Could Get Oversight As Fed Expands Role” as reported Kara Scannell in yesterday’s WSJ, and “SEC Poised to Act on Short Selling” as reported by Joanna Chung in yesterday’s FT.

Senate Hearings This Week on Off-Balance Sheet Accounting, More
The Securities, Investment and Insurance Subcommittee of the Senate Banking Committee will conduct a hearing on Thursday, September 18 at 2:30 pm on: “Transparency in Accounting: Proposed Changes to Accounting for Off-Balance Sheet Entities.” Scheduled to testify are FASB board member Larry Smith, SEC Corp Fin Director John White, SEC Deputy Chief Accountant Jim Kroeker, former FASB board member Donald Young, and others. We reported earlier this week that FASB released three Exposure Drafts amending FAS 140 and FIN 46R, the accounting and disclosures for securitization and consolidation standards, which impact off-balance sheet treatment of special purpose entities (SPEs), qualified special purpose entities (QSPEs) and variable interest entities (VIEs).

Additional hearings are scheduled this week and next week at the Senate Banking Committee on the upheaval in the financial markets and regulators’ response, including a hearing during the morning of Sept. 18 on “Recent Bank Failures and the Regulators Response,” and a hearing on Sept. 23 on, “Turmoil in US Credit Markets: Recent Actions Regarding Investment Banks and Other Financial Institutions.” The House Financial Services Committee has scheduled a hearing Sept. 25 on Oversight Hearing to Examine Recent Treasury and FHFA Actions Regarding the Housing GSEs, and Rep. Frank posted this Letter to the Editor of the WSJ, “Wall Street Journal Editorial Board Stifles Dissenting Opinion,” in response to an oped published last week in that paper. Frank claims the WSJ has so far refused to run his letter. In related news, Manu Raju reported in The Hill last night, “AIG Rescue Plan Sparks Hill Concerns.”

Perhaps the mood of the day (week, year) was best expressed by Paulson’s chief of staff, as quoted in the final lines of “No Bailout: Feds Made New Policy Clear in One Dramatic Weekend” by David Cho and Neil Irwin in yesterday’s Washington Post: “As the bankruptcy of Lehman became official, someone remarked about the historic nature of the weekend. Jim Wilkinson, Paulson's chief of staff, was within earshot of the comment and responded to the group discussing the events: ‘This would be extremely interesting from an analytical perspective if wasn't happening to us.’”

FASB Releases Proposed Changes to FAS 140, FIN 46R, on QSPEs, More; Banking Agencies Look at Proposal; FAS 157 and Lehman

Earlier this afternoon (Sept. 15) FASB issued a press release announcing the release of three Exposure Drafts (EDs) that would amend the accounting and related disclosures for transfers of assets including securitizations, and consolidation of certain off-balance sheet entities (commonly called Special Purpose Entities (SPEs), Qualified Special Purpose Entities (QSPEs) and Variable Interest Entities (VIEs).

As noted in FASB’s September 3rd media advisory issued in advance of today’s release, “The proposed Statement to amend Statement 140, would, among other things, remove the concept of a qualifying special-purpose entity (SPE) and would remove the exception from applying Interpretation 46(R) to qualifying special-purpose entities (SPEs).” Additionally, “The proposed Statement to amend Interpretation 46(R) would amend the guidance for determining whether an enterprise must consolidate a SPE, including those previously considered qualifying SPEs.”

There is a 30 day comment period (ending Oct. 15) on the proposed FSP containing disclosures only; and there is a 60 day comment period (ending Nov. 14), on the other two EDs.

Reaction of the Banking AgenciesUpon issuance of FASB’s proposals, the federal banking agencies issued a statement, saying: “The Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision are evaluating the potential impact that these proposals could have on banking organizations' financial statements, regulatory capital, and other regulatory requirements. The agencies expect to engage in discussions with banks, savings associations, and bank holding companies to review and understand fully the implications of the proposed amendments.”
In other words, banks and other financial institutions could find their balance sheets ballooning when FASB’s proposals become finalized, thereby potentially threatening their compliance with bank and other regulatory capital requirements as currently established. The capital shortfall could occur, e.g., if those institutions are required (as proposed) to return to their balance sheets billions of dollars of mortgages and other financial assets previously treated as ‘off balance sheet’ under the original rules for FAS 140 and FIN 46R, including but not limited to use of QSPEs, a concept that is being ‘removed’ from the accounting literature. It remains to be seen if the regulatory agencies will adjust their capital requirements in light of changes to the accounting standards, if some kind of transitional capital requirements will be put in place for some period of time, or if any other particular action would be taken by the regulators.

Links to Proposals, Effective Date(s); Reference to Earlier SEC Guidance

Proposed Statement of Financial Accounting Standards: Accounting for Transfers of Financial Assets – an amendment of FAS 140 [Revision of Exposure Draft issued Aug. 11, 2005]
Effective date and transition: “This proposed Statement would be effective as of the beginning of a reporting entity’s first fiscal year that begins after November 15, 2009. Earlier application would be prohibited. Additionally, on the effective date, the concept of a qualifying SPE would no longer be relevant for accounting purposes. Therefore, formerly qualifying SPEs (as defined under previous accounting standards) would be evaluated for consolidation by all reporting entities on the effective date in accordance with the applicable consolidation guidance. If the evaluation results in consolidation, the reporting entity would apply the transition guidance provided in the pronouncement that requires consolidation.”

Proposed Statement of Financial Accounting Standards - Amendments to FASB Interpretation No. 46(R) [Consolidation of Variable Interest Entities].
Effective date and transition: “This proposed Statement would be effective as of the beginning of each reporting entity’s first fiscal year that begins after November 15, 2009. Earlier application would be prohibited. If an enterprise is required to consolidate an entity upon the implementation of this proposed Statement, the enterprise would recognize and measure all assets and liabilities pursuant to paragraphs 18–21 of Interpretation 46(R) as of the date the requirements of this proposed Statement would be applicable, except that any amounts that were ordinarily recognized as goodwill or a gain or loss would be recognized as a cumulative effect adjustment to retained earnings.”

Proposed FSP FAS 140-e and FIN 46(R)-e, Disclosures about Transfers of Financial Assets and Interests in Variable Interest Entities . Scope: this proposed FSP applies to public entities.
Effective date and transition: “This FSP shall be effective for reporting periods (interim and annual) beginning with the first reporting period that ends after the FSP is issued.” Additionally, “An entity (enterprise) is encouraged, but not required, to disclose comparative information in periods earlier than the effective date for disclosures that were not.” FASB explains the urgent need for the proposed disclosures contained in this FSP to be provided as soon as practicable, “given the current market environment.” They concluded an early effective date is practicable “because many of the proposed disclosures required by this FSP are similar to those the SEC’s Division of Corporation Finance suggested public entities (enterprises) consider in its December 2007 Sample Letter Sent to Public Companies That Have Identified Investments in Structured Investment Vehicles, Conduits or Collateralized Debt Obligations (Offbalance Sheet Entities). However, this proposed FSP would require certain of those disclosures to be applied more broadly to public entities (enterprises) not subject to the SEC letter. It also would require additional disclosures not included in that letter.”

Will Proposed Changes to FAS 140, FIN 46R Impact Appetite to Modify Mortgages?
An interesting question now that the proposed changes to FAS 140 and FIN 46R are out, is whether they will encourage, discourage, or have no effect on the desire of financial institutions and servicers of their loans to modify the terms of mortgages for those at risk of default, particularly subprime mortgages. I will add links to related commentary on this point or feel free to post such links in comments.

FAS 157 and Lehman?
We (and many others) reported earlier today on the major changes taking place in the markets preceding and following today’s announcements of Lehman Brothers declaring bankruptcy, Merrill Lynch being bought by Bank of America, and AIG reportedly seeking a cash infusion. (This afternoon, the NYT reported: “New York State Throws Big Insurer [AIG] a Lifeline.”)

CNBC posted a Guest Blog today (Sept. 15) “Bowyer: Debunking Laissez Faire Lehman,” by Jerry Bowyer, Chief Economist, Benchmark Financial Network, (who began his career with Arthur Andersen). He criticizes earlier remarks of Governor (and former Senator and Goldman Sachs Chair) Jon Corzine, who, according to Bowyer, “blamed the current crises in the market on what he called the "laissez faire" mood of regulation which we have seen "over the past decade.”

Bowyer does not believe the last decade has been ‘laissez faire,” and has some strong words about post-Sarbox regulation, adding: “It’s not just Sarbox, and Spitzer; it’s stuff like FASB 157, which forces firms to "mark to market" even when the market has collapsed.” He continues, “Under political pressure the financial accounting system now takes localized panic pricing and imposes it on the whole system. These companies built their balance sheets over many decades under what were then the Generally Accepted Accounting Principles. Did we think that changing those rules in a flurry of legislative retribution would not have tremendously disruptive effects on those balance sheets? Did our legislators think about the effects at all? Apparently not.”

Clearly Bowyer has some fairly strongly held views; a more moderate take may be, as some have suggested, that the timing of the effective date of FAS 157, requiring a new methodology for Fair Value Measurement to be done with emphasis on a ‘market participants’ model, was one element that, when combined with the subprime crisis and suddenly illiquid markets, appears to have been caught up in a ‘perfect storm’ of sorts. And, economic downturns of historic proportions cannot always be anticipated in advance. However, urged to action by the Presidents Working Group, the Financial Stability Forum, the IMF and others, FASB, the IASB and the SEC have tried to reach out through various roundtables, working groups, and other forums gather feedback on the issue of valuation, as well as issues relating to securitization, consolidation and off-balance sheet entities addressed in the EDs issued today.

And, as we previously reported, at the conclusion of an SEC roundtable on fair value reporting earlier this summer, (July 9) SEC Chairman Christopher Cox stated: “The Commission and staff will meet with FASB and PCAOB to consider next steps, making certain Fair Value accounting truly serves the interest of investors and all users of financial statements.” More recently, we told you that FASB plans to hold a webcast on Application of FAS 157, Fair Value Measurement, on Sept. 29 at 11am EDT. If you received this blog post from ‘a friend’ and you’d like to get our blog by email, enter your email address here.