Wednesday, September 24, 2008

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.

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