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

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