Saturday, February 7, 2009

Suspend Disbelief: How Fair Value Accounting Could Be Modified For Geithner's Plan

[UPDATE Sun. night Feb. 8, 7pm: U.S. Treasury Secretary Tim Geithner will present a speech outlining a new comprehensive financial stability plan on Tuesday, Feb. 10 - pushed back from the original date announced by the Treasury Department of Mon Feb. 9 - as noted by Assistant to the President for Economic Policy Larry Summers on ABC News earlier today. As described in Bailout Announcement Pushed Back to Tuesday on "With Congress wrangling over the details of the $800 billion-plus stimulus package, the Treasury Department said on Sunday that it would cede the political stage to those negotiations and delay until Tuesday the rollout of the Obama administration’s multibillion dollar plan to assist the nation’s troubled banking system." Geithner is also scheduled to testify before the Senate Banking Committee and the Senate Budget Committee this week, according to the U.S. Treasury Department's Public Engagement Schedule released on Friday.]

Citing a “well-informed source,” Albert Bozzo of CNBC reported Friday night that Geithner’s financial stability plan “will include an aid package for the banking industry.”

Plan Expected to Include Ring Fence, Bad Bank
CNBC’s Bozzo further explains in Treasury’s Geithner to Unveil Financial Plan Monday [as noted in the UPDATE above, now scheduled for Tuesday] that:

  • the banking component of the rescue plan will be "smaller" than originally expected
  • the plan will include some "bad bank" component [i.e. in which the government purchases ‘toxic assets’ such as mortgage-backed securities from banks, leaving them – the good banks - with less risky assets, and placing the toxic assets in a separate entity or ‘bad bank’], and
  • the plan will be centered around government guarantees and insurance of troubled assets—what's called a "ring fence" concept.
Bozzo further reports that while there is general agreement around the ring fence concept, there is less agreement on the bad bank, adding, “Other sources told CNBC that the ‘bad bank’ would be able to buy up to $500 billion in troubled assets from financial institutions.”

Why Fair Value (Mark-to-Market) Accounting Could Impact Bailout
“At this point, the Obama administration appears to have settled on the most controversial aspect of the bad bank: pricing the toxic debt,” reports CNBC’s Bozzo. He explains in broad terms how the pricing mechanism is expected to work, and the fact that accounting rules may be modified to retain the desired benefit of setting up the bad bank without triggering unintended consequences.

Citing once again his unnamed source, CNBC's Bozzo states:

  • The government will buy toxic assets below the banks' ‘carrying value,’ which is basically market value, but not at fire-sale levels, the source said, representing something of a compromise.
  • Such a pricing approach will likely placate both taxpayer and Congressional concerns about the government overpaying for the assets.
  • But, the source noted, it could ‘trigger an accounting problem for the banks,’ presumably because the institutions will have to report a loss on the transactions.
  • The Obama administration is now working on ideas to address that, which might entail a temporary suspension of certain accounting rules. It is unclear what that might be, said the source.
Regarding Bozzo’s reference above to how the government’s purchase of toxic assets at a price below carrying or ‘book’ value could ‘trigger an accounting problem for the banks’ – to clarify, I don’t think the issue is so much about whether a particular bank selling a particular portfolio of assets into the bad bank would have to recognize a loss on the sale of those particular assets (although I could be wrong, and I welcome those with other views on this or other issues to post a comment on this blog). Although those losses will likely be huge, there would presumably be an offsetting gain in confidence – by investors and depositors - in the strength and stability of the remaining ‘good bank’.

I do, however, believe there is a significant issue to be addressed with respect to the application of FASB Statement No. 157, Fair Value Measurement, on the remaining portfolio of similar assets in the particular banks that transact with the government as part of the bad bank plan, and more broadly, on all other entities holding similar assets. That is because FAS 157 requires a ‘market participants’ or ‘exit value’ approach to valuing assets that are required by U.S. Generally Accepted Accounting Principles (U.S. GAAP) to be recorded at ‘fair value.’ [Note: FAS 157 does not specify which assets or liabilities must be recorded at fair value - it only specifies how to determine fair value - other accounting standards issued before or after FAS 157 set forth the measurement basis (e.g. historical cost, lower of cost or market, or fair value) for particular types of assets, liabilities, transactions or events.]

FAS 157 not only requires entities to look to current market transactions as being indicators of fair value, it requires entities to consider the price that would be obtained in a hypothetical transaction in current markets, when there is a dearth of actual transactions. The requirement to look to a current or hypothetical market price – as applied even in the current illiquid markets – has been the central criticism of FAS 157 for over a year.

Published in September 2006, roughly a year ahead of the market downturn, FAS 157 became effective in fiscal years beginning after November 15, 2007, just as the subprime crisis and its broader effects on the housing, credit, and stock markets accelerated. This point about when FAS 157 was issued vis-à-vis the then-unforseen financial crisis which arose, some say, from a perfect storm of black swan or unlikely events, is extremely significant in why I, for one, believe that some modification of FAS 157 may not be that outlandish of an idea.

But, its not just because of unforeseen events that I have this view - i.e. I do not believe accounting standards are made for when the sun shines, only to be abandoned in a storm; no, my belief is also due in significant part to the very wording underpinning FAS 157, which you can find by reading the 3 page Summary at the beginning of FAS 157, right below the subheading “Differences Between This Statement and Current Practice” which says:

  • The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.

The key term, ‘orderly transaction,’ is defined in para. 7 of FAS 157 as follows:

  • An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).
'Forced' or 'distressed' transactions are addressed in para. 17 of FAS 157 as follows:

  • [A] transaction price might not represent the fair value of an asset or liability at initial recognition if… [t]he transaction occurs under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.

Now, take a look at the Timeline-Financial Crisis, to put the timing of issuance of FAS 157 into perspective.

And that brings us to today: New U.S. Plan to Help Banks Sell Bad Assets (NYT, Feb. 7, 2009); Treasury Plans More Expansive Approach to Financial Rescue (WSJ, Feb. 7, 2009); and the article we opened with: Treasury’s Geithner to Unveil Financial Plan Monday (CNBC Feb. 6, 2009).

The role of accounting – fair value accounting specifically (also called mark-to-market, although there are some technical differences between the two terms, the level of similarity is such that the terms are used interchangeably by the general public) – may be key to the success of the bailout; however, a number of articles in the past couple of days have reported conflicting views on whether any action will be taken to ‘suspend’ fair value accounting. See, e.g. the first report circulating on Thursday afternoon Feb. 5, Wall St. Jumps on Bank Accounting Talk (Reuters, via, Feb. 5, 2009), and a later report circulating Thursday night, SEC, Treasury Not Discussing Suspending Fair Value (Reuters, Feb. 5, 2009) which appeared to refute the earlier report. However, maybe too much emphasis is being placed on the lightning rod word of ‘suspend[ing]” fair value. I think any suspension of fair value is DOA. But, there may be room for some ‘modification’ of fair value. If you read the words attributed to Senator Chris Dodd, Chair of the Senate Banking Committee, as quoted in the articles, he was talking about a ‘modification,’ not a ‘suspension,’ so don’t let the inflaming term ‘suspension’ used in some headlines get the better of you in trying to understand what may lie ahead.

The second article cited in the paragraph above said:

  • Key policymakers have suggested that the rule could be amended. Sen Christopher Dodd, the Democratic chairman of the Senate Banking Committee, said it might be possible to modify fair value accounting rules for banks facing steep write-downs of troubled assets without abandoning the underlying accounting standard. Dodd told reporters on Wednesday evening that at least one former bank regulator was discussing how to approach the difficult issue without "walking away from" fair value (also called mark-to-market) standards.

[Hmm… could the unnamed ‘former bank regulator’ referenced in the Reuters article cited above, said to be looking at fair value, be former Federal Reserve Board Chairman Paul Volcker? Volcker was named yesterday by President Barack Obama to head up a new Economic Advisory Board - see yesterday’s White House Press Release, Obama Announces Economic Advisory Board, and related article in today’s Washington Post, Obama Names More Economic Advisors. I closely followed Volcker’s remarks with respect to fair value, as he described in a meeting earlier this year of the Treasury Department’s Advisory Committee on the Auditing Profession (ACAP), which I cited again at the end of my blog post Thursday evening, FASB Advisory Group Calls for Further Guidance on Fair Value.]

And, Senator Dodd's counterpart chairing the House committee overseeing these issues, Rep. Barney Frank, chair of the House Financial Servces Commitee, expressed similar views to Dodd in remarks in late October, in which he said, according to Reuters (Lawmaker Urges Flexibilty in Accounting Rule, Oct. 29, 2008):

  • "We will never legislate accounting," Frank told business leaders in Boston. But "there are modifications that we are looking at" related to mark-to-market requirements.

Given all of the above, let’s suspend any notion of a full-on ‘suspension’ of fair value, but let’s cut to the chase: if the government (i.e., Treasury or the SEC) or the private sector (i.e. FASB) were to modify fair value accounting to facilitate the aims of any potential Treasury plan which could include, as part of the plan, the movement of toxic assets into a bad bank, through the government purchasing those assets from banks at something lower than the banks carrying value (book value) but higher than a ‘fire sale’ price as described in yesterday’s CNBC article cited above - how could such a plan be accomplished, given that FAS 157 as currently written would require – in the eyes of some – use of any purchase price of those billions of dollars of bad assets by the government as a ‘market price’ for purposes of valuing similar assets left in the good bank or held at other banks, which could potentially cause a downward spiral of writeoffs, thereby potentially negating the intended effect of the good bank/bad bank program?

As noted in my summary of Thursday’s FASB Valuation Resource Group (VRG) meeting (FASB Advisory Group Calls for Further Guidance on Fair Value), even after the SEC and FASB issued guidance last fall on fair value in illiquid markets, experts on the VRG have reached a consensus that there is still undue pressure explicit or implicit in applying the words written in FAS 157 to use actual market transaction prices, even in inactive markets, since they establish third party, hard ‘evidence’ of what a ‘market participant’ would pay for an asset. These actual market prices are referred to as ‘level 1’ inputs, which are the favored pricing mechanism when available according to FAS 157 - i.e., direct, observable market inputs. If level 1 inputs are not available, one has to move down the FAS 157 hierarchy to ‘level 2’ or ‘level 3’ inputs and classifications – i.e. valuation methodologies which rely more on modified extrapolations of observable prices for similar assets, or modeling methods when market prices for similar assets are not observable, e.g. in thin or illiquid markets.

How Fair Value Accounting Could Be Modified

Based on the language in FAS 157 itself, (see paragraphs we cited further above from FAS 157) particularly how it defines key terms like ‘orderly transaction’… ‘usual and customary’… ‘not… forced .. or … distressed,’ I believe that some may say that the exceptional market conditions alone may be reason enough to look for something beyond business-as-usual in applying FAS 157 such that it may in fact not apply; i.e. that the current market conditions may be viewed as not matching up with the conceptual underpinnings of FAS 157 in general. However, even if that belief is viewed as a fair weather yes/stormy weather no view; there is also the fact that, as stated by some FASB VRG members earlier this week, the wording in FAS 157 does not seem to provide sufficient flexibility to move off using actual market transaction prices, even in distressed markets. And, if the government were to buy some large amount of toxic assets, that would put an ‘actual market transaction’ price out there, which is the central point of concern for some, in potentially causing downward procyclical effects if the price paid for those toxic assets were extrapolated across remaining portfolios of selling banks, and of other banks, as some believe FAS 157 would require.

Couple that with the fact that any purchase of $500 billion or some similarly scaled amount of toxic assets by the government is an extraordinary event which in and of itself, I believe, could warrant a modification of the FAS 157 for this exceptional situation.

Here are some illustrations of some potential actions we may see --based on some historical actions taken in similar situations: the SEC staff and FASB staff could issue a letter to the U.S. Treasury Department (or could simply issue a press release or an SEC Staff Accounting Bulletin (SAB) or FASB Staff Position (FSP) saying they ‘would not object’ to banks excluding from fair value determinations - the price paid by the U.S. government for toxic assets as part of the bad bank program - for purposes of valuing the remainder of the portfolio of similar assets by those banks selling into the bad bank (via Treasury or directly) or for other banks with similar assets. Or, FASB or the SEC could issue a more formal staff document. Here are some examples of how this could be accomplished:

Some may be of the view that the strongest of the three possible actions above - in terms of standing up to second guessing by auditors, regulators, the plaintiff’s bar or others, may be for FASB to issue an FSP (following their due process, with a proposed FSP first) - that way the modified treatment would be embedded in U.S. GAAP itself.

Such an FSP could modify FAS 157 for the extraordinary circumstance not only of the current economic crisis vis-à-vis the language regarding ‘orderly’ transactions and ‘distressed markets’ but moreover to establish that a $500 billion (or some similar amount, on the order of billions - the precise dollar amount does not need to be cited in the SEC/FASB guidance so as not to draw a bright line threshold) purchase of toxic assets by the U.S. Government under a special bailout plan is an exceptional circumstance which does not need to be referenced as a ‘market value’ for purposes of applying FAS 157 to similar assets retained by banks selling into the bad bank, or which remain in the portfolios of other banks.

The above 3 possibilities are hypothetical examples of how a 'modification' of FAS 157 could be structured by the regulators or FASB, if they were going to contemplate any such modification relating specifically to the bad bank. Other modifications may result from separate contemplation by FASB (and by the parallel international standard setting body, the IASB) based on, e.g. the recommendations made by FASB's Valuation Resource Group at its meeting last week.

As a reminder, the content of this blog represents my own personal views (unless I am specifically citing a comment letter or other document issued by FEI); I direct you to the Disclaimer box in the right margin of this blog above the Blogroll; and I invite those with other views to share them by posting a comment.


Update Sunday 2.8.09: I wanted to clarify, and thank a commenter for asking about this, that I am not saying potential modifications or improvements to FAS 157 may only be considered with respect to the specific issue of the bad bank. Although this post focuses on the bad bank issue, I would note there have been calls for improvements to be considered to FAS 157 separate and apart from the bad bank issue, including in the SEC's report to Congress on mark to market accounting issued on Dec. 30, 2008. Additionally, to be more precise on the results of the FASB VRG meeting noted above, they reached a consensus that FASB should issue further guidance on FAS 157 with respect to fair value in inactive or distressed markets; this was a general recommendation, not with respect to any particular transaction or event like the anticipated bad bank. Similarly, as noted in the Timeline-Financial Crisis linked above, FEI's Committee on Corporate Reporting (CCR) and the U.S. Chamber of Commerce's Center for Capital Market Competitiveness (CCMC) filed a comment letter with FASB on Nov.25, 2008. The FEI-U.S.Chamber letter made a formal request under FASB’s Rules of Procedure for FASB to reconsider some aspects of FAS 157 in light of information learned about application of the standard during the credit crisis.

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Anonymous said...

I don't understand why the accounting rules are to blame. The accounting is what it is. Instead of changing the fair value accounting rules, why don't the banking regulators simply change the bank capital requirements to reflect the "bad bank transaction loss" and ease the capital requirements.

Edith Orenstein said...

Thank for your comment! I understand your point about bank regulators potentially adjusting the effect of 'bad bank transaction losses' in terms of meeting capital requirements; what about whether the 'bad bank' transaction price paid by Treasury for the toxic assets as far as whether that should become the refrence point for all other financial institutions (or nonfinancial institutions) holding similar assets (in terms of marking-to-market)?

Randy Schostag said...

I have been following your blog and and have generally been in agreement. That changed today. The discussion about FASB 157 has been ignited by the financial melt down last fall, but the issues do not pertain only to bank loans. I would have hoped that by now there would be a consensus that the heavy focus on mark-to-market obscures the real problem with using these values: it fails to consider inefficient market pricing, most especially for those which are thinly traded. There is an established body of knowledge from certifying appraisal organizations and from courts of law which have developed recognized methods and procedures for doing valuations and which use not only the mark-to-market method, called the market approach, but also the income approach and the asset-based approach to obtain values. If this three-legged stool, this broad perspective is not used in az valuation report, a court may easily throw out the conclusion. That is because after using other approaches, the appraiser must 'reconcile' the values to ascertain why there may be differences in the findings. The SEC, FASB, and the AICPA fail to require and, in fact, discourage this kind of cross checking under SFAS 157. Thus, the standard fails to use the body of knowledge which has been developed in practice over the past 25 years.

Edith Orenstein said...

Thank you very much for your very informative comment comparing FAS 157's requirements to standard valuation methodologies used by certified appraisal professionals and those required by the courts.

[I note for our readers that Randy holds many valation credentials, includng CFA and more, as shown in his bio on his firm website, Minnesota Business Valuation Group ]

I understand your area of 'disagreement' with my post was on whether I was suggesting that any modification of FAS 157 should be limited to the bad bank matter; I didn't mean to imply that, I added an Update at the end of the post to clarify; I appreciate your pointing that out to me.

Randy Schostag said...

Thank you for the clarification as well as your added post reply, Edith. For the record, Ms. Orenstein replied almost immediately after I posted, and we exchanged several emails to ensure we were 'communicating'. As an analyst, I really respect that, viz., getting it right. As I already noted, I read Edith's blog regularly; she keeps me up on what's going on, and I appreciate that kind of due diligence.

Randy Schostag

Gene said...

Ms. Orenstein: excellent summary of how we got to this point.

It remains shocking to me how the FAS eschews any responsibility for the crushing markdowns of assets. Talk to any banker and you will learn of billions of dollars of loans that are being paid on time, but signficantly reserved due to MTM accounting.

Any change now would be seen as a retreat from real valuation rather than an improvement in accounting valuation.

In my personal portfolio are some bonds trading below par, but the issuer continues to pay me interest right on time. I don't feel any poorer and plan to hold to maturity.

Anonymous said...

You might find the commentary by Lloyd Blankfein (CEO of Goldman Sachs)in today's FT interesting.

Edith Orenstein said...

Thank you for pointing out the OpEd in today's FT by Lloyd Blankfein, CEO of Goldman Sachs, Do Not Destroy the Essential Catalyst of Risk (, in which he discusses seven lessons learned from the financial crisis, including as he states:

"Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures."

For a counterpoint from a former Goldman Sachs executive, Robert Rubin, see Robert Rubin Says Mark-to-Market Has Done Damage ( ) published in Bloomberg Jan. 29, which quotes Rubin saying:

"I spent my whole life at Goldman Sachs believing in mark- to-market accounting, and having said that, if you look at the experience from the last two years, I think mark-to-market accounting has led to terrible vicious cycles in asset prices.”

Then, for a counter - counterpoint, see David Reilly's Commentary published in Bloomberg Jan. 30: Bob Rubin Wants Your Kids To Pay For Banking Mess ( ) in which Reilly - who moved from the WSJ to Bloomberg at the beginning of this year - states:

"Using market prices makes it more likely that we, and the banks, will have to face immediate pain. Ignoring market prices means we pass the tab to future generations. Not surprisingly, plenty of people -- now-retiring baby boomers, bank shareholders and executives -- prefer that someone else feels the pain.
For that to happen, these pay-later folks need to insist losses aren’t as big or as bad as mark-to-market makes them out to be. The problem is, markets disagree. So executives such as Robert Rubin attack the practice of using market prices."

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