Thursday, March 5, 2009

Homeland Security Hearing On Market Meltdown: Now, We’re Talkin’ Systemic; Mark-to-Market Hearing Announced By House Financial Services

Not only are the House Financial Services Committee and Senate Banking Committee holding hearings on the market meltdown and regulators’ response, the Senate’s Homeland Security and Governmental Affairs Committee (HSGAC) got into the act yesterday with its hearing on: Where Were the Watchdogs? Systemic Risk and the Breakdown of Financial Governance.

As explained in opening remarks by HSGAC Chair Sen. Joseph Lieberman (ID-CT), “We are undertaking this series of hearings pursuant to the Committee’s traditional ‘Governmental Affairs’ mission.”

However, the interest of the Homeland Affairs side of the committee also seemed apropos, given the testimony of Dr. Robert (Bob) Litan who compared the economic downturn to an ‘economic nuclear meltdown.’ Litan is vice president for Research and Policy at the Ewing Marion Kauffman Foundation and is a senior fellow in Economic Studies at the Brookings Institution.

Others testifying at the hearing were Robert (Bob) Pozen, Chairman of MFS Investment Management (and chair of the SEC Advisory Committee on Improvements to Financial Reporting or CIFiR, which delivered its report last year), and Damon Silvers, Associate General Counsel of the AFL-CIO and Deputy Chair of the Congressional Oversight Panel (COP). COP was established by Congress as part of the Emergency Economic Stabilization Act of 2008 to oversee the Troubled Asset Relief Program (TARP).

Hat tip to BNA’s Richard Hill for reporting on the hearing. In his article, Collins Endorses Idea of Council Of Regulators to Monitor Financial Risk, BNA’s Hill reported:
  • “Sen. Susan Collins (R-Maine) … [said] that a systemic risk regulator is needed for the financial services industry, and that it should be a council comprised of the heads of the nation's financial regulatory agencies.”
  • “Pozen advocated that one federal agency should be the systemic regulator, and he identified the Fed as that entity…. [and] in the best position to take on the challenge because it already has the job of bailing out financial institutions whose collapse would pose the greatest risk to the system as a whole. At the same time, he said, the [Federal Reserve] [B]oard should work closely with other financial regulatory agencies, including the Securities and Exchange Commission and the Commodity Futures Trading Commission—or the resulting entity should they be combined… he recommended that the Fed focus on five key areas: inflated real estate prices, highly leveraged institutions, new products that fall into regulatory “gaps,” rapid growth in any asset class, and mismatches of assets and liability. Pozen also urged that the Fed not become the primary regulator of hedge funds and other non-banking institutions."
  • “Litan said he envisioned two agencies overseeing the nation's financial industry—one focusing on solvency, the other in consumer protection, with the solvency group also monitoring systemic risk. Barring that, he also would give the systemic risk oversight to the Fed. Both options, he counseled, are better than creating a new agency just for systemic risk or running it through a ‘collage’ of existing regulators, as Collins advocated…. He likened the tumult begun last year to an economic nuclear meltdown and said that he ‘cannot be fully confident’ that the fixes he was recommending ‘will be ideal and immutable.’”
  • “Silvers endorsed the idea of a body made up of key regulators. However, he also referred to a 2008 report from the … Congressional Oversight Panel that said the systemic regulator could be either a new body, an existing agency, or a group of existing agencies. He emphasized, though, that he was testifying on his and the union's behalf, and not that of the panel…. He said that of all the alternative approaches, a commission of current regulators would work best because it would have breadth of expertise as well as built-in intra-governmental cooperation. Silvers rejected suggestions that the Fed have the key role.”
A ‘council’ approach to forming a regulatory umbrella, as referenced by Sen. Collins, sounds similar in theme to the U.K.’s Financial Services Authority or FSA.

The FSA model was referenced indirectly as one of many regulatory models available in a Dec. 2008 speech by FASB Chairman Robert Herz. On pg 24 of Herz' Dec. 08 remarks, he noted, “Some point to systems, such as the UK, where there is a single financial capital markets regulator.”

Mark-to-Market Hearing Confirmed for March 12; Rep. Gerlach May Propose Legislation to Suspend MTM and Call for GAO Study
What had been rumored on Reuters a couple days ago is now confirmed: Late this afternoon, the House Financial Services Committee posted a link to an upcoming March 12 hearing on: Mark-to-Market Accounting: Practices and Implications. The hearing will be conducted by the Capital Markets Subcommittee, chaired by Rep. Paul Kanjorski (D-PA). Kanjorski’s subcommittee held a hearing this morning on Perspectives on Systemic Risk.

Rep. Jim Gerlach (R-PA), a member of the House Financial Services Committee, sent a letter to Treasury Secretary Tim Geithner and National Economic Council Director Larry Summers on Feb. 12, (see Gerlach letter to Geithner, Summers) with the text of a bill that Gerlach said he may propose, which would:
· Suspend mark-to-market accounting for two years, and
· Require a GAO study of mark-to-market accounting.

The blogsophere (and twittersphere?), like much of the rest of the world, is full of speculation on fair value (mark-to-market) accounting. See, e.g. Bill Sheridan’s discussion in the Maryland Association of CPA’s CPA Success Blog earlier today.

I’ve observed that people seem to be lining up on two sides of this issue. However, the complicating factor is that the two sides don’t line up neatly, or rather, aren’t exactly as opposed to one another as some may think. That is, many folks are what I’d call ‘pro fair value’ – i.e. when asked if they’d like to know what the ‘fair value’ of an asset is, their gut reaction is ‘yes.’ These people tend to be ‘pro mark-to-market’ at a basic level, since many belief that ‘market value’ equates to ‘fair value,’ and that is underlying premise of FAS 157, Fair Value Measurement. Additionally, this group of people will defend ‘transparency’ to the death, and often believe that ‘fair value’ = ‘market value’ = ‘transparency.’ In and of itself, transparency is generally a good thing (except, perhaps, when it unduly discloses competitive secrets or threatens attorney-client privilege, the latter subject of which is being taken up at a FASB roundtable tomorrow on disclosure of loss contingencies.)

But, is the pursuit of ‘transparency’ being used by some as a crutch to say, leave the fundamental tenets of FAS 157 as they are, and report everything at ‘market value’ when a ‘fair value’ is called for? I think it’s important to avoid getting caught up in emotional words like ‘transparency’ -when reasonable people may differ on what is truly 'transparent' - and look at FAS 157 more clinically. To keep things simple, let’s say we all want ‘transparency.’ The crucial question then is, are ‘market values’ or ‘fair values’ as computed under FAS 157- particularly in inactive markets - ‘transparent’? To answer that question, one has to really understand how those ‘market values’ are computed in accordance with FAS 157.

One thing that concerns me about the chatter out there when people criticize ‘mark to model’- or what is referred to as a ‘level 3’ estimate of fair value in inactive markets (FAS 157 identifies three levels, with level 1 being market quotes on identical assets, level 2 market quotes on similar assets, and level 3 assets not actively traded, requiring other pricing methodologies). Some of the level 2 or level 3 values computed by models like discounted cash flow – are, to me, no more ‘mark to model’ than a ‘mark to market’ performed in accordance with FAS 157, which expressly requires an exercise of determining a ‘hypothetical’ market value when there is not an actual (or are very few) market quotes.

Is a hypothetical amount paid by a ‘marketplace participant’ in an inactive, dysfunctional market (which equates in essence to a market value under FAS 157) more transparent than a discounted cash flow valuation? In sum, I think the common perception that ‘market values’ = ‘fair value’ = ‘transparency’ – even in dysfunctional, frozen markets, is where practical education needs to take place, and maybe people could then work together in pursuit of common goals like meaningful financial reporting and getting the economy back on its feet (whether you believe the two are mutually exclusive (putting you in the ‘neutrality’ camp) or symbiotic (putting you in the ‘procyclicality’ camp.)

For example, one thing that is not commonly pointed out is that Congress asked the SEC (in Section 133 of the Emergency Economic Stabilization Act of 2008) to specifically answer the question: Should FAS 157 be modified? The SEC’s report to Congress on mark-to-market accounting, published on Dec. 30, 2008, concluded that FAS 157 should not be suspended, and recommended ‘application guidance’ be considered by FASB, but did not (to my reading, anyway) provide a definitive view as to whether FAS 157 should or should not be ‘modified.’ The rubber will meet the road in FASB’s recently announced project to develop ‘application guidance’ on FAS 157 if the effort to provide guidance runs up against the fundamental ‘marketplace participants’ – ‘exit value’ model which underlies FAS 157.

Some, like FEI’s Committee on Corporate Reporting, in a joint letter with the U.S. Chamber of Commerce’s Center for Capital Market Competitiveness sent to FASB on Nov. 25, 2008, called upon FASB to take stronger measures than simply providing ‘application guidance’ – but rather to conduct a reexamination of FAS 157 in light of lessons learned in the credit crisis. (See FEI CCR-US Chamber CCMC Nov. 25, 2008 letter) Note: The U.S. Chamber's 3rd Annual Capital Markets Summit is slated for next Wednesday, March 11.

I’ve been wondering what former SEC Commissioner Joe Grundfest would say – given that he was one of the few who identified early on some very specific words in PCAOB Auditing Standard 2 as triggering a great deal of the difficulty in implementing that standard – specifically, the words ‘more than remote’ with respect to defining what a significant deficiency in internal control was, and in turn what constituted a material weakness – as far as whether the words ‘marketplace participants’ and 'exit value' could be to FAS 157 what ‘more than remote’ was to AS2. This gets at the heart of the issue of whether there is a need for more than just ‘application guidance’ on fair value. Application guidance may be viewed by some as something you need to help preparers and auditors ‘get it right’ in implementing a standard (whether an accounting or auditing standard, i.e. similar to SEC or PCAOB Staff Q&As provided to assist in implementing an existing standard). In contrast, some may ask whether there is a need for a more fundamental modification of the terminology used in the underlying standard (e.g., FAS 157, or in the comparative case, AS2, which was ultimately superceded by AS5).

I think if people can get past the ‘suspend/don’t suspend’ rhetoric and consider whether ‘application guidance' - or perhaps what some may view as a stronger term - ‘modifications’ of FAS 157 are called for, there may be a heightened likelihood of making progress while still aiming for ‘transparency’ and usefulness. (If you are a new visitor to this blog, you may want to see our Feb. 24 post on User Views on Fair Value, which links to interviews of analysts Vinny Catalano and Randy Schostag. More recently, Catalano posted a podcast interview of FASB Board Member Mark Siegel, in his blog, Vinny Catalano-Musing on the Markets; the interview is part of Catalano’s Beyond the Sound Bite series.)

More Hearings on Regulatory Reform Confirmed by Frank, Dodd
Additionally, at a press conference earlier today, House Financial Services Committee Chair Barney Frank announced (see press release): “[T]he committee will continue its work on financial reform that started in 2007, the first year of the Democratic majority, both in legislation and through committee oversight. Hearings in March will focus on regulatory restructuring and the role of law enforcement in the current financial crisis and whether law enforcement agencies have the tools to pursue fraud and prosecute individuals. Also in March, the committee will move legislation to the House floor that will curtail abusive mortgage lending practices and reform credit card and overdraft practices that are harmful to consumers.” Dates of various committee hearings are outlined in the press release.

Separately, the Senate Banking Committee, chaired by Sen. Chris Dodd (D-CT) has announced a hearing will take place on March 10 on Investor Protection and Regulation of the Securities Markets.

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gene said...

As always, a very nice summary. Since my firm is going through a very painful audit at this moment, I can state with certainty that the Big 4 are insisting on marking to last price. And, no matter how strong one's balance sheet is, an extremely hypothetical determination of the discount rate for those models you describe.

Worse, under their "market participants" logic, Berkshire Hathaway and Microsoft have largely the same cost of capital as General Motors. Since they were asleep at Enron, Fannie Mae and MCI, they have become hyper-conservative.
Given that the CPA firms have become the official arbiters of cost of capital, market participants, etc., one can only hope for a suspension of MTM until some practical points of view have time to emerge.

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