Global equity markets lurch in waves of volatility. Banks are loathe to lend, withholding the lubricant that makes economies function. At the epicenter of the storm, an arcane concept known as "fair value" accounting is spurring a heated debate.
The principles of fair value--also known as "mark-to-market"--accounting are described in the Statement of Financial Accounting Standards (SFAS) No. 157, which was adopted by FASB in 2006 for use after Nov. 15, 2007. Fair value measurements rely on exchange prices between market participants in orderly transactions. The system replaces historical cost accounting, which had been standard since 1938. The previous version required preparers to book assets at their original cost, and to mark them down where they deemed a permanent impairment--but never to mark them up.
When SFAS No. 157 was first adopted--about a year before the meltdown--it was considered relatively uncontroversial. A year later, battle lines are drawn. Lawmakers, regulators and the financial sector blame fair value rules for the destruction of banks' balance sheets, while opposing forces maintain that marking to market helps protect investors by reflecting economic conditions, harsh as they may be. After all, the overarching purpose of accounting is to provide useful information that is reliable and relevant to decision makers. "Events and activities must be captured when and as they happen, and not deferred or smoothed over or modified to present a picture that misleads or distorts," says Patrick Finnegan, director, Financial Reporting Policy Group at the CFA Institute.
Across the fence, William Isaac, chairman of the FDIC from 1981 to 1985, has been a vocal champion for returning to historical cost. "We had a perfectly good working system before they decided to impose this grand experiment," he insists. He cites a suite of correspondence in the early 1990s from Alan Greenspan, then-Secretary of the Treasury Nicholas Brady, and Bill Taylor, chairman of the FDIC, all expressing alarm that market value accounting could lead to misleading and volatile bank earnings. It could even result in "more intense and frequent credit crunches, since a temporary dip in asset prices would result in immediate reductions in bank capital and an inevitable retrenchment in bank lending capacity," Brady wrote to the FASB on March 24, 1992.
Blame for the Meltdown
Sixteen years, later, as Congress was debating the $700 billion rescue/bailout last October, a group of Republicans tried to substitute a moratorium on fair value for the bailout package. Although that effort failed, part of the final bailout legislation calls for the SEC to deliver a report to Congress on Jan. 2, 2009, examining whether mark-to-market accounting did contribute to the destabilization of financial institutions. That critical report could determine the fate of fair value accounting, if lawmakers should decide to set the clock back.
Depending on the intention, there are different ways to hold financial instruments. Are they to be sold, traded or retained? Fair value does not apply to those assets held to maturity rather than in trading accounts. Suppose a bank has issued a loan to a real estate developer. Even if the development is in trouble, as long as the bank intends to hold the loan to maturity and has the ability to do so, it does not have to mark it down at all unless the asset has been impaired, showing some evidence like a missed interest payment. Corporate treasuries also frequently keep financial instruments for maturity, just as many held auction rate securities.
It makes sense that banks or insurance companies should carry loans at book, rather than market value, as long as borrowers are making interest payments. At first blush, that long established tradition might seem to dispel one thorny problem. However, as institutions packaged their loans and securitized them away from their balance sheets, the layers and distinctions between loans and securities became blurred. Finnegan takes issue with the notion that mark-to-market has been responsible for the meltdown of banks' balance sheets. "Decisions to put banks in a precarious position at the edge of a precipice was not a function of an accounting decision. Leverage and high risk investments were to blame." He would like to see fair value applied to loans as well. Using a mix of fair value and historical cost, he argues, makes financial statements more complex and difficult to interpret. The concern is that leaving loans to be marked at cost sows the potential to undermine fair value at the margin, and moves overall standards to a lower quality.
When the rules took effect last year, no one foresaw the unprecedented volatility to come. Some liquid stocks, like General Electric, have seen their share prices halved; most people would concede to an assumption that its price was fair a year ago, and is still fair today. Other securities, like the ABX index, which is composed of the longest duration, highest risk subprime issues, have been disproportionately hammered. "Hedge funds and speculators have been constantly manipulating the ABX," Isaac comments.
Still other markets have simply dried up as buyers retreated en masse, leaving no quoted prices in active trading, or else gargantuan spread prices that reflect abnormal conditions. Many of the securities being marked down now are illiquid. Distressed or forced liquidation sales are generally not orderly, whereas some securities were never intended for sale at all. "These instruments were, by nature, intended to be 'buy and hold' and never traded in a real-time, reported secondary market," explains Patrick Daugherty, chief strategy partner in the Business Law Department at Foley & Lardner. They might, for example, represent the tail end of one of several series of asset-backed or mortgage-backed securities, held by a dozen or even a few hundred investors, but not tens of thousands.
SFAS No. 157 attempts to bridge the gap by offering a model for interpolation when no bids or asks or trading data are available. The rule sets out a fair value hierarchy, distinguishing between pricing assumptions based on "observable" inputs (when markets trade) and those reliant on "unobservable inputs," gleaned from the best estimates from different sources such as credit ratings, cash flows or models that show values in an adjacent space.
Even in cases where there is just one vulture--or lowball--bid, managements can rely on some of these other metrics. Fixed income securities are at least predicated on an income flow, so if interest and principle payments remain current, it would be hard to mark them to zero. Equities present a challenging case, since their returns are, in a sense, purely hypothetical. Discounted cash flow models provide yet another approach, yet nobody can anticipate future cash flows with certainty. Consider a company like Colgate, Finnegan suggests, whose cash flows still come under pressure, "though everyone uses toothpaste." He insists that illiquidity should not be downplayed or ignored as a characteristic of an instrument that reflects economic reality. At least, include an adequate consideration of illiquidity in whatever discount rate you may select.
So is a given market regular and continuous, or is it infrequent, featuring wide spreads? Here, expertise and judgment come into play for drawing the line. In the latter case, one may use portfolio modeling; it is less justifiable for the former. Where a bid price does exist, SFAS No.157 calls for the exit price--the one used to sell--and not the entry price that is used to acquire. But suppose there are no transactions taking place, the focus on the bid price is a "mirage," says Maureen O'Hara, professor of finance at Cornell University's Johnson Graduate School of Management. She suggests using a midpoint price, as a better reflection of what the asset is worth.
Objectivity--Both fair value and historical cost accounting depend on elements of judgment, as it is impossible to banish all aspects of subjectivity. For instance, when they must examine whether any permanent impairment has taken place, preparers ask what discounted value the present cash flows represent and whether they might be interrupted. "Senior management and accountants are motivated to get it right--or they know they could be sued!" says Isaac, now chairman of The Secura Group. He accuses the mark-to-market faction of usurping the name 'fair value' as a reminder of the power of nomenclature. "They should be reported for deceptive advertising!" he laughs.
Advocates of fair value prefer to resort to the market's conclusion, in every possible case--even illiquidity. "What makes your view as a preparer superior to what the market is saying today?" Finnegan asks. If there are no transactions taking place, perhaps it is because investors take a very dim and conservative view of the ultimate value of an asset. They may believe that as soon as they buy it, the value will decline. He emphasizes, "What makes you so confident that long-term, intrinsic value will be dictated by expected cash flows discounted at some contractual rate?"
Transition--Nobody, including the architects of fair value, envisaged how fragile the banking system would become. Ron Muhlenkamp, who runs the Muhlenkamp Fund from Pittsburgh and is fairly agnostic between the valuation approaches, highlights the dangers of switching from one system to another, especially during a turbulent time. Muhlenkamp warns that, "when you change from one model to another, odd things happen." Because asset holders are still uncertain what the marks will be, they create protective cushions, effectively quarantining their capital rather than deploying it to write new business.
"If prices had been flat, or up this year, it would not matter," says Muhlenkamp, adding that the SEC changed the rules without fully thinking through the consequences. In the throes of a credit crunch, institutions are setting money aside for safety, because they have no confidence in their own marks in the new regime--let alone anyone else's.
Market Efficiency and Bubbles--Kenneth Herbert, likewise, appreciates the pros and cons of the debate. Herbert, vice president in the Business and Financial Services practice at global consultancy Frost & Sullivan, praises the transparency that marking to market provides. At the same time, he points out the inaccuracies that can result from relying on inefficient markets. You will find yourself pricing something that reflects greed on the upside and fear on the downside, he says, which may not be the best measure of value. Does noise become eliminated when markets revert to the mean? "Over time, inefficiencies become pushed out of the market, and you don't always want to be making adjustments," says Herbert.
Fair value critics contend that procyclical fair value methods exacerbate destructive trends, with the potential to amplify effects. When markets are exuberant, a bank can be marking assets to inflated prices, which might create the illusion of profits that do not exist, and then use those paper profits to build additional leverage on the balance sheet. They might parlay those phantom profits to buy back stock, distribute larger dividends or pay heftier management bonuses. In downturns, fair value methods take equal toll. Adherence lowers capital just when banks need to be building it. Financial firms begin to require ever more capital, without which they cannot grow and lend and meet capital adequacy tests. The fair value camp responds by noting that cost accounting, while it smoothes results, may engender unwarranted complacency. Sometimes managers should be taking heed and making corrective changes.
Protecting Different Interests--Bank regulators represent one constituency and investors, another. Each has its own agenda to promote, creating logical fissures. The SEC is responsible for investor protection, while the FDIC is trying to preserve the soundness of banks.
"It would not offend me to have two sets of accounting rules, since two different purposes are to be served for different agencies," Foley & Lardner's Daugherty suggests.
Very senior regulators--both past and present--are opposed to marking to market. Their stance is reasonable, considering their statutory mandate encompasses the safety and soundness of financial institutions, especially for depositors and for the government's deposit insurance. As a bank regulator, you might resist allowing assets to be speedily marked down, if that means a bank should lack capital adequacy and need to go into receivership or raise fresh capital. Regulators are charged with making assumptions around a firm's ability to continue as a going concern, on a liquidation basis.
Investors, on the other hand, demand discipline and transparency as bedrock for bolstering confidence in what has become a crisis of confidence. "Until we identify the true extent of losses, they will not believe any values that are put out," the CFA Institute's Finnegan warns. In other words, the longer accountants steer away from reporting unpleasant truths, the worse the crisis could grow. Elisa Parisi, banking and finance analyst at RGE Monitor, points to the 1992-1993 financial crisis in Sweden, where banks wrote down bad assets and "received a good review" for their handling of the situation. "Sweden used a principle of transparency to clean the system, close some institutions and recapitalize," Parisi explains. The episode contrasts starkly with the bank upheavals in Japan, which allowed its large bank debts to overhang.
Consider how a return to amortized costs, as a lagging indicator, might bring the same information to light, but in a more convoluted guise. (The old system actually required footnotes to financial statements to indicate marketplace values.) Less visible trading information would indeed be available to some, such as hedge funds and proprietary trading desks, who would dig it out and use it to their advantage, but to the detriment of the general public. Prices would fall in any event, albeit less rapidly. Thus, information traders might take advantage of noise traders.
Wealth managers and family offices might take note of a couple of points that would resonate with their own clients. Herbert points out that sellers may not be eager to face reality and are clinging to the hope that prices are artificially depressed. Fair value provides a cleaner picture, in his opinion, and a "sanity check." Herbert, who frequently advises private equity and venture capital funds, observes the gap between the market and model estimates can yawn as wide as 30% to 50%. After 2000, many investors were still extrapolating from the phenomenal and unsustainable performance of the late 90s. As an example, Herbert cites a pension plan he advises that has decided to offload their private equity exposure, rather than leave money on the table. In this climate, they believe the near-term reality is closer to the market, and that their responsibility calls for them to exit some holdings.
Nonetheless, wealth managers should not automatically assume that market prices necessarily represent fair value of assets. Now may be the time to apply some modeling of your own, to determine values in such distressed market conditions, rather than rely on the extrinsic evidence of market prices alone. It is no small challenge to determine values in highly unusual circumstances. To some degree, the answer will always be wrong, but the goal is to place it within a range of fairness.
Vanessa Drucker, who used to practice law on Wall Street, wrote the cover story, "Noise" in the October issue of Wealth Manager.