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Banks: The Fight over Fair Value

Financial firms want to suspend or change the rules concerning asset markdowns. S&P Ratings tells why that's a bad idea

From Standard & Poor's RatingsDirectThe current market disruption has triggered a chorus of complaints from many financial institutions and other market participants about the effect of fair value accounting, including an outcry to suspend or substantially modify the rules. The push to suspend and evaluate the accounting for fair-value measurements is evident in sections of the Troubled Assets Relief Program (TARP) legislation. The concerns relate primarily to accounting rules that force financial institutions to value securities at what they believe are overly depressed prices that do not reflect their true value. Further, they contend that reporting these depressed values has resulted in a loss of market confidence that has further exacerbated the current credit market disruptions.

This may seem to imply that fair-value measures should be dispensed with altogether. To the extent that fair-value accounting guidance is suspended or modified, in the absence of addressing analytical needs through greater disclosure and transparency, Standard & Poor's Ratings Services would view these changes as a significant step backward. However, we do believe the recently issued Securities & Exchange Commission and Financial Accounting Standards Board (FASB) guidance, which clarifies how companies should determine fair-value measurements in light of the current market conditions, is helpful.

We recognize that accounting for assets and liabilities at market prices can produce results that could mask the underlying economics for certain businesses and activities, especially during volatile and uncertain economic and market conditions. Yet, we believe the limitations inherent in fair-value accounting do not detract from the usefulness of fair-value measurements in providing a consistent starting point in analyzing financial statements. Rather, the imperfections underscore the need for financial statements to complement fair-value measures with additional information about uncertainties in the measurement of assets and liabilities. Thus, we recommended that certain refinements to fair-value accounting and disclosures be considered.

Fair Value: How Useful?

In the wake of the recent market stress, some market participants question whether fair value provides useful information for investment and credit decisions. Company executives contend that the performance measures produced using fair value create financial reporting that is misleading and disconnected from the reality of their business activities. They also say it creates unjustified and unexpected economic effects, including covenant and regulatory capital stress and liquidity shocks.

Further, there are bank analysts who don't agree that marking loans to market is the best way to assess loan portfolios because it presents a view of the portfolio valuations without giving effect to the expected future earnings that would help cover potential losses.

Many critics have faulted fair-value accounting for creating a spiral of declining valuations arising from forced asset sales. For many financial institutions, mark-to-market losses—coupled with the triggering of significant margin and regulatory capital calls—have forced rapid asset liquidation, exacerbating the loss of value, diminished counterparty confidence, and constrained liquidity.

Recent distressed asset sales by Lehman Brothers Holdings (LEH), Merrill Lynch (MER), and other distressed asset portfolio sellers set a precedent concerning asset valuations; the actual prices became benchmark prices for real-estate-backed assets and other asset classes. Lehman announced gross mark-to-market losses approximating $7 billion on residential and commercial mortgage-related positions immediately preceding the company's downfall. The impact of these marks on Lehman's financial results contributed to intensified efforts to offload its exposure in residential mortgages and commercial real estate loans and other less-liquid asset exposures.

Merrill Lynch sold a substantial majority of its collateralized debt obligations, incurring a $4.4 billion pretax loss (a 40% decline in its mark in a matter of weeks) in an effort to enhance the company's capital position and reduce risk exposure. The rapid and extreme portfolio devaluations that ultimately contributed to Lehman's failure and Merrill Lynch's loss of independence also became observable inputs for fair-value pricing by other financial institutions.

Also momentous was American International Group (AIG) capital raise of approximately $20 billion by the second quarter of 2008 to replace essentially all of the capital lost in the preceding two quarters because of market valuation losses and other-than-temporary impairments on mortgage-related securities. During the third quarter, however, liquidity demands increased, leading to AIG's unprecedented $85 billion secured loan facility agreement with the Federal Reserve on Sept. 16, and a subsequent securities lending agreement providing an additional $37 billion in liquidity.

The challenges faced by market participants struggling to determine representative fair values in volatile and illiquid markets, in the absence of further guidance, would have stressed any financial reporting system.

Proponents of reforming fair-value measures look to influence the U.S. Congress, the SEC, banking regulators, and accounting standard-setters, asserting fair-value accounting is faulty. They assert this is largely because of inadequate guidance and the impact of FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) on financial instrument valuations in distressed or illiquid markets. Similar calls are echoed globally.

The SEC and the FASB recently responded to this call by issuing guidance clarifying practical issues surrounding the application of SFAS 157 in determining market prices. We believe the additional guidance is helpful in clarifying the application of fair-value accounting during periods of market illiquidity. Yet, many other market participants call for the suspension of fair-value accounting altogether.

The recent SEC and FASB guidance emphasizes that fair-value measurements and the assessment of impairments are subject to significant management judgment. As a result, it reiterated the need for clear and transparent disclosures to provide investors with an understanding of the significant judgments management has made. In addition, the SEC issued letters in March and September providing further guidance and requesting enhanced disclosures surrounding fair-value measurements. The FASB has also taken steps to clarify how the fair value of a financial asset should be determined when the market for that asset is not active.

The SEC and FASB clarifications will potentially ease the greater weight placed on values derived from current market transactions for the valuation of similar or identical positions when markets are less active or distressed. Broadly, all other things being equal, we believe the effects of this guidance on financial institutions may increase GAAP [Generally Accepted Accounting Principles] equity and regulatory capital. There might also be a short-term earnings boost through a mark-up for some previously written-down assets, as values are based on greater use of intrinsic valuation assumptions.

Congress looks to the SEC

Section 132 of the TARP gives the SEC broad authority to suspend the use of SFAS 157 by issuer class or category of transaction, if it deems it necessary or appropriate in the public interest, and is consistent with the protection of investors. Section 133 requires the SEC—in consultation with the Federal Reserve Board and the Treasury—to study and report to Congress on SFAS 157 adoption and implementation and the impact to the markets within 90 days. It includes studying the impact and effects of SFAS 157 in the context of:

A financial institution's balance sheet;

Bank failures in 2008;

The quality of financial information available to investors;

The process used by the FASB in developing accounting standards;

Advisability and feasibility of modifications; and

Alternative accounting standards to SFAS 157.

The nature or extent of disclosure that would be required in the suspension of SFAS 157 or the absence of its disclosure requirements is unclear. However, suspension of the guidance could result in market participants questioning valuations. Under these circumstances, it seems analysts and investors will view the resulting valuations with greater skepticism, resulting in further erosion of investor confidence in valuations that could complicate recent efforts to stabilize the capital markets.

We reiterate our belief that fair-value accounting should continue to have a significant role in the accounting for financial assets and liabilities but that it should be reinforced and enhanced with more informative disclosures and revisions to the income statement to achieve desired financial reporting objectives.

To succeed in improving fair value measurement guidance, active participation and contributions by all affected constituencies (including companies, accounting standard setters, auditors, investors, regulators, and analysts) is essential. This ultimately could lead to an improved financial reporting discipline that will be capable of meeting the information needs of investors and creditors, and of supporting the evolving global capital markets, under varying economic conditions, for many years to come.

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