Fair Value Accounting: Mark to What Market?

In recent months, the world financial markets have been decidedly rattled to draw comparisons to the Great Depression of the 1930’s in the United States. Trillions of dollars in market capitalization have vanished over the last year.  Just one year ago the Dow Jones Industrial Average was at an all-time high even in the midst of the first signs of the subprime asset meltdown.

To the non-business community, the catch-phrase “sub-prime” is thrown out in passing to pass blame on this current financial crisis.  However, to fully understand the ripple effect that has transpired requires a little more investigation.  These sup-prime loans have been bundled into exotic assets such as CMO’s (Collateralized Mortgage Obligations) and CDO’s (Collateralized Debt Obligations) which have been hanging on their respective companies’ balance sheets at cost until recent pronouncements by the FASB and SEC.

As the real estate market soured during the past two years, accounting experts considered measures to better value these assets to their fair value (FV).  Statement of Financial Accounting Standards No. 157 (FAS 157), Fair Value Measurements, an accounting standard recently approved by the FASB and adopted by the SEC (http://www.fasb.org/st/), brought widespread changes to the accounting treatment targeted towards many financial investments.  At heart, the standard addresses the application of fair value to assets and liabilities, and a framework which sets a hierarchy of methods to determine FV.  Additionally, it provides guidance on disclosure of the methods used to value assets and liabilities.

The reaction to this pronouncement has been torn at best.  Accounting professionals, industry leaders and politicians have provided arguments toward the application of historical cost vs. FMV to value many assets torn down by the mortgage crisis.  The reasoning behind the FMV approach is that it arguably provides more relevant information.  Proponents say that this standard unfairly requires the FMV approach to derive an “exit price” for assets which customarily do not have a reliable market to value them. 

Additionally, marking to FMV causes unnecessary earnings volatility. Using “mark-to-market” for these assets has resulted in the domino effect we see today with investment banks such as Bear Stearns, Wachovia and AIG incurring huge losses from mark to market activities which have resulted in billions of dollars in lost earnings. 

The volatility mentioned has caused a ripple effect due to the leverage that many banks were using with these hard to value assets.   In valuing these assets at steep discounts, companies have experienced difficulty providing sufficient collateral to support their cash flow demands. 

Most recently, AIG had to report $18 billion in losses due to a derivative sold known as a credit-default swap, constructed to protect investors from default in assets such as subprime mortgages.  This triggered the company having to contribute billions more in assets as collateral.  The Company then had to absorb a downgrade from a rating agency, experience a massive short selling in their stock and ultimately required the government to infuse cash through a direct equity interest.

In February 2008, the FASB reacted to this crisis by issuing pronouncements to FAS 157 (FSP FAS 157-2) to defer further application to “non-financial” assets such as goodwill and intangibles for companies until fiscal years beginning after Nov. 15, 2008.  Additionally, on October 29, 2008 the SEC hosted the first of two roundtable discussions open to the public regarding the effect in the financial industry related to the current economic crisis.  The discussion also looked to shed light on potential improvements to be made to the current mark-to-market accounting model. (Please see www.sec.org.)