Accounting’s Role in the Market Bailout

Some of my friends and relatives ask me who to blame for their 401(k) losses, the $700 billion bailout, and the fact that they can’t refinance their mortgage.

There is lots of blame to go around: Homeowners who borrowed too much. Mortgage brokers who helped homeowners over-borrow. Institutions that lent based on anticipated escalation in housing prices, rather than based on the borrower’s ability to pay. Regulators who didn’t do enough to intervene and lawmakers that didn’t give them authority to do so. Investors who bought securities they didn’t understand.

People also ask me whether the accounting is to blame. I’d like to say yes; that accounting is all-powerful and people need to start showing us accounting experts more respect. On the other hand, blaming accounting for the problems we have is about the best example of shooting the messenger that I’ve ever heard.

The target of all these potshots is “mark-to-market” accounting. As the story goes, the requirement to report assets like mortgage-backed securities at today’s market prices results in a “pro-cyclical” effect that makes the holders of those assets look weaker than they would otherwise look, causing them further problems by inhibiting their ability to get financing or make loans.

I’m sure that many entities faced with reporting the fair value of mortgage-backed securities do truly believe that the market is undervaluing those assets. But we should be careful not to conflate and confuse reporting to investors with bank regulation. The danger for the capital markets is that, in a good faith attempt to unlock credit markets, we might deprive investors of the information they need right at the very time they need it most.

What Does GAAP Require?

Financial Accounting Standard No. 157, Fair Value Measurement, defines fair value for accounting as the price at which an asset could be sold in an orderly current market transaction between willing parties. The debate is whether markets for some securities are so troubled that prices in those markets don’t represent fair value.

While forced transactions clearly don’t represent fair value, those pressing for flexibility now want to exclude all transactions in markets that, while not nearly as active as they used to be, still see regular trades in a variety of similar securities. If buyers are demanding hig-risk premiums due to liquidity or other issues, why would that not be relevant in determining the fair value of the securities? Certainly, many entities believe these risk premiums are too high and refuse to sell at the prices being offered. But what’s strange about that? In any market, companies don’t sell if they believe the price is too low.

Accounting standards for financial assets do not allow a company to report its own perceived value instead of the market’s. To do so would result in recognizing profit (or avoiding a loss) anytime the company believes the market is wrong. Given that managers tend to work for companies in which they believe, the systematic overvaluation of assets would be substantial.

Indeed, investors like FAS 157’s definition of fair value precisely because its principle is understandable and its objective is clear. An alternative measurement principle that looks to management’s estimates of value would be subjective and difficult for financial statement users to understand and evaluate.

Many argue that the deviation from market prices, while normally a bad idea, is justified because the factors affecting the markets right now are so unusual. In a letter dated Oct. 13, 2008, the American Bankers Association asserted: “The use of distressed sale prices neither represents genuine fair value nor provides useful information to users of financial statements.” I don’t understand why highly unusual market price fluctuations make reporting assets at the values derived from those prices less useful to investors. Turbulent markets are when fair-value reporting is most crucial, so that financial statement users get a clear picture of what market participants think the securities are worth. Investors have in large majorities weighed in with the view that market prices should continue to be used in determining fair value for accounting purposes.

How Does Accounting Tie Up Lending?

Some have asserted that reporting securities at the low current market values will result in confusion, presumably because users will improperly believe that the reported values reflect the ultimate cash realization on these assets. But who is being deceived? Surely analysts and institutional investors understand that market prices for securities can and do change and may very well go up. And the lower reported values can’t really be fooling banks into not making loans they would otherwise make, can they?

This is where bank regulations come into play. Bank regulators have, for several decades, based regulatory measures on U.S. Generally Accepted Accounting Principles. This puts some rigor behind the regulatory measures and reduces recordkeeping requirements. Unfortunately, the purposes of GAAP and regulatory reporting are quite different. Regulators are concerned about the bank’s safety, and in that context, loan loss reserves are never too high and market price fluctuations aren’t relevant unless the institution is planning to sell assets.

But investors need information that allows them to put a value on the institution, and to evaluate decisions regarding keeping or selling assets based on today’s values. Because regulatory measures of capital, leverage, and risk use GAAP figures, accounting standard setters are pressured to consider regulatory implications of their standards that are inconsistent with the needs of investors.

Using today’s security values could trigger regulations requiring increases in capital or limitations on lending. Indeed, that appears to be have happened (or what a number of institutions fear will happen). And so lending has slowed to the point that even credit-worthy borrowers can’t get loans.

If the institutions are correct that the market is undervaluing the assets in question, lending is perhaps being restricted unnecessarily. But resolving this by taking information from investors that they want and understand is not the right solution. Congress and bank regulators can change the regulations if they believe it wise. This would attack the lending freeze without reducing the quality of financial reporting to investors. There is neither need nor good reason to sacrifice the quality of financial reporting to avoid lending restrictions.

Will We Ever Learn?

Changing GAAP in ways that conflict with the needs of investors is dangerous. Politicians have advocated this in the past, for example, arguing against expensing of stock options due to fears that it would inhibit small business growth. In the current crisis, many members of Congress have asked the SEC to suspend mark-to-market accounting. I have seen a member of Congress advocating a suspension of fair-value accounting just to see if it helps, because, after all, “It’s free.” But providing investors with less useful information has significant costs. And the current turmoil provides a great example.

FAS 140, Accounting for Servicing and Transfers of Financial Assets, provides the guidance on accounting for securitizations. Under this guidance, it is fairly easy to get assets and debt off the books while still retaining substantive risks, and even control, of those assets. Originally, “Qualifying Special-Purpose Entities”—the SPEs that get a break from consolidation—were intended to be solely pass-through, “brain-dead” entities. But they have, with the knowledge of FASB, developed into something much more. The fact that institutions have modified mortgages that were sold to QSPEs and have injected cash into QSPEs to shore up asset values shows that many of these entities never met the original concept behind the QSPE.

Getting these assets off the books was so important for two reasons. First, bank regulators impose more stringent requirements for on-balance sheet assets than they do for off-balance sheet assets, even if the risk is the same. And, as discussed earlier, the measures are based on GAAP. Second, of course, investors might very well not have liked to see the debt associated with these assets on the books of the sponsors. For both reasons, pressure was put on FASB to accommodate off-balance securitizations, and FASB did so.

Almost immediately upon the promulgation of the standards, problems became evident. Analysts, credit-rating agencies, and other users of financial statements routinely attempt to reverse the effects of securitization arrangements in their work, because they don’t believe the accounting adequately portrays the risks. The Sarbanes-Oxley Act correctly flagged off-balance-sheet accounting as an issue, but the actions that followed it—including the promulgation of FIN 46R by FASB and new disclosure mandates from the Securities and Exchange Commission—have proven insufficient. FASB was even persuaded to scale back some of the parts of FIN 46 that might have consolidated more SPEs.

FAS 140, FIN 46R, and the related interpretations facilitated the huge growth in securitizations and structuring, without providing investors with enough information to evaluate the risks involved. While securitizations would have happened even with more illuminating accounting, there would almost certainly have been less activity, and the risks held by those participating in securitizations would have been much better understood.

FASB is finally moving to improve these standards and has published proposals that would eliminate QSPEs and change the guidance for taking assets off the books. But the project’s effective date has been pushed back a year amid pressure from Congress to slow down, and certain constituents have called for the project to be halted.

This is alarming. Providing incentives for certain transactions and arrangements by allowing less-than-transparent reporting is a terrible idea. And if we haven’t learned that from this crisis, which was indeed made worse by accounting standards engineered to promote securitizations, what will it take?

If regulators or lawmakers believe that securitizations are a good thing, they should provide for favorable regulatory outcomes regardless of GAAP. Accounting standards should be allowed to focus on investors. If it turns out that securitizations can only flourish if their substance is hidden from investors, that says something quite important about what shareholders think about the transactions. We ought to respect their views, not deprive them of information that leads to those views.

The same is true with regard to information about market values of securities. Investors want that information and they understand it. If reporting institutions or companies believe the market is undervaluing their assets, they should explain that as well. Investors would benefit from having this information in addition to information about current market values, but not instead of information about current market values. And if using current markets values will needlessly trigger regulations regarding lending and capital raising, we should discuss changing the regulations, not the accounting.