Struggling on Values, Banks Fire at FAS 157

As liquidity and earnings continue to go down the drain in a flood of first-quarter earnings reports, bankers are stepping up their appeal to regulators to help rein in fair value accounting—and investor advocates are preparing to stand their ground.

The American Bankers Association fired off a fresh round of correspondence last week to banking regulators asking for help in repealing controversial fair value accounting requirements and blocking any new such requirements. “There is concern that today’s marketplace may not be providing quality fair values, which results in lower-quality financial statements than we believe is acceptable,” wrote Donna Fisher, ABA senior vice president.

If the “lower quality” is code for volatility, Fisher can cite any number of recent periodic filings to support her claim. But the raging debate in these days is whether that volatility is the result of fair-value accounting, or whether new approaches to measuring fair value are simply giving investors a better view of trouble that had been there all along.

The Financial Accounting Standards Board issued Financial Accounting Standard No. 157, Fair Value Measurements, in late 2006 to become effective with the start of the 2008 fiscal year, although many financial institutions elected early adoption in 2007. FAS 157 doesn’t require any new use of fair value in financial reporting, but it establishes a framework for measuring fair value, creating a three-level hierarchy that relies first and foremost on market prices as an indicator of value for any asset or liability.

The ABA says the markets are not accurately interpreting the requirements of FAS 157, leading to a downward spiraling of valuations and liquidity. One institution with a liquidity crisis unloads a security at a low price, and that price becomes a benchmark for everyone else’s instruments, ABA says. Asset prices degrade further, leading to further liquidity problems, “and around and around we go,” Fisher wrote.

FAS 157 allows the market price for a given transaction to be overlooked only in the event of a distressed sale, but it doesn’t explicitly extend the distressed sale concept to the market as a whole. Given the current market environment—where buyers have evaporated for a number of complex, credit-based instruments—the ABA says FAS 157 does not adequately address how values should be established when reliable market pricing information has gone haywire.

FASB Chairman Robert Herz and Director Linda MacDonald published a summary of the state of fair-value accounting recently to fend off growing criticism as FAS 157 goes into force in an unprecedented downward cycle in the market. They reiterated that the requirements to report certain financial assets at fair value, and the underlying concept to rely on market pricing, existed long before FAS 157.

Herz

“Further, the use of fair value in determining write-downs in periods of down markets is not new,” Herz and MacDonald wrote. “And while current conditions in the credit markets certainly pose significant challenges in valuing a number of asset classes, the concepts and practices employed in valuing illiquid and non-marketable assets are not new.”

The ABA even concedes in its letters to banking regulators it had no quarrel with FAS 157 when first issued nearly two years ago. “In light of the economic and market environment at the time of the proposal, ABA interpreted it in a common sense manner and believed much of it to be similar to existing practice,” Fisher wrote.

FAS 157 FEARS

Below are excerpts from a letter the American Banking Association sent to the Federal Reserve Board, outlining the ABA’s concerns over fair value accounting.

The ABA believes there is evidence that an inaccurate interpretation of the Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), by auditing firms and others may be contributing to and exacerbating the recent turmoil in financial markets. This is due to the downward impact of the interpretations of SFAS 157 on valuations and on the cyclical nature of valuation and liquidity. In an environment where one institution, due to liquidity issues, is required to dispose assets at unnaturally low prices to improve liquidity in the short-term, other institutions are subsequently required to impair their own securities to reflect the new lower price point set by the distressed institution. This circle of impairment is self-perpetuating, despite no change in the risk underlying the subject security. As asset pricing degrades, this impairs institutions’ ability to provide liquidity to the markets due to capital constraints. That lack of liquidity further erodes pricing, accelerating the decline in liquidity pricing, and around and around we go …

Unfortunately, when implemented, not only did SFAS 157 not address the reliability of market pricing information, its implementation in fact even appeared to validate the use of low quality price reference sources over fundamental economic valuation methods that have proven effective and reliable for many years.

Our members are currently obliged to use price quotes that are supported by little market evidence, which lack prices reflective of actual transactions, or that include expectations of transactions with truly distressed sellers. In practice, banks and thrifts are currently being required to report many fair value measurements using “bad” Level 2 prices (that is, those that are poor quality but which can be referenced) over “good” Level 3 information (that is, those that must be estimated using judgments and modeling subject to second-guessing and contention). Additionally, banks as lenders and users of financial statements must rely on those valuations in the normal course of business …

There are several courses of action that could be taken to help with the current situation, although they may fall short of resolving it:

Standard setters could clarify that the Statement 157 reference that pricing in distressed situations does not reflect fair value applies to market transactions if one of the participants is in a distressed situation – as opposed to only if the preparer is the one in the distressed situation

Regulators could clarify for auditors and preparers that if distressed transactions are the only transactions, there may not be sufficient market depth to look to those prices for fair value evidence.

Standard setters could clarify that a “good” Level 3 may better for financial reporting than a “bad” Level 2.

Standard setters and regulators could provide interpretive guidance to assist preparers and auditors in recognizing that market value discounts in turbulent times may reflect many market considerations besides other-than-temporary-impairment.

Source

ABA Letter to Federal Reserve (May 12, 2008).

The crux of the problem, then, is really whether the evaporation of buying and selling in particular asset categories results in reliable or unreliable pricing. That is, should values for all assets in a given category be based on the limited trading of only a few such assets, while the rest are in the deep freeze?

Finding the Trend Line

FASB established a Valuation Resource Group to help smooth over a number of implementation issues, including how FAS 157 should be interpreted when market pricing is thin or nonexistent. Michael Mard, managing director of the Financial Valuation Group and a member of the VRG, says the question of whether a thin market constitutes an observable one for purposes of establishing a value is legitimate. “Does a dot make a trend?” he asks.

The VRG met in early May to discuss whether FASB should consider some supplemental implementation guidance on that very question. It advised FASB staff that guidance would lead to new rules and bright lines—exactly what FASB wants to avoid in its quest for more principles and use of judgment in financial reporting.

Hart

“I think, and others said too, the market will eventually work itself out,” says Jolene Hart, another VRG member and a partner with the accounting firm McGladrey & Pullen.

From the ABA’s perspective, the problem is that low values established by only a handful of transactions leads to depressed values for all instruments, even where the underlying risk of default has not changed and even when the entity holding the instrument plans to hold it longer while waiting for the market to recover.

Booking that lower fair value leads to recognizing an “unrealized loss,” says Travis Harms of the consulting firm Mercer Capital. Such losses are a bone of contention for those who want to avoid volatility in financial reporting.

“A realized loss is one you’re never going to get back. The asset has gone down in value, you’ve sold it, and you took the loss,” he explains. “An unrealized loss is one that you may still have a chance to recover. The company may say, ‘I plan to hold the asset a long time and I’m convinced the decline in fair value is temporary, so why record the loss now and in the next period record the gain? Isn’t that introducing unnecessary volatility to my earnings?’”

Investors say a loss is a loss whether it’s realized or not; the decline in value is real and should be reported. Jeff Mahoney, general counsel for the Council of Institutional Investors, says FAS 157 has given investors better disclosures around accounting estimates that play into the valuation process, and it’s useful. “Last quarter, I incurred a loss in my mutual fund,” he says. “I am confident that over time my mutual fund will recover that loss. However, the economic reality is that I incurred a loss in my mutual fund this past quarter.”

Trott

Ed Trott, a former FASB member who helped write FAS 157, likes to compare the use of FAS 157 on valuation measurement to the use of a speedometer for motorists. “Imagine if I said as long as I’m staying on the road, I’m not interested in any information about how fast I’m going until my speed changes at an increment of 50 miles per hour,” he says. “That’s pretty dumb.”

Hart says the extreme spreads in bids compared with asking prices makes it difficult to apply judgment about whether the true value of a given asset might lie somewhere in the middle, especially when the underlying cash flows are still strong. “The big spread makes people really uncomfortable,” she says. “When the bid-ask spread starts shrinking, 157 will be easier to understand.”

Working Through This

Randy Marshall, managing director at consulting firm Protiviti, says the market still has much work to do in digesting and implementing FAS 157. “This is clearly not an exact science,” he says. “There are a range of market practices that exist now. We will see more convergence of market practice over time as companies have experience working through this over several quarters.”

CFOs are finding the standard complex to implement, Marshall says, and not just because of the judgment involved in tough-to-value assets and liabilities; they also struggle with systems, models, outside valuation specialists, and auditors. Preparer groups lobbied FASB to delay the entire standard for a year, and FASB instead granted an extension for only a narrow portion of the standard focused on certain non-financial assets and non-financial liabilities.

Marshall

“The majority of CFOs would probably say it’s a lot more than they anticipated coming into the actual implementation date,” he says. “There’s probably a camp that would say it may not promote comparability among companies, because they’re valuing similar assets but arriving at different valuations and as a result different financial performance.”

Stephen King, a partner with Ballard Spahr Andrews & Ingersoll, said the transition to FAS 157 may be a factor contributing to volatility for some complex securities, but he believes a difficult market environment “is a considerably more important factor contributing to volatility.” Both, he says, will eventually settle and their effect on volatility will wane.

As practice matures and the market settles into a pattern, then it will be time to watch for a wave of restatements, predicts William Scotti, director for consulting firm Meradia Group. He says companies are scurrying with a lot of manual data entry, a classic recipe for error, in the transition to FAS 157.

“A lot of companies need to change their coding to be able to state values under FAS 157, and there simply isn’t time to do that,” he says. “They’ll have to do top-level adjustments, or manually adjust a particular line item of a particular security. Mistakes are bound to happen.”