Experts seem to disagree how much fair-value accounting may or may not have played a role in Bear Stearns’ downfall. While some argue that the Financial Accounting Standards Board’s new fair-value standard—Financial Accounting Standard No. 157, Fair Value Measurement—caused a write-down spiral that is still descending rapidly, others argue that the financial firm’s valuations of instruments were too opaque for the investment community to understand and digest.

Financial institutions largely adopted FAS 157 as soon as it was available to them at the beginning of 2007. Among other provisions, the standard establishes three hierarchies for measuring instruments at “fair value.” At level 1, assets and liabilities are measured at easily observable market prices. At level 2, values are established using less direct market data, meaning figures that are closely related, but not exactly. At level 3, companies are using their own data and modeling techniques to say what assets and liabilities are worth.

That issue of level 3 valuations and transparency is the cause of the disagreement.

Increasingly, companies that have struggled with how to value troubled securities where the market has dried up for them have turned to internal modeling to establish values for those troubled investments. Industry watchers like James Kaplan, chairman and founder of research firm Audit Integrity, wonder whether investors got a good view of just how risky Bear’s level 3 holdings were.

Kaplan

“It’s incredibly subjective,” he says. “They really can’t be valued directly. The investor has real questions about whether Bear Stearns treated the price of those securities fairly.”

Even under FAS 157, says Kaplan, the degree of disclosure is not such that investors can tell what the company is holding and how the company reached its conclusions about value. “It’s considered proprietary information to the firm,” he says. “When a company keeps a secret, that’s often an indication of a problem. Bear Stearns never overtly recognized there was a problem. The market did it for them.”

Blaine Frantz, senior vice president of the finance and securities team for rating agency Moody’s, followed Bear Stearns closely as its liquidity evaporated. He doesn’t believe there’s a great deal of gaming going on with level 3 valuations.

“Bear saw confidence in its funding wither away very quickly as a result of rumors,” he says. “I know what Bear’s exposure was ahead of the crisis. I know where they had assets, how they were marked, and where they had hedges on. They were not in terrible position. Once market rumors started to spike and confidence waned, they did not have sufficient unencumbered collateral to fund the outflows that occurred.”

Mard

Michael Mard, managing director of the Financial Valuation Group and a member of the Valuation Resource Group formed by the Financial Accounting Standards Board, agrees with Frantz at Moody’s. He says that fair value “is getting a bum rap in all of this.” FASB wrote FAS 157 and then formed the VRG to help iron out implementation questions and problems, including the extent to which companies can or should use their own data instead of market data to reach value conclusions.

“The fair-value issue overall is one of disclosure, thus leading to transparency,” he says. Critics of the three-level hierarchy likely don’t understand how it works, he says. “The various levels are not classes of assets,” he says, emphasizing his views are his own. “The level addresses the amount of disclosure required in the financial statements. When you get to level 3, because you don’t have a clear market or market participant, that’s where the most disclosure is required and transparency is maximized.”

Mard also points out that companies can’t simply toss in flimsy estimates or inflated views about value because the figures and assumptions still have to pass muster with appraisers, auditors, and the Securities and Exchange Commission. “Level 3 doesn’t mean weak estimates,” he says.

SEC Wants ‘Flavor and Color’

“Everywhere you looked in Bear Stearn’s 2007 10-K filing, you saw evidence of risk and deterioration, and bad news.”

— Anita Ford,

Member,

FASB’s Valuation Research Group

To drive home that point, the SEC’s Division of Corporation Finance recently published a sample letter, identifying a number of disclosure issues it will expect companies to address in the Management’s Discussion and Analysis section of their periodic reports (including their next 10-Qs). The staff sent the letter to roughly 30 companies—primarily in the financial services sector—that reported in their most recent 10-K annual filing significant levels of asset-backed securities, loans carried at fair value or the lower of cost or market, and derivative assets and liabilities.

SEC spokesman John Nester said there’s nothing in the new guidance that in any way expands or alters the requirements of FAS 157.

While FAS 157 maps out disclosure requirements for the financial statements and footnotes, the SEC’s letter outlines some disclosures companies “may wish to consider” for MD&A related to their FAS 157 measurements.

Harms

But not all see that as the case. Travis Harms, senior vice president at Mercer Capital, says the guidance seems to tell companies they need to provide more detail in their MD&A than FAS 157 requires for the financial statements themselves. “For example, 157 says you have to indicate unrealized gains and losses in level 3 assets,” he says. “The SEC guidance says in addition to disclosing the amount, you have to give the reason for any material increase or decrease. The SEC is pushing for a little more flavor and color in these times in MD&A.”

Nestor also notes that the guidance was in development well before Bear Stearns crumbled and was not issued as a response to the collapse.

POINTS TO PONDER

Below is an excerpt from the SEC's sample MD&A disclosure letter that was sent to public companies.

If you conclude that your use of unobservable inputs is material, please disclose in your MD&A, in a manner most useful to your particular facts and circumstances, how you determined them and how the resulting fair value of your assets and liabilities and possible changes to those values, impacted or could impact your results of operations, liquidity, and capital resources. Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:

The amount of assets and liabilities you measured using significant unobservable inputs (Level 3 assets and liabilities) as a percentage of the total assets and liabilities you measured at fair value.

The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2:

1. If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:

(A) The significant inputs that you no longer consider to be observable

(B) Any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded

With regard to Level 3 assets or liabilities, a discussion of, to the extent material:

1. Whether realized and unrealized gains (losses) affected your results of operations, liquidity or capital resources during the period, and if so, how

2. The reason for any material decline or increase in the fair values

3. Whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views.

The nature and type of assets underlying any asset-backed securities, for example, the types of loans (sub-prime, Alt-A, or home equity lines of credit) and the years of issuance as well as information about the credit ratings of the securities, including changes or potential changes to those ratings.

Source

SEC Sample MD&A Disclosure Letter (March 2008).

Harms agrees that the overall market condition and not a single event likely drove the SEC to issue such guidance. “Every day you open the newspapers and there’s another multibillion-dollar write-down being announced,” he says. “I’m sure that’s increasing the focus at the Commission on this.”

Risks Abound

Ford

Nonetheless, Bear Stearn’s 2007 10-K offered plenty of evidence of risk, says Anita Ford, who is director of assurance services with CPA firm Clifton Gunderson and a member of FASB’s Valuation Research Group. “Everywhere you looked in the filing, you saw evidence of risk and deterioration, and bad news,” she says.

The 10-K provides a tabular summary of how much of the firm’s assets and liabilities fell into each of the valuation hierarchy levels. At the end of fiscal 2007, the firm valued $29.5 billion of its securities at level 1, or using direct market data; $227.1 billion at level 2, based on market evidence but less directly available; $28 billion at level 3, or based on no market evidence.

The 10-K points out significant asset transfers into level 3 as a result of “a significant reduction in observable trading activity for these instruments during the latter part of fiscal 2007.” Bear Stearns said assets transferred into level 3 included primarily mortgage and mortgage-related securities, including commercial loans, residential loans, and investment-grade collateralized debt obligations.

Ford said the level 3 valuation methodology may be taking some heat because so many companies are forced to move inactive securities into that category. “It was never FASB’s intent to have level 3 investment disclosures be associated with bad investments,” she says. “The market didn’t really understand complex CDOs and mortgage-backed securities and it was caught off-guard with the losses.”

Frantz says companies are taking hits to earnings reflective of what’s happening in the market, suggesting there’s no lack of transparency or gaming going on in the level 3 valuation process. “They look for every possible indicator of value in the marketplace,” he says. “To the degree there are no cash trades getting done, the Street is looking to ABX and other indices to get indications. To the degree market prices and index values have been pushed down low, these firms are using these in their valuations. My sense is the level 3 valuation is not being misused by the major firms.”

Kaplan says there’s still good cause for vigilance and caution on the part of investors. “At the end of the day, this valuation issue is the critical issue,” he says. “It comes to the marketplace in a dramatic way when other institutional investors refuse to invest in a company when they know the values reflected on the books are not fair. … As long as entities have latitude to value these things, it’s unfair accounting.”

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