Mark-to-Market Zealots Kidnapped GAAP

Fair value accounting has hijacked GAAP accounting. It is one of the great ironies of the day that the Financial Accounting Standards Board’s own rulemaking has managed to undercut public confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles, turning financial reporting on its head. Value is now based on a bankruptcy model, one that assumes that a firm’s value is only that in distressed liquidation, rather than the net present value of cash flows generated as a going concern. The damage to our economy and its growth prospects is enormous and gives life to many of the misguided, unhelpful policy prescriptions (the recent push for a general bank nationalizations being one), that would take a bad situation and make it worse.

Fair-value accounting needs to be fundamentally reformed. “Fair market value” concepts in accounting are long-standing, but the “fair value” measurements of FAS 157 became effective just this past year. And it’s not that the new rule required banks to mark more of their financial assets to “fair value”. Though most commercial banks mark only a small portion of their balance sheets (e.g., General Electric marks just 2% of assets), FAS 157 required that all banks disclose in footnotes the “fair value” of their financial assets and liabilities. So, in our unhappy present economic circumstances, these disclosures became the perceived reality. The math is easy. Many banks that are well-capitalized and solvent in accordance with GAAP are simultaneously insolvent when GAAP results are adjusted to “fair value”. Look, for example, at Capital One (COF).

To many market participants, GAAP has become irrelevant. That’s crazy. Even crazier is the confidence that so many investors attach to these “fair value” results. As promulgated by FASB, fair value’s conceptual flaws are fundamental and run deep.

It’s worth noting, first off, that “mark-to-market” accounting is a misnomer. FAS 157 actually removed “market” from the definition of “fair value.” Under previous rules, “fair market value” meant the value implied by the non-compulsory exchange of property between willing buyers and sellers, with equal knowledge and equity to both. Now, FASB defines “fair value” as a sale in an “orderly transaction” between “market participants.”

The differences are subtle, but they yield strikingly dissimilar results. The prior definition, for instance, determined “fair market value” from an actual transaction between willing participants. But under FAS 157, “fair value” is premised on a hypothetical, immediate sale to yet another “market participant.” Recall from Economics 101 that when a market is in equilibrium, the marginal buyer is induced to purchase only when price falls. As defined, then, “fair value” tends to impair asset values even in stable environments.

In unstable environments, by contrast—well, you’ve seen what’s happened. According to the FASB and the SEC, forced or liquidating sales represent neither “fair market” nor “fair” value. And yet such sales nonetheless must be taken into account under FAS 157. Consider Merrill Lynch’s sale of its large securities book at 22 cents on the dollar. The company was surely an “unwilling seller.” But the transaction was nonetheless “orderly,” as ownership was transferred to the hedge fund buyer. Was the price paid, then, “fair value”? It is really a judgment call, but under FAS 157, the answer, ultimately, was yes.

What about investments that the owner has no intention of selling? Why should those investments’ “fair value” matter to investors at all? In the FASB’s conceptual framework, remember, the objective of financial reporting is to provide information to help “assess the amounts, timing, and uncertainty” of an entity’s cash flows. But users of financial statements are actually misled if losses are recorded based on the market’s perception of an asset’s value, if in fact that asset has experienced no credit problems and is performing fully in accordance with its terms. In recent quarters, we’ve seen frequent examples of “other than temporary impairment” (OTTI) losses in precisely such circumstances.

In a recent article in Strategic Finance magazine, Alfred M. King, a recognized expert in the art of financial valuation, concludes persuasively that the “very essence” of valuation is professional judgment, and that FAS 157 is “fundamentally flawed.” “One can argue that management should be willing to sell any and all assets,” he says, “but we have not reached the point where creditors and shareholders actually run the company. In fact, the only time creditors do … make such decisions is after the company has filed for bankruptcy … There is a vast difference between valuing assets for the purpose for which they were acquired, and valuating them as though they would or could be liquidated.”

It astounds me that the SEC, FASB, Treasury, and the bank regulators are not engaged in a full-court public relations press to affirm GAAP financial results, while at the same time emphasizing the conceptual problems and doubtful accuracy of “fair value” in such a highly stressed and illiquid economy as this one. What’s the matter with these people? They give idleness and bureaucracy a bad name.

It’s time to suspend this misguided and flawed rule. Mary? Tim? Are you listening?