Blame the Accountants: A Lynch Mob Forms

by: Belvedere

Someone's got to take the fall the market's falling out of bed and the economic turmoil. No managers of financial institutions have been brave enough to step forward and acknowledge that it was their fault. No regulators have been bold enough to say, well, they weren't bold enough as regulators.

So there's only one thing left to do: blame the accountants. There's an angry mob forming, and it looks like they brought a rope. They're converging at the Rayburn House Office Building in Washington, DC on Thursday, March 12, when Congressman Paul Kanjorski holds a hearing to "address problems facing mark-to-market accounting."

The press is having a field day with this: it's been a long time since an accounting standard was in the news so much. Ben Stein threw a tantrum in the Sunday New York Times, calling for someone, anyone, to "immediately end the near-universal applicability of the accounting rule formally known as FAS 157." Ben: get a grip. Statement 157 is universal, alright - it applies to any balance sheet account that had been given fair value treatment before the issuance of Statement 157. The most pervasive and confidence-destroying myth about Statement 157 is that it's somehow requiring fair value reporting for the first time in places where it hadn't ever been used before.

If folks like Ben would maybe just READ Statement 157, they'd understand that. If they'd really stretch and read the SEC's Congress-mandated study on fair value accounting, they'd know that at the banks where all the alleged fair value damage has been wrought, only about 31% of total assets are given the fair value treatment - hardly "near-universal." The biggest assets on banks' balance sheets are their loans - and they do not receive fair value treatment. Their greatest amount of assets were unaffected by the implementation of Statement 157. It's easier to deflect blame on an accounting rule than face culpability for bad loans made, however.

The conventional wisdom (hard to call it that) that Statement 157 is creating fair value reporting where it had not been applied before. It's simply misinformation: Statement 157 put one definition of fair value into the accounting rules and added more disclosures for users - including the widely-used Level 1, 2 and 3 fair value hierarchy disclosures.Skeptical? You could read Statement 157 - or just the following excerpt from the SEC's report:

Statement 157 wasn't in effect in 2006; it was required to be employed in the first quarter of 2008. The percentage of assets using fair value in 1Q08 was 4% higher than in 2006, and it wasn't because of the standard. While the percentage jumped at broker-dealers, over half of it was due to voluntary application of fair value principles - these firms took the fair value option available to them in Statement 159. Again, there was nothing in Statement 157 that made B-Ds apply more fair value reporting where they hadn't applied it before. Credit institutions' percentage of assets on fair value reporting were nearly flat and the insurance companies' proportions were exactly the same. The now-crippled GSEs actually showed a decline in the proportion of fair valued assets to total assets, as they tried to put the brakes on their securitization activities.

So - where is the "near-universal" reach of the new and nuclear Statement 157? The standard didn't spread the reach of fair value accounting. And the empirical facts don't support the claims of the fair value Cassandras.

Another critic, Steve Forbes, threw an even bigger, louder tantrum in his op-ed piece in Saturday's Wall Street Journal. Forbes' record on finding the right side of an accounting issue is not too good: he was an ardent critic of treating stock options as compensation earlier in the decade. On Statement 157, he has this to say:

Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market -- which was in force before the Great Depression -- is why FDR suspended it in 1938. It was unnecessarily destroying banks.

But bad ideas never die. Mark-to-market was resurrected by the Financial Accounting Standards Board and became effective in the fall of 2007 (FASB rule 157) to the approval of the Bush administration, its Treasury Department, and the Securities and Exchange Commission.

Mark-to-market accounting is the principal reason why our financial system is in a meltdown? A preposterous statement on many levels. First, the foolish lending by financial institutions led to the meltdown, and the lending was lubricated by all-too-opaque securitization accounting. If Mr. Forbes would like to foam over accounting rules leading to meltdowns, I'd suggest he spend some time reading Statement 140. That standard made it too easy for bad loans to disappear from lenders' balance sheets through securitizations - and we all know how well that process diversified away risk around the world, right?

Another false assertion: FDR somehow saved the banks in 1938 by suspending mark-to-market accounting. He did no such thing in the realm of financial reporting, which lets investors know how corporate managers are doing for their shareholders. What happened was a loosening of the credit standards for regulatory accounting principles - in effect, regulators look the other way when market values are telling a story about the creditworthiness and solvency of a financial institution. If there's a beef with the way regulators have been setting capital limits, take it up with the regulators, Steve. Don't try to change capital limits by blinding shareholders.

Mark-to-market "resurrected" by the FASB in 2007? Another case of disrespect for facts. Mark-to-market has been around in varying strengths for decades. Until the early 1990s, firms couldn't mark securities beyond their cost basis if they had to first mark them down to market values. When Statement 115 became effective in 1992, firms choosing to do so (as a policy decision, not on a one-by-one basis) could recognize gains beyond any writedown. Firms could also elect (as a policy choice, again) to hold investments to maturity, without fair value fluctuations. The rules prohibit gains-timing by switching from one classification to another, but Statement 115 hardly created "unfairly represented" balance sheets. (If anything, it showed that more fair value reporting could eliminate a lot of complexity; save that for another post.)

Critics tend to forget that what's different in this credit crisis is that there are far more instruments being fair-valued than ever before - and they're not the best financial assets on the planet, making them tough to value. According to Federal Reserve statistics, there were $2.2 trillion of asset-backed liabilities outstanding at the end of 2003 - and $4.2 trillion of them at the end of the third quarter of 2008. We know they're not all worth 100 cents on the dollar.

What's new is trying to develop fair values for the volume of these kinds of instruments when there are no liquid markets. If Statement 157 had never existed, they would still have to be reported at what they're worth. The fair values for those things have plummeted or there are no markets for them at all. And if there are no markets for them at all because nobody wants them - what's their value? You can make a strong argument that if nobody wants something offered for sale, it hasn't got any value. Statement 157 isn't even that draconian - it permits estimates of fair value when markets aren't working.

But, hey, it's more fun to have a lynching than accept facts. Thursday's hearing is being greeted as some kind of market event, with reports of trades being positioned for the expected "suspension of mark-to-market" outcome. We'll see: it's only a hearing and not an act of Congress. Will it lead to one? That will take a lot longer to find out.