Articles On Subprime Crisis, Market Turmoil That Mention Accounting
March 21, 2008
FEI Summary

Below is a sample of articles published in March/April 2008 that discuss information provided by accounting standards as relate to the subprime mortgage crisis, the impending takeover of Bear Stearns Cos. Inc. by JPMorgan Chase & Co., announced on March 16, and recent market turmoil generally. This sample is provided for illustrative purposes and is not meant to be comprehensive. For balance, links and excerpts are provided to seven articles noting the benefits of fair value accounting and disclosures, and seven articles that raise questions about whether fair value accounting should be revisited. Articles on other accounting topics (e.g. off-balance sheet accounting) are linked at the end.    

Sample of Seven Articles Noting Benefits of Fair Value Accounting and Disclosures

“For an Exciting Career, Try Accounting!” by Financial Executives International (FEI) president and CEO Michael P. Cangemi, from his upcoming President’s column published in the April issue of Financial Executive Magazine. Cangemi is also a member of the Financial Accounting Standards Advisory Council (FASAC) and the International Accounting Standards Board’s Standards Advisory Council (IASB SAC).

“Among the most significant recent headlines dealing with financial issues, you will find the subprime/credit crisis and the trading losses at French bank Société Générale,” Cangemi notes in his column. “While neither of these problems were caused by accountants, the accounting profession is right in the middle of the ruckus.”

He adds, “I remember vividly watching a bank’s earnings being reported on cable television, where the commentator said preliminarily that the bank had a write down of X billion dollars; however, they were still analyzing the FAS 157 disclosures. This example puts accountants right in the middle of the subprime valuation process. The importance of the additional disclosure demonstrates the value of the accounting standards process. Score one for the FASB!”  

Cangemi observes, “Last year’s credit market turmoil underscored a key problem, in my view: financial products are often developed to circumvent regulatory controls or accounting, or to exploit loopholes. That’s not how things should work. The accounting should be determined as the products are developed, not afterward. As it stands, accountants and auditors are left grappling with confusing scenarios – and literally, trying to put a price tag on losses that, at least in the current subprime debacle, keep rising. Handling accounting that way might crimp the creativity of financial markets – and souse some of the after-the-fact excitement this creativity has brought.”

 
“Fair Value Accounting and Subprime,” by Michael R. Young, partner, Willkie Farr & Gallagher.  Young, co-chair of his firm’s Litigation Department and its Securities and Shareholder Litigation Practice Group and a member of  FASAC.

“In speaking to the proper valuation of assets, FAS 157 is the latest contribution to one of the oldest debates in accounting,” says Young. “That is whether assets are better recorded at “cost” or at their “fair” (or market) value. The issue is one that has been vigorously debated for years.” He adds, “The present détente in this debate is an approach to accounting that seeks to acknowledge the good points made by both sides.”

Young provides a plain English explanation of the development of FAS 157 and its three-level hierarchy of fair values, and discusses how FAS 157 would be applied to difficult to value instruments like collateralized debt obligations (CDOs) and subprime investments.

“One way or another, well meaning preparers found a way to come up with their best estimates and report them to investors,” notes Young.  He adds, “Not all investors seemed to appreciate, though, the extent to which reported declines in value, presented numerically and thereby suggesting a level of precision that numerical presentation often implies, were necessarily based upon financial models that relied upon predictions about an inherently unknowable future. It is hardly surprising, therefore, that in some instances asset values had to be revised either because models were being adjusted or because predictions were being updated as things seemed to get worse.”

He notes, “To some, particularly to those who never liked fair value accounting to begin with, this was all evidence that fair value accounting is a folly,” and adds, “According to one managing director at a risk research firm, ‘All this volatility we now have in reporting and disclosure, it’s just absolute madness.’”   

Young responds, “The frustration is understandable. But defenders of fair value accounting would point out that keeping financial assets on the books at levels well above that for which they could be sold is not exactly a model of transparency in financial reporting.”

“Whatever one thinks of fair value accounting, though,” says Young, “one feature of the subprime aftermath has the potential to be completely counterproductive. It is the extent to which our system of litigation and regulatory oversight results in unjustified assertions of “fraud” against those who were doing their best under circumstances that were exceedingly difficult.”

“If it does turn out that financial statement preparers and auditors are to be penalized where good faith judgment calls turned out to be wrong,” warns Young, “then continued progress in financial reporting – at least in the highly litigious environment of the United States – will foreseeably be frozen in its tracks.”

He explains, “No responsible accounting or auditor will want to make difficult judgment calls when doing so is almost necessarily a career-terminating event. The subprime crisis, therefore, may present the opportunity for us to come to grips with a much bigger question. That is the extent to which we are to permit our present system of litigation and regulatory second guessing to impede continued evolution in financial reporting.”

[NOTE: These are selected cites from Young’s article linked above. For those interested in hearing more  on this topic, the Director’s Roundtable is holding a Conference on April 11, 2008 in New York City entitled, “ A National Conference on Historic Challenges Arising From Fair Value and Other New Accounting.”  Panelists include FASB Chairman Robert Herz, Willkie Farr partners  Michael Young and Antonio Yanez, Jr., KPMG partner Michael Hall, and a financial executive (to be announced).]

“Don’t Blame Mark-to-Market Accounting for Bank’s Problems,” commentary by Jon Weil, Bloomberg, March 17. Weil states: “there's so much misinformation floating around the markets on this subject that it's time, once again, to debunk the myths.” He begins, “Myth No. 1: The rules known as Financial Accounting Standard No. 157 are to blame. The latest iteration on this tired saw comes from Christopher Whalen, a managing director at Institutional Risk Analytics, who gave an interview on the subject Friday. Among his recommendations: ‘`Rescind FAS 157 so if you have a real quoted price for an asset, fine, use it. Otherwise you allow companies to use historic cost. You had a transaction, you know what you paid for it, it's a fact. All this other stuff is speculation. We are literally creating the impression of losses.’'' [NOTE: We cite Whalen’s article in the next section below.] Weil explains: “The truth: FAS 157 doesn't expand the use of fair-value accounting. Rather, it requires companies to divulge more information about the reliability of their reported fair values.” He continues by countering other ‘myths’ about FAS 157.

“The Fair-Value Blame Game - Fallout from the credit crisis has put mark-to-market accounting to the test,” by Sarah Johnson March 19 in CFO.com. Johnson quotes International Accounting Standards Board (IASB) Chairman Sir David Tweedie: "Fair value in a time of crisis can in effect exacerbate the concerns about a situation. But on balance, fair value keeps the situation honest.”

 “Is Fair Value Accounting the Problem?” by Dave Lynn in he CorporateCounsel.net blog (March 21), citing in turn the CFO.com article above. Lynn concludes: “It seems to me that it is highly unlikely the SEC or Congress would bow to this pressure and seek to suspend FAS 157 at a time when up-to-date financial information is more important than ever to investors. The days of book value accounting for financial instruments are long gone – and probably for the best.”

“Today’s Fair Value Lesson,” by analyst Jack Ciesielski in his AAOweblog March 17.Ciesielski provides a graph of Bear Stearns stock price for the past 10 months going from $150 a share to the price close to $2 a share following JPMC’s bid on March 16, and predicts:  “No doubt, there will be catcalls about mark-to-market accounting because of this.” However, he notes, ‘One of my early mentors in accounting liked to warn me that "with some folks, a little knowledge is a dangerous thing. And they often prove it.’” He adds, “Observers who have learned the fair value hierarchy three-step act as if carrying securities at fair values - even if you have to guess at what they're worth - is something new. It isn't - what's new is that firms now have to tell you how much of the values are mere guesses, and the degree to which they're guessing. Statement 157 didn't require broad new classes of instruments to be reported at fair value - it just required more information about the ones that have been handled that way.”

“CFA Institute Centre for Financial Market Integrity Says Fair Value Being Used as a Scapegoat for Bad Decisions, Lack of Compliance,” published by the CFA Institute on March 17, quotes Georgene Palacky, director of the CFA Institute Centre’s financial reporting group, saying: “Putting the blame on fair value for current market conditions is misguided.”

“Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors,” states CFA Institute’s Palacky. “Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition.” 

She added, “we believe providing investors with full transparency is essential both for the global capital markets to weather today’s turmoil and to prevent future bubbles and their associated economic dislocations. Also, the CFA Institute Centre does not agree with those who are calling for a watered down version of fair value.  This ‘shoot the messenger’ mentality will not restore investor confidence.  Rather, only when fair value is widely practiced will investors be able to accurately evaluate and price risk.”

Sample of Seven Articles Asking If Fair Value Accounting Needs To Be Revisited

“What’s Really Rocking the Stock Market,” by Elizabeth MacDonald  of FoxBusiness News, March 13. MacDonald, an award-wining writer formerly with Forbes and The Wall Street Journal states: “A growing chorus of thoughtful, reasonable critics–including experts who help write accounting rules–are saying it’s time these rules were amended. Yes banks profited big time from problem loans and securitizations. Yes they and investors are paying the price, with many of these pummeled lenders sheepishly going hat in hand to sovereign wealth funds in the Middle East and Asia, as well as private equity firms. The question is, are the rules causing massive writedowns that are as inflated as the profit figures they tossed off during the bubble? Is it right to have these gigantic pendulum swings socking investors in the head?” She adds, “The problem is, you can quickly get a price on a stock because there is a ready, liquid market, people trade in and out of stocks daily. You can rapidly get a price on oil or gold, too. But housing is stickier, people don’t sell their houses on an everyday basis, and prices historically move in cycles, with rapid- or slow-growth periods. That makes it harder to get the correct price-tag for long-term, complicated asset-backed securities based on housing assets.” Further, she notes, “Even though the credit market has largely frozen over, the rules say the banks must book prices on these bonds as if they were being sold today. You can’t get a price tag when there is no market. You can’t mark to market when there is no market to mark to. This is starting to sound like an Abbot and Costello routine. This isn’t mark to market. It’s mark to madness.”

“Accounting Rules Jeopardize Bear, Lehman, Whalen Says,” by Hugh Son in Bloomberg March 14, interviews Christopher Whelan, a managing director at Institutional Risk Analytics.

[NOTE: Whalen’s comments are countered in Jon Weil’s article “Don’t Blame Mark To Market Accounting for Bank Failures” cited in the section above.] 

“Mark to No Market,” by Todd Sullivan in his ValuePlays blog, March 17, tries to provide plain English analogy to explain what’s happening in the credit markets and related accounting issues.

“The Fair Value Fall-Out,” by Rob Lewis in AccountingWeb’s UK edition, March 20, describes global standard setting and regulatory efforts relating to accounting for subprime, including guidance issued by the Global Public Policy Committee (GPPC) paralleling efforts by the U.S.-based  Center for Audit Quality (CAQ – affiliated with the AICPA). The role of the IASB and U.K. FSA are also discussed. Lewis states: “Now that national economies may be at stake, reforming fair value has ascended the agenda. To what extent it will survive in its original incarnation remains to be seen.  Potentially, the IASB may itself suffer from the fair value fall-out. Considered an unstoppable force as recently as six months ago, the discussion paper on fair value [published by IASB on March 19] may signal a loss of momentum. For some time, critics of convergence have argued the IASB was setting out international standards without first establishing consistent, international frameworks - consider the European Commission’s decision to defer IFRS 8 last year. Reconsidering fair value could be seen to bolster this line of thought, and worse, it could come as too little, too late if further write-downs trigger greater turmoil.”

“The Mark To Market Fiasco,” by Terence Corcoran, Financial Post, March 18. While others note concern with equating fire sale prices to market, Corcoran likens the $2 a share price offered by JPMC for Bear to  a ‘garage sale’ price, and offers other views on this subject.

“Time to Renew the Financial Toolbox,” Financial Times OpEd, March 17, also posits five solutions to the current market crisis, and states: “Part five is to show some urgency in dealing with the policy problems revealed by the crisis: the role of mark-to-market accounting and the pro-cyclical effects of the Basel II capital requirements, for example. Though all of these rules have been adopted for good reason, some are having perverse consequences and it may even be necessary to suspend parts of them for a time. The disease need not be fatal but it does need aggressive treatment.”

“You Can’t Treat a Virus with Antibiotics,” by Vinny Catalano, CFA, in his blog “Musings on the Markets,” March 20, responded to some questions I raised after reading his March 18 post: “FAS 157: Timing Is Everything.”

Catalano responded in his March 20 post, (referring to some quotes of former Fed Chairman Paul Volcker in my earlier blog post on Treasury ACAP meeting): “To begin, nothing captures the essence of my argument better than your quote of Paul Volcker: ‘There are beautiful theoretical models in economics which impress accountants, [since the Economists] get Nobel prizes, but applied to the real world that don't work well, [that] is the real challenge.’”

Catalano continued: “Assets rise and fall in value for many reasons, some of which are tied to the theoretical models Mr. Volcker refers to such as the inputs that go into the discounted cash flow model. Such valuation levels reached via these methods are anchored in the rational investor theory as postulated in the "Modern Portfolio Theory" (MPT) and the "Efficient Market Hypothesis" (EMH).  However, recent research in the field of Behavioral Finance has shown what common sense has known all along - investors are not rational at all times and, therefore, are just as easily motivated by non-theoretical factors that are more self interested such as loss aversion and regret.” He continued, “It is easy to understand why FASB and the CFA Institute are willing to accept the long established dogma of MPT and EMH. Mr. Volker has referenced one reason why. And, in the case of FASB, the threat of litigation as noted by Michael Young, of WIlkie, Farr, & Gallagher is, no doubt, a contributing factor. Nevertheless, the fundamental principle underlying price as ‘fair value’ for long duration assets, particularly in a time of deleveraging and capital base impairment (which begets further price pressure on the current price of an asset), is both out of date and at odds with reality (how the markets really work), common sense, and current theory,” Catalano concluded.

Other articles discussing subprime/market turmoil and accounting

“Regulatory Underkill,” OpEd by former SEC Chairman Arthur Levitt, Jr. in The Wall Street Journal, March 21, 2008. Levitt does not discuss fair value, but on accounting generally states:  “The third factor responsible for today's troubles is that, once structured financial products were purchased, investors had little ability to discover how exposed banks were to these products' risks.”

He adds, “Failing to recognize and understand the changing risks and accompanying lack of transparency for investors, the Financial Accounting Standards Board (FASB), and the SEC that oversees it, allowed Structured Investment Vehicles (SIV) and conduits to be kept off bank balance sheets.”

“Because this loophole was not closed when it was first recognized more than five years ago, we are today still trying to figure out the depth and severity of the current crisis,” says Levitt, adding, “If the FASB is to maintain its credibility with investors, it will need to bring the off-balance sheet risks and losses associated with both SIV's and other securitizations onto companies' financial statements, with full disclosure, within the next 12 months.”

Prepared March 21, 2008 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International. This summary does not represent represent FEI opinion unless specifically stated above. This summary was linked in FEI's Financial Reporting Blog on March 24, 2008; if you would like to  receive the blog by email, enter your email address here.