Bruce Carton of Securities Docket put together a great panel of securities and accounting experts to discuss the evolution of fair value accounting regulations and the impact of the guidelines in accounting and legal contexts.
These are my notes from the webcast.
Fair value accounting records the estimated market value of many assets and liabilities on balance sheets. Although sometimes called “mark-to-market” but that is a misnomer. You need to estimate the value if there is no market for the asset. Fair value estimation methods were standardized by SFAS 157 (ASC Topic 820 –Fair Value Measurements and Disclosures) issued by FASB in 2007.
The standard came out just in time for the financial meltdown.
There are three types of measurement:
Level 1: Based on quoted prices in active markets for identical instruments.
- Listed stocks, actively traded bonds.
Level 2: Based on observable (auditable) inputs used to estimate an exit value.
- Two similarly situated buildings in a downtown real estate market.
- OTC interest-rate swap, fair valued based on observable data such as the contract terms and the current LIBOR forward rate curve.
- Contracts with option-like features, fair valued based on contract terms, observed volatility, interest rates.
Level 3: Based only on unobservable inputs and assumptions used by the company to estimate an exit value (i.e., where markets don’t exist or are illiquid).
- CDOs, many financial derivatives, stock in unlisted companies.
- Level 3 fair value estimates usually employ the company’s own models, notably variants of Discounted Cash Flow (Present Value) models.
Huge losses reported by financial firms on subprime assets led to a debate over the implementation of SFAS 157 when markets become illiquid and price inputs aren’t readily available. During the crisis, banks and investment banks were required to reduce the book value of mortgage-backed securities to reflect their current prices.Those prices declined severely with the collapse of credit markets as mortgage defaults escalated. Banks were forced to raise capital and quickly jettison some of thee securities to raise capital, further providing downward pressure on the values. So, banks and politicians have blamed fair value accounting for contributing to the crisis.
On the other side, fair value accounting gave a more realistic view of the financial health of an institution. One of the factors in the financial crisis was that parties did not trust the credit-worthiness of their counterparties. Fair value provides important information about the values of financial assets and liabilities, as compared to their historical costs (original price). There should be greater transparency allowed for better informed decisions. It also limits the ability to manipulate earnings by timing the sale of assets.
But there are downsides to fair value accounting. When markets are illiquid, fair value is a hypothetical transaction price that cannot be measured reliably. When fair values are provided by sources other than liquid markets, they are unverifiable and allow firms to engage in discretionary income management. By recognizing unrealized gains and losses, fair value accounting creates volatility in a company’s equity. This is particularly important for financial institutions because it affects their regulatory capital.
There is also the quirk of the fair value accounting for one’s own liabilities. Some banks reported gains because of a decline in quality of their debt. They recorded an income gain because they were more likely to default on their debt.
One of the issues in the financial crisis is that mortgage-back securities moved from Level 1 valuations to Level 3 valuations very quickly. Models were not established for valuations of these assets when they went toxic and cash flows dried up.