Banks: The Fight over Fair Value

Financial firms want to suspend or change the rules concerning asset markdowns. S&P Ratings tells why that's a bad idea

By Joyce Joseph-Bell, Ron Joas, and Neri Bukspan From Standard & Poor's RatingsDirect

The current market disruption has triggered a chorus of complaints from many financial institutions and other market participants about the effect of fair value accounting, including an outcry to suspend or substantially modify the rules. The push to suspend and evaluate the accounting for fair-value measurements is evident in sections of the Troubled Assets Relief Program (TARP) legislation. The concerns relate primarily to accounting rules that force financial institutions to value securities at what they believe are overly depressed prices that do not reflect their true value. Further, they contend that reporting these depressed values has resulted in a loss of market confidence that has further exacerbated the current credit market disruptions.

This may seem to imply that fair-value measures should be dispensed with altogether. To the extent that fair-value accounting guidance is suspended or modified, in the absence of addressing analytical needs through greater disclosure and transparency, Standard & Poor's Ratings Services would view these changes as a significant step backward. However, we do believe the recently issued Securities & Exchange Commission and Financial Accounting Standards Board (FASB) guidance, which clarifies how companies should determine fair-value measurements in light of the current market conditions, is helpful.

We recognize that accounting for assets and liabilities at market prices can produce results that could mask the underlying economics for certain businesses and activities, especially during volatile and uncertain economic and market conditions. Yet, we believe the limitations inherent in fair-value accounting do not detract from the usefulness of fair-value measurements in providing a consistent starting point in analyzing financial statements. Rather, the imperfections underscore the need for financial statements to complement fair-value measures with additional information about uncertainties in the measurement of assets and liabilities. Thus, we recommended that certain refinements to fair-value accounting and disclosures be considered.

Fair Value: How Useful?

In the wake of the recent market stress, some market participants question whether fair value provides useful information for investment and credit decisions. Company executives contend that the performance measures produced using fair value create financial reporting that is misleading and disconnected from the reality of their business activities. They also say it creates unjustified and unexpected economic effects, including covenant and regulatory capital stress and liquidity shocks.

Further, there are bank analysts who don't agree that marking loans to market is the best way to assess loan portfolios because it presents a view of the portfolio valuations without giving effect to the expected future earnings that would help cover potential losses.

Many critics have faulted fair-value accounting for creating a spiral of declining valuations arising from forced asset sales. For many financial institutions, mark-to-market losses—coupled with the triggering of significant margin and regulatory capital calls—have forced rapid asset liquidation, exacerbating the loss of value, diminished counterparty confidence, and constrained liquidity.

Recent distressed asset sales by Lehman Brothers Holdings (LEH), Merrill Lynch (MER), and other distressed asset portfolio sellers set a precedent concerning asset valuations; the actual prices became benchmark prices for real-estate-backed assets and other asset classes. Lehman announced gross mark-to-market losses approximating $7 billion on residential and commercial mortgage-related positions immediately preceding the company's downfall. The impact of these marks on Lehman's financial results contributed to intensified efforts to offload its exposure in residential mortgages and commercial real estate loans and other less-liquid asset exposures.

Merrill Lynch sold a substantial majority of its collateralized debt obligations, incurring a $4.4 billion pretax loss (a 40% decline in its mark in a matter of weeks) in an effort to enhance the company's capital position and reduce risk exposure. The rapid and extreme portfolio devaluations that ultimately contributed to Lehman's failure and Merrill Lynch's loss of independence also became observable inputs for fair-value pricing by other financial institutions.