Strange Bedfellows: Fair Value and the Bailout Plan

The presence of the government in the market could be just another piece of information to assess.

The fear of litigation, however, may have led to lower valuations. “It’s the rules-based nature of the historic audit profession and the historic CFO profession running kind of head on into the principles-based concept of 157,” he said. “If an auditor doesn’t follow the rules, they get beat up by their regulator, but 157 is principles-based, so it clearly allows judgment.”

Rick Nathan, managing director of Trenwith Valuation LLC, speaking with CFO.com before the SEC and FASB issued new guidance, said he thinks banks were “overly conservative” in their valuations, relying too heavily on market prices in a market that essentially didn’t exist. “As a consequence, they are really hurting investors, and, by extension, taxpayers.”

While FAS 157 “is not completely infant in use, it’s still not very well understood in terms of balancing the various choices one has,” says Nathan — a view apparently confirmed by FASB’s new guidance. And banks aren’t the only ones taking the wrong approach. “You have auditors who are trying to determine fair value on a fairly current basis,” Nathan says.

The standard lays out a so-called measurement “hierarchy” that provides ways to value securities depending on how liquid they are. Regularly traded securities (Level 1) are valued on their selling price, whereas securities that are thinly traded (Level 2) or in illiquid markets (Level 3) have a different set of inputs. “These mortgage-backed securities are Level 3-based securities, and one is not forced to rely on the last price or on recent transactions,” Nathan explains. “There should be more patience and more exploration into what FAS 157 allows without fear that the last-traded price is the best determination in the eyes of the commission or shareholders.”

With a second House vote on the Congressional rescue package passed by the Senate yesterday expected by the end of the week, however, the question of how well fair value can coexist within an increasingly government-controlled financial system is still up in the air. Mark-to-market opponents contend, of course, that there can be no such thing as “fair value” in a market dominated by the government. What kind of “market participant” could the federal government be, if it sets out to pay banks higher than market prices for distressed assets, as the plan envisions?

“A highly unusual, unanticipated market participant,” but one that the FAS 157 valuation regime could still accommodate, thinks Larsen. To be sure, the government could be a participant with “ulterior motives,” and non-governmental asset holders would do well to view the effects it has with “some level of questioning,” he said.

But the nature of the financial instrument being bought and sold remains the same, he says, and the fact that the government is involved should be treated just another piece of information in valuing the assets.

Contending that fair-value accounting has led banks to dump distressed securities into the market at fire-sale prices, some have floated the notion that a bailout plan should include a suspension of the use of mark-to-market accounting of perhaps two years. Larsen wasn’t having any of it. “A moratorium on mark-to-market accounting doesn’t make sense conceptually. If you, say, suspend application of 157, the only impact that would have would be potentially less disclosure on how values are being determined,” he says.

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