Capital Markets

Investors Smack Banks for Fair-Value Attack

Blame the subprime mess on your own bad investments, not on accounting, FASB's investor group says.
Marie LeoneMay 30, 2008

Are bankers covering up their own blunders by blaming their mishaps on fair-value accounting? One investor group — an offshoot of the Financial Accounting Standards Board — thinks so, and has published a letter to get the word out.

When financial institutions argue against mark-to-market financial reporting to avoid acknowledging their own poor business investments, they essentially are saying, “Pull the covers over the problems and maybe they will go away,” the group, FASB’s Investors Technical Advisory Committee, wrote last week. Formed to provide the standard-setter with input from investors, the 12-member committee boasts top-tier accounting talent.

Blaming fair-value accounting for worsening the subprime-mortgage crisis is a “shoot the messenger” argument, added the ITAC. The May 23 letter was written in response to several public statements made by managers of financial institutions and representatives of banking groups that condemned the increased use of fair-value accounting for exacerbating the current credit crisis. For example, in April American Bankers Association CEO Edward Yingling blasted the idea of using fair-value accounting for financial instruments. “Under the stress of current market conditions, accounting policy should focus on measuring the heat of the flame instead of pouring gasoline on the fire,” he said.

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The ITAC disagrees with that argument. Financial institutions are supporting a “return to the old financial reporting model…[that was] in effect decades ago with its out-of-date historical cost reporting and lack of transparency,” the committee wrote to FASB chairman Robert Herz and International Accounting Standards Board chairman David Tweedie. The group also said its members were “dismayed” at the call from major financial institutions to suspend fair-value reporting for financial instruments.

In 2006 FASB issued FAS 157, Fair Value Measurement, to provide a standardized way to measure financial assets and liabilities at fair value, and present related disclosures. The standard went into effect last year, specifically for companies that began their fiscal years after November 15, 2007.

As a result, when accounting rules require a company to record a financial asset or liability at fair value, rather than historical cost, it must do so using the new FAS 157 yardstick. Companies balked at the fair value measurement, however, when the the subprime crisis caused the value of many mortgage derivative instruments to plummet, and companies — most of them banks and other financial institutions — were forced to mark the securities to market and then write down what turned into massive losses.

The ITAC insists that the banks most critical of fair value are the same ones that have reported major write-downs of subprime mortgages and derivative instruments based on them. While the letter didn’t name the specific banks, some of the world’s largest institutions have made headlines recently with announcements of enormous first-quarter write-downs related to subprime losses. Those banks include Citigroup, which recorded a $12 billion write-down during the period, and Merrill Lynch and JPMorgan Chase, which posted charges of $6 billion and $2.6 billion, respectively, for the first quarter.

In its letter, the ITAC also scolded the “few” banking managers who tried to “shift the blame for the current crisis from the poor business and investment decision-making, including the flawed underwriting, securitization, risk management, and disclosure practices in which they engaged, to fair value financial reporting.” The advisory group called the managers’ reasoning “perplexing and misleading,” since fair-value reporting was “instrumental” in uncovering the market’s widespread problems.

The group defended mark-to-market valuation methodology as supplying relevant, high-quality, and transparent information to investors. “The higher the quality of fair value information that is provided, the faster will be the necessary market adjustment to the problems,” noted the letter.

The committee also took issue with the banks’ argument that fair value’s “pro-cyclical” characteristics aggravated the credit crisis. According to the ITAC, critics complain that the fair-value requirement to measure and recognize losses “results in a positive feedback loop that propels values downward.” But that argument is conveniently one-sided, said the ITAC, since fair value “does not draw similar criticism when news is good and prices rise.” What’s more, the feedback loop is doing its job by sending warning signals in the form of sinking prices in response to bad news, the same way it reflects good news by boosting prices, the group wrote.

Such downward triggers are a “normal part of the contracting process and designed to protect the investors, including lenders,” the ITAC added. “The fact that the triggers were activated is not an indictment of the measurement system but rather is a direct function of the poor or deteriorating quality of the investments.”