Capital Markets

Former FDIC Chief: Fair Value Caused the Crisis

Things were fine before the accounting standards-setters barged in and "destroyed hundreds of billions of dollars of capital," he contends.
David KatzOctober 29, 2008
Former FDIC Chief: Fair Value Caused the Crisis

In perhaps the most sweeping indictment of fair-value accounting to date, the chairman of the Federal Deposit Insurance Corporation during the 1980s savings-and-loan debacle told the Securities and Exchange Commission today that mark-to-market accounting rules caused the current financial meltdown.

Speaking at an SEC panel on mark-to-market accounting and the recent period of market turmoil, William Isaac, FDIC chairman from 1978 to 1985 and now the chairman of a consulting firm that advises banks, said that before FAS 157, the controversial accounting standard issued in 2006 that spells out how companies should measure assets and liabilities that have been marked to market, took hold, subprime losses were “a little biddy problem.”

Isaac rhetorically asked the participants how the financial system could have come upon such hard times in under two years. “I gotta tell you that I can’t come up with any other answer than that the accounting system is destroying too much capital, and therefore diminishing bank lending capacity by some $5 trillion,” he asserted. “It’s due to the accounting system, and I can’t come up with any other explanation.”

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As of late 2006, Isaac, now chairman of The Secura Group, a financial institutions consulting firm, argued, “inflation was under control, economic growth was good, unemployment was low, and there were no major credit problems in the banking system.” There were $1.2 trillion worth of U.S. subprime mortgages, with about $300 billion provided by FDIC-insured banks and the rest held by investors world-wide.

Since subprime losses were estimated to be about 20 percent in 2006, federally insured U.S. banks had lost about $60 billion in that market, according to Isaac. But those banks had recorded about $150 billion in after-tax earnings and had $1.4 trillion of capital.

The devastation that followed stemmed largely from the tendency of accounting standards-setters and regulators to force banks, by means of their litigation-shy auditors, to mark their illiquid assets down to “unrealistic fire-sale prices,” the former FDIC chief asserted. The fair-value rules “have destroyed hundreds of billions of dollars of capital in our financial system, causing lending capacity to be diminished by ten times that amount,” he said in his prepared remarks.

Noting that 157 was issued in 2006, Isaac noted that he wasn’t “asking that we change the whole system of accounting that has been developed for centuries.” Instead, he said, “I’m asking for a very bad rule to be suspended until we can think about this more and stop destroying so much capital in our financial system. I think that’s a basic step that needs to be taken immediately.”

Isaac added that it’s his “fervent hope that the SEC will recommend in its report to Congress that we abandon mark-to-market accounting altogether.” The panel was held as part of the commission’s effort to comply with a requirement in the Emergency Economic Stabilization Act signed earlier this month that the SEC complete a study of mark-to-market’s role in the current crisis by Jan. 2, 2009.

Isaac’s remarks seemed to underline the highly polarized current state of the fair-value debate, with the banking industry pitted in fierce opposition to mark-to-market against the strong defense of investors and auditors. The latter point of view was represented by Ray Ball, a professor of accounting at the University of Chicago’s graduate school of business. Noting that fair value has been a subject of accounting debate for five decades, he declared, “I think it would be a terrible shame if we shoot the messenger and ignore the message” mark-to-market accounting conveys about the current condition of banks.

Similarly, Vincent Colman, a partner at PricewaterhouseCoopers, encouraged the SEC to look at the “root causes” of the crisis, “including those that go beyond accounting and financial reporting.” In particular, regulators should refine current capital guidelines and enforce “an independent standards- setting process” that’s free of political influence, he said.

The auditor urged the commission to keep the current fair-value rules intact during the credit crisis. “Any fundamental change to fair value runs the risk of reducing confidence among investors,” he said, “which tends to restrict the flow of capital.”

Espousing a middle position in the debate, Damon Silvers, associate general counsel for the AFL-CIO, asserted that there were errors on both sides. Countering fair value’s critics on the banking side, he said that the opacity in the reporting of mortgage securitizations is a root cause of the credit freeze.

Further, even if fair-value accounting were eliminated, the trillions of dollars of distressed mortgage-backed assets on bank balance sheets “are never going to be worth their full value,” he said. “Assuming that those people who are thrown out of their homes will return with a pile of cash is deeply deluded.”

On the other hand, 157’s provision that companies holding assets and liabilities in inactive markets need to use models to value them runs the risk of “making a complete hash of financial statements,” according to Silvers.

The provision causes companies to move “further and further away from the stated mark-to-market regime,” he observed. “If we don’t have that market [on which to base valuations], we move to a more baroque series of arrangements.”