Capital Markets

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.
Tim Reason and David KatzOctober 2, 2008

Contrary to many incorrect media reports, the guidance on fair-value accounting issued on Tuesday by the Securities and Exchange Commission and the Financial Accounting Standards Board wasn’t intended as another nail in the coffin of fair-value accounting.

Rather than responding to the growing cries by banks and legislators to suspend mark-to-market reporting, FASB and the SEC were merely clarifying their previously held position that FAS 157, the now controversial fair-value disclosure standard, should be applied with an eye toward broad principles, rather than rigid rules, at least one valuation expert suggests.

It was that rigid interpretation—and not the fair-value standard itself—that may have helped intensify the financial crisis by moving financial CFOs and auditors to price distressed assets much lower than they needed to, David Larsen, a managing director with Duff and Phelps, told

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Because of the lowered valuation of their assets, banks might have felt impelled to tighten lending, the theory goes. To be sure, the language of 157 may have tilted them toward lower asset pricing, according to the valuation expert.

The standard, titled Fair Value Measurement, defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” That price is also referred to as an “exit price.” In the current market for distressed mortgage assets, as spreads have widened between the asking and bidding prices, “the exit-market concept of 157 inherently pushes one toward the bid price because that’s what the market is offering,” Larsen says.

Thus, he adds, some issuers have placed too much emphasis on the price at which they bought or sold their last securities as markets were freezing up, rather than also incorporating the instrument’s cash flows and risk portfolios in the valuation. Perhaps responding to that issue, the SEC and FASB declared in their guidance that, while transactions in inactive markets “should be considered in management’s estimate of fair value,” such deals aren’t “determinative.”

Earlier in the guidance release, the standard-setters state that “when an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.” They add: “The determination of fair value often requires significant judgment.”

Such a principles-based approach to compliance was the intent of the standards-setters even before Tuesday’s guidance, contends Larsen, who is a member of FASB’s Valuation Resource Group.

Months before the guidance, both FASB and participants at a summer SEC roundtable indicated that “just because there’s been a single transaction in an illiquid market, you don’t necessarily have to record that as your fair value,” he said. “But because that [interpretation is] out there, many people have latched onto that.”

In fact, Larsen noted, accounting literature actually provides issuers with the flexibility to look at the asset’s underlying cash flows and its true risks, as well as the last transaction price: “Whereas the bid may be 20 and the ask may be 90, maybe a more fair representation [of fair value] may be something like 60.”

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 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.

Further, having been provided with added disclosures under 157, investors might not enjoy having it taken away from them. “How would they react to having less information than they’ve had?” he asked. “How does less transparency help?”

Nathan also opposes those who argue for suspending fair value. “I think that’s a cop out,” he says. “I don’t think people are really looking into the spirit of FAS 157, and they are blaming 157. No one said it’s easy.”

Nathan is not a fan of the proposed bailout, objecting in particular to a provision which requires the Secretary of the Treasury to hold reverse auctions to buy distressed securities. “It might be easy to do a reverse auction, and it might be faster and it might be a transparent mechanism, but that doesn’t mean it’s the right solution,” he says.

The reverse auctions proposed under the bailout plan would provide an “observable price,” he acknowledges. But that won’t change the fact that the securities need to be valued as Level 3, in which the bailout’s price would still be just one of many valuation factors to be considered. “In a reverse auction, you are artificially creating a market as opposed to letting free forces create that market,” says Nathan.

For his part, Larsen feels that a government bailout could be an efficient way to activate the credit markets. To be sure, the criteria for judging the potential for success of any bailout proposal will be in the details. Overall, however, the core of the original plan submitted by U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke–buying distressed mortgage-backed securities at above-market rates from banks, which would then use the excess capital to begin lending money again–is solid, according to Larsen. The valuation specialist says, for instance, that if the government pays $40 per share for an instrument recorded on a bank’s books at $20 per share, the bank gets $20 of additional capital.

Depending on the leverage it can get, the bank could borrow 10 to 15 times that $20 of liquid capital and use it to provide “$200 of additional liquidity, or borrowing capacity, to the marketplace,” he said, noting that under such circumstances, “the bank’s balance sheet doesn’t just look better, it’s really is better because [it’s] just changed that $20 of illiquid assets for $40 of cash.”