Congress Members Fume at Fair Value

Lawmakers bear down on FASB chairman Robert Herz to modify fair-value rules.
Marie Leone and Sarah JohnsonMarch 12, 2009

In their most public flogging to date, fair-value accounting rules were vilified in a congressional hearing today for causing major writedowns at financial institutions and allowing the crisis to continue.

For more than a year, the standards have been blamed for bringing volatility to financial reporting and acting as a major contributor to the U.S. financial downturn. The latest criticism came from both Republicans and Democrats during a House Financial Services subcommittee hearing today. To be sure, the critics stopped short of calling for the suspension of fair-value accounting.

But they pressed standard-setters and regulators, who traditionally use lengthy due-process procedures before making major changes, to alter existing related rules immediately. “This is an emergency situation that requires expeditious action, not academic treatises,” said Rep. Paul Kanjorski, a Pennsylvania Democrat who chairs the subcommittee. “They must act quickly.”

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In effect, anti-fair-value members of the subcommittee appeared to blame the accounting for the problems they are having in their districts: rising foreclosure rates, unemployment, and small businesses that can’t get bank loans. Their reasoning appeared to follow the path that major banks have taken in arguing that mark-to-market accounting rules helped push the economy into a downward spiral. “We can no longer deny the reality of the pro-cyclical nature of the mark-to-market accounting has produced numerous unintended consequences and exacerbated the ongoing financial crisis,” Kanjorski said.

Under FAS 157, which provides the current framework for fair-value measurements, companies must use a three-level hierarchy when estimating the current worth of their financial assets and liabilities. Level 3 is designated for thinly traded or untraded assets that have a value derived from “unobservable inputs.” Fair-value critics say this category of assets has caused extreme volatility and massive writedowns in the financial-services sector. The volatility and the writedowns have led firms to violate their regulatory capital requirements, they contend.

But most of the valuations done by financial institutions were based on observable inputs, according to an Securities and Exchange Commission study done last year. The regulator concluded that fair-value-related losses did not a have a “significant” effect on hurting banks’ capital.

Moreover, the Financial Accounting Standards Board has disputed bank advocates’ notion that fair-value accounting has resulted in excessive writedowns of their securities. In a review of publicly traded banks, the board’s staff found that 52 percent of them were trading at less than tangible book value up until last November.

For their part, representatives from the FASB and the SEC tried to discourage House members from blaming the rules themselves for keeping the crisis going. “Accounting did not cause this crisis and accounting will not end it, but accounting should not make it worse,” said James Kroeker, acting chief accountant for the SEC.

Rather, part of the problem may be how the rules are interpreted, they note. For that reason, FASB is working on guidance that could change how companies assess an asset’s fair value in an inactive or illiquid market. This advice will stress the need for judgment and move practitioners away from the tendency to consider the last price for which a financial instrument has been traded as its fair value. Herz is hoping more preparers will realize they can use expected cash flows of an asset as an alternative to trying to nail down market prices when making difficult valuations. The lack of internal expertise at financial institutions, however, may be discouraging them from doing so.

Badgered to give a time frame for issuing this guidance by Rep. Gary Ackerman, a New York Democrat, FASB chairman Robert Herz said his board could have the guidance ready for the public in three weeks. That would be a very quick turnaround for the board, which usually issues changes to rules for a public-comment period that can last many weeks after lengthy deliberations.

At Thursday’s hearing, many subcommittee members interpreted Herz’s promised guidance as a major change to existing rules, which he tried to clarify many times. “We can have the guidance in three weeks, but whether that will fix everything is another [issue],” he said.

A more long-term project FASB is working on could allow companies to distinguish between impairments made because of credit and liquidity problems. Herz told the representatives the project will take at least a year.

While most of the lawmakers refrained from proposing legislative changes, two subcommittee members promoted a recently introduced bill that would create a new oversight body to monitor FASB. This group would be made up of five top regulators: the Secretary of the Treasury, the chairman of the Federal Reserve, the chairman of the SEC, the chairman of the Federal Deposit Insurance Corp., and the chairman of the Public Company Accounting Oversight Board. The board must also make sure that accounting rules “handle illiquid and liquid assets differently.”

Not all of the representatives at the hearing demanded changes to the accounting rules. In the minority was Florida Democrat Alan Grayson, who spoke last. Essentially, Grayson wants to keep fair-value accounting intact. He wryly compared changing mark-to-market rules to what he considered other outlandish ideas.

For example, it would be like changing the circumference measurement Pi from 3.14 to 4 so the crowded circular highway around Washington known as the Beltway would be expanded; or increasing the size of an inch so he could be more comfortable on a plane; or make the number 98 larger than 109, so the loss the Washington Wizards pro basketball team had just suffered at the hands of the New Orleans Hornets would be recorded as a win. “Does it make sense to kill the messenger?” he asked the panel.

Kroeker asserted that the SEC did not advocate suspending fair-value rules. But he did admit that the standards “warrant improvement” in areas other than “scorekeeping,” such as how to determine fair value and how to calculate other-than-temporary income. Likewise, his boss, SEC chair Mary Schapiro, told a separate House subcommittee yesterday that FASB needs to guide companies on how to provide “a better application” for determining what assets are worth.

For his part, Herz pointed out that “the single largest assets on a bank’s balance sheet ­- if it is not a money center bank – are loans, which are carried at historical cost and do not reflect the [fair-value] problem.” He also agreed with Grayson’s assessment that most of the fair-value critics “clamoring” for a rule change were part of institutions on the brink of insolvency.

Indeed, while Herz said that there were valid issues about fair-value accounting that FASB would address, he said that he often had visits from critics that became insolvent a few weeks after visiting him at FASB. The “most vocal opponents” of fair value have been institutions that have failed and have received billions of dollars in handouts from taxpayers, Herz told Congress.

Both Grayson and Herz also saw eye-to-eye on one other subject, that some banks that may not have fully disclosed their dire financial position yet. “Bank stocks continue to trade below their accounting book value,” noted Herz. “Which means,” added Grayson, “that there may be institutions that are insolvent that have not written down [assets] enough yet, and want [rule] changes before they have to disclose that.”