Fair Value, Mark to Market Not Going Anywhere Soon

Fair-value Accounting: Here to stay
While changes are needed, a proponent concedes, mark-to-market accounting does a fair job of assessing a company's financial health.
Fair value accounting is still fair game for attack, but there may be more common ground than imagined between critics and proponents of the rules governing how financial firms value the securities they hold.

The Securities and Exchange Commission at a Wednesday roundtable heard comments on fair value, or mark-to-market bookkeeping, which requires firms to value securities in their portfolio at, well, market prices.
Such accounting arcana has turned into a political football in recent months as firms were forced to write down the value of debt for which few buyers existed - like mortgage-backed securities in a deflating real estate bubble. SEC chief Christopher Cox said Wednesday that the fair-value standards need "further work." He wasn't alone. Though fans maintain the fair-value approach results in greater transparency for investors, critics such as former Federal Deposit Insurance Corp. chief William Isaac argue that it does no such thing.

Worse, they say, it's intensifying the financial-sector meltdown by forcing banks to write down the value of debt securities even if the loan payment streams behind them are flowing satisfactorily. "Mark-to-market accounting has been extremely and needlessly destructive of bank capital in the past year, and is a major cause of the current credit crisis and economic downturn," Isaac said in prepared remarks. "The 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." (Banks typically lend out around ten times their capital.)

Caught in the middle is the Financial Accounting Standards Board, the private-sector group that sets U.S. accounting rules along with the SEC.

Not so opposite
Despite the lively debate, one expert says there is more common ground than might be initially apparent - which, in his view, means the mark-to-market rules are likely here to stay. "Those who looked like polar opposites were actually much closer than they appeared," says David Larsen, a managing director at financial advisory firm Duff & Phelps and a member of the FASB committee that advises the board on fair-value accounting issues. "The task now is to harmonize the conflicting views."

Isaac's broadsides aside, Larsen says he believes many comments made at Wednesday's meeting show that critics of the mark-to-market regime often misunderstand the current rules and how they should be applied. Proponents and critics of the rules, he says, often agree on some principles but don't know it because they're "speaking different languages."

That observation, he says, gives the FASB and the SEC latitude to possibly issue further guidance and make minor changes to the rules, without throwing them out - a move that he said would reduce whatever insight investors have into often opaque financial firms.

One aspect of the fair-value approach that may need adjusting, Larsen says, revolves around how to hold accountants, auditors and financial executives accountable for the judgments they make in assessing the value of an infrequently traded security. He says that one common misperception centers on what happens when a recent trade has been at a fire-sale price. He takes the example of Merrill Lynch's (MER, Fortune 500) agreement in July to sell a $30.6 billion portfolio of troubled debt to Lone Star funds for 22 cents on the dollar.

Fair value rules don't force holders of similar securities to use 22 cents as their mark, Larsen says. But he says some comments made by opponents of the fair value rules suggest they believe otherwise - and he fears that accountants and auditors who recall Arthur Andersen's prosecution for its mishandling of Enron's books may see things the same way.

"We have people who are doing the right thing who are just afraid of making a mistake," said Larsen. He says one thing regulators might consider is some sort of safe harbor that would permit accountants to make difficult securities-valuation judgments without the risk of jail time. Those aren't the only changes that may come to the fair-value regime. The FASB is working on adding disclosure requirements, Financial Week reported, that would help investors and analysts more fully understand the types of assumptions firms made in valuing infrequently-traded securities.

Wednesday's roundtable came about as a result of the passage earlier this month of the Emergency Economic Stabilization Act, which directed the SEC to study the economic impact of fair-value accounting. The agency is due to hold another roundtable next month and to report back to Congress by Jan. 2. Larsen, for one, believes the fair value rules are here to stay, even if their form is apt to change at the margins. "My sense is that investors want and need transparency," he said. "That's out of Aladdin's lamp, and you can't push it back in."
By Colin Barr, Fortune

SEC: Back to the Drawing Board on Fair Value, Mark to Market

SEC's Cox Says Fair-Value Rule Needs `Further Work'

U.S. Securities and Exchange Commission Chairman Christopher Cox said an accounting rule blamed for pushing American International Group Inc. and other firms to the brink of collapse needs ``further work.''

``Illiquid markets are bringing new challenges to the measurement of fair value,'' Cox said today during an accounting conference at the SEC's Washington headquarters. ``These challenges have brought into focus the need for further work on improving the tools that companies have at their disposal to achieve transparent'' financial reporting, he said.

Cox's comments may provide an opening for business groups that want regulators to give financial companies more flexibility in valuing assets after more than $684 billion in losses since the start of 2007. Fair-value accounting forces firms to mark down holdings to current trading prices every quarter, which companies say makes no sense when markets are frozen.

Fair-value has been ``extremely and needlessly destructive of bank capital in the past year and is a major cause of the current credit crisis,'' said William Isaac, a former chairman of the Federal Deposit Insurance Corp. ``Assets should not be marked to unrealistic fire-sale prices,'' he said.

The rules on fair-value accounting instruct companies to measure assets and liabilities assuming ``an orderly transaction between market participants.'' A forced or distress sale isn't an orderly transaction, the rules say.

Cox didn't endorse a suspension of fair-value accounting, a move that Isaac and some members of Congress have advocated.

`Independent and Deliberative'
The SEC chairman also said the Financial Accounting Standards Board should be free from outside pressure, and should consider changes to the rule in an ``independent and deliberative manner.'' The SEC oversees Norwalk, Connecticut-based FASB, which writes U.S. accounting standards.

The American Bankers Association and the U.S. Chamber of Commerce have urged Cox to override FASB, which they say has been too rigid in interpreting accounting requirements.

The SEC is required to examine fair-value accounting under terms included in the $700 billion federal financial-rescue package enacted this month. The agency must submit a written report to Congress by Jan. 2 that evaluates how the rule can be improved and whether it has caused banks to fail.

Former executives of AIG, the insurer saved from collapse by an $85 billion Federal Reserve loan last month, told lawmakers the requirement forced the company to book unrealized losses on distressed mortgage-backed securities and credit-default swaps.

`Historic Cost'
Placing a moratorium on the fair-value rule would be a mistake, said Raymond Ball, a University of Chicago accounting professor. He cited Japan, which in the 1990s let its banks hide losses by holding assets at ``historic cost'' instead of current trading prices.

``Investors in the capital markets didn't know which were the strong banks and which were the weak banks,'' Ball said at the SEC conference. ``That inhibited the recovery of the economy.''

The accounting industry has defended the fair-value requirement, arguing in letters to the SEC and lawmakers that it gives investors transparency about the health of companies.

Isaac said accountants, who must sign off on companies' financial statements, are worried about getting sued if their clients go bankrupt. He said Congress should consider giving auditors protections from lawsuits when they base fair-value assessments on ``reasonable business judgment.''

``One important consequence of subjecting accountants to enormous potential liabilities is that the profession reacted by moving toward very rigid rules that leave little room for judgment,'' Isaac said.
By Jesse Westbrook and Ian Katz at Bloomberg

SEC Roundtable: Accountants Battle it Out

SEC Gets Conflicting Advice On Mark-to-Market Accounting

U.S. securities regulators received conflicting advice Wednesday on whether to dispense with mark-to-market accounting rules that critics say are deepening the nation's economic woes.

The issue was debated at a public forum at the Securities and Exchange Commission, which is under pressure to suspend or repeal mark-to-market accounting for certain financial instruments. Congress ordered the SEC to examine the matter and provide a written report by Jan. 2. SEC Chairman Christopher Cox said regulators will hold a second public session on the topic on Nov. 21, and seek written input from the public through Nov. 13.

Supporters and opponents of fair-value, or mark-to-market, accounting clashed at Wednesday's session on whether the approach is helping or harming investors.

Former Federal Deposit Insurance Corp. Chairman William Isaac called for fair- value accounting to be suspended or repealed immediately, saying it is " transparently wrong" and "senselessly destructive" to force companies to slash the values of loans and other financial assets to unrealistically low levels.

Yet changing the rules on fair-value accounting could increase uncertainty among investors and make markets more anxious rather than less, countered University of Chicago accounting professor Ray Ball.

"I think it would be a terrible shame if we shot the messenger and ignored the message," said Ball.

PricewaterhouseCoopers LLP partner Vincent Colman defended the current rules and said the Norwalk, Ct.-based Financial Accounting Standards Board should be kept "free from political pressures" and undue outside influence.

Although the SEC oversees the FASB, it rarely overrules it. Isaac recommended more direct oversight, requiring U.S. accounting rules to be approved by the Federal Reserve and the Federal Deposit Insurance Corp. He endorsed a return to historical accounting, which values assets and liabilities at their original cost, terming that vastly superior to the more volatile mark-to-market approach.

Mark-to-market accounting rules require companies to adjust valuations of certain assets and liabilities they intend to trade or sell to reflect current market prices. Critics say it makes earnings too volatile and intensifies market downturns. Even supporters of the approach concede that it is much harder to apply when markets aren't functioning normally, requiring companies to estimate values using computer models, or look to distressed "fire-sale" transactions.

While it's "deeply deluded" to think some battered assets will recover anytime soon, efforts to value something that isn't trading could produce "mark to mush, " worried AFL-CIO associate general counsel Damon Silvers.

"There is a real risk that things here are not what they seem to be," said Silvers.

Mark-to-market accounting rules also are crimping mergers because companies have to adjust valuations of assets they acquire even if they don't intend to sell them, a nasty side-effect that only makes bad markets worse, warned Aubrey Patterson, chairman and chief executive of BancorpSouth Inc. (BXS), based in Tupelo, Miss.

Cleveland-based KeyCorp (KEY) abandoned some acquisitions for that reason, according to accounting policy director Chuck Maimbour. He said the bank "just couldn't make it work" and walked away from deals due to the potential hit from mark-to-market accounting rules.

PwC's Colman suggested that the current fair-value accounting rule could be tweaked to distinguish between actual credit losses and other factors, such as declines in value due to illiquid markets. The idea drew a mixed response, with some questioning whether companies could make such calls easily, or if that would make it even harder to determine the fair value of an illiquid asset.

Cindy Ma, a managing director and valuation expert with Houlihan Lokey Howard & Zukin, said she would be afraid to use that approach, fearing it would rely heavily on computer models that "can be manipulated," and create a "nightmare" for auditors who have to sign off on a company's financial reports.

Swiss Reinsurance Co. (SWCEY) Managing Director and Chief Claims Strategist Richard Murray, who chairs the U.S. Chamber of Commerce Center for Capital Markets Competitiveness, said there is no easy way to value a company, with or without mark-to-market accounting rules. He stressed the need for companies and auditors to bring judgment to bear and asked regulators to consider offering a "safe harbor" from legal liability for honest valuation mistakes.
By Judith Burns, Dow Jones Newswires

SEC Roundtable on Mark to Market Today

The SEC is having its Roundtable on mark to market accounting today.

The agenda is here.

You can listen here.

Don’t Blame Accounting

Will 'mark to market' accounting take the fall for the Wall Street mess?
Mark to market is a business rarity - an accounting term that draws reactions from people who don't know spreadsheets from bedsheets. Mark to market, which we'll call MTM, evokes images of Enron's made-up profits and the other corporate scandals that marred the first years of this decade. Not pretty.

Now MTM - which means valuing marketable securities at market prices - is a hot item again, but for the opposite reason. This time financial companies and their allies are claiming it's too strict. They argue that marking the value of complex, illiquid securities to artificially low market prices has unnecessarily crippled the U.S. and world financial systems by creating billions of illusory losses on perfectly fine (albeit illiquid) securities, such as collateralized debt obligations linked to mortgages. Markets for these things, the argument goes, are depressed way below true economic value.

Accountants argue that MTM - known formally as Financial Accounting Standard 157 - is fine, although the Financial Accounting Standards Board has agreed to tweak it some. (Don't ask me for details - the written arguments on this are so sleep-inducing they could be marketed as an Ambien alternative.)

This week, the Securities and Exchange Commission is scheduled to hold a high-profile public meeting about MTM. The SEC, which has the power to overrule FASB, is holding the meeting because Section 133 of the $700 billion bailout bill requires that it study MTM and report to Congress by late December.

The guy who got 133 into the bill, Representative Spencer Bachus (R-Alabama), the ranking minority member of the House Banking Committee, told me he wasn't trying to politicize accounting. "It just says, 'Study it,'" he told me. "It doesn't say [to do] a study to repeal it. It doesn't say [to do] a study to suspend it."

But given that it's finger-pointing time both in Washington and on Wall Street, it's not going to be easy for the SEC to leave mark to market strictly alone. In this environment what regulator dares run the risk of being held responsible for not doing something that would supposedly mitigate the world's credit crunch? Would you want to find yourself accused of failing to act if the financial world totally melted down, as it has occasionally seemed about to do?

Normal accounting is being overridden to help banks in various ways. In early October, for instance, federal financial regulators jointly ruled that the $125 billion of preferred stock the Treasury is buying from nine big banks will be treated as tier-one capital (the best kind), even though it normally wouldn't qualify.

Second, in a little-noted move, regulators allowed banks with losses on some Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) securities to treat the resulting tax savings as tier one in their regulatory statements for the third quarter. That's strange, given that the fourth quarter ended Sept. 30, as usual, but legislation making this tax break usable didn't become law until Oct. 3. How often has my source for this nugget - accounting guru Robert Willens of Robert Willens LLC - seen such grandfathering in his 40-year career? "Never," he says.

Of course, this is more about optics than economics. As is mark to market, in my humble opinion. Credit markets have been frozen much of the past 15 months largely because banks haven't trusted the balance sheets of other banks and have thus been afraid to lend to them. I can't imagine that confidence problem being resolved by changing MTM.

There are problems with MTM: It's relatively new, and parts of it seem arbitrary. But its problems have been exaggerated. It's easier to blame accountants for your problems than to admit you made your institution vulnerable by overleveraging its balance sheet and buying securities you didn't understand. Ironically, many of today's whiners adopted MTM a year before they had to, partly because of an arcane provision that let them count as profit the decline in the market value of their publicly traded debt.

The bottom line: Despite MTM's flaws, blaming it for the world's financial problems isn't the answer. Neither is shooting the messenger - or, in this case, the accountant.
By Allan Sloan, senior editor at large, Fortune Magazine

EU: Hands off Fair Value Accounting

Brussels defuses threat of 'fair value' demands
Changes to controversial fair value accounting rules will be left to the accounting rulemakers, European officials said yesterday after a meeting that defused the threat of political intervention. Mounting pressure to ease fair value, which requires companies to mark most of their financial holdings at their current market value, had led to suggestions the European Commission could "carve out" sections of the current rules or even form its own rulemaker.

European Union accounting is set by the International Accounting Standards Board, whose rules are followed, or are being adopted, by more than 100 countries. Yesterday the Brussels meeting, comprised of Commission officials, regulators, banking and insurance representatives, investors and accountants, drew up a modest list of issues that it would like the IASB to consider but stopped well short of the high pressure for immediate action that some had expected.

"Everyone stressed the importance of a solution at a global level," said one par-ticipant afterwards.
Others agreed the meeting had in effect buried any suggestion of a European "carve-out" of the IASB's rules or the creation of a new regional standard-setter - fears that had surfaced publicly beforehand. "There was a very positive outcome, with unanimous support for working within the IASB framework and in line with proper due process," said a spokesman for Charlie McCreevy, EU internal market commissioner.

Last week the IASB eased its fair value rules to align them with US generally accepted accounting principles (GAAP) following pressure from Brussels and a number of banks and insurers. The market seizures of the past year have forced financial institutions to write down billions in the value of their assets, hitting profits and undermining their capital reserves.

The commission will still pursue with the IASB further changes to the rules. Areas likely to be considered include allowing financial institutions to reclassify assets containing embedded derivatives from being marked at fair value to "amortised cost", which would ignore further violent market swings and smooth out their impact on reported profits and capital reserves.

However, this will be done through the IASB's regular processes and not be sought on an emergency basis as were last week's changes, which come into effect for third-quarter accounts that close at the end of this month. Any new changes could instead be brought in for year-end, but not sooner. Earlier this week the IASB and its US counterpart, the Financial Accounting Standards Board, agreed to set up a joint global advisory group to examine accounting issues thrown up by the credit crunch and was expected soon to announce high-profile appointees.
By Jennifer Hughes Nikki Tait of the Financial Times

Don't Change Mark to Market

Accounting rule changes could dent confidence, say analysts
Hasty revisions to controversial accounting rules on how to value assets risk undermining investor confidence in company accounts, a group of senior investors and analysts has warned.

Members of the Corporate Reporting Users Forum, a pan-European group of investors and analysts, urge the European Commission not to make further amendments to accounting rules.

The Commission is hosting a meeting today involving regulators, banking and insurance representatives, investors and accountants to discuss further changes to the rules.

The resulting "wish list" will then be presented to the International Accounting Standards Board, which sets accounting rules for more than 100 countries, including those in the European Union. The so-called fair value accounting rules require companies to mark most financial instruments at their market value.

In the present illiquid markets, values have plunged, forcing banks and insurers into a series of enormous write-downs that have savaged their capital reserves.

The IASB has eased its rules to align them with US practice but many banks and insurers believe the standards misrepresent their true financial health and have called for immediate changes.

In a letter to the Financial Times, the CRUF pledges to oppose any steps by the Commission that could lead to a European "carve out" of the IASB's rules or potentially lead to the creation of a new regional standard setter. "Now especially, investors need comparability and transparency, not further uncertainty and inconsistency," the group said.

Although the final "wish list" is not yet known, today's discussions will cover calls for further easing of fair value rules in illiquid markets and for more instruments to be accounted for not at fair value but at "amortized cost" - a practice that would smooth their impact on institutions' balance sheets.

The list could, however, pose a threat to the IASB, which is likely to have previously dismissed many of the requests and could struggle to revisit them without damaging its credibility.

Other countries that have adopted, or are adopting, the IASB's rules include China, Hong Kong, South Africa, Australia and Canada. Many have warned the IASB about the dangers of being seen to be led by one interested bloc.

If the IASB finds it cannot accede to the requests, there have been some private suggestions that Europe would do better with its own accounting rulemaker - a move that would be a death blow to the long-running and almost successful effort to converge all accounting into a single global set of rules.
By Jennifer Hughes in London and Nikki Tait in Brussels for the Financial Times

Blaming the Bean-Counters
Accounting rules did not cause the financial crisis; changing them won't end it.

Inevitably, perhaps, the deepening financial crisis has spawned a search for scapegoats and quick fixes. According to many Republican members of Congress, banking industry lobbyists and financial pundits, the Wall Street meltdown would not be nearly as bad as it is but for the baleful impact of "mark-to-market" accounting rules. These are national standards, adopted in the wake of the savings and loan debacle of the 1980s, that require banks to carry certain financial assets on their books at the current market price. The idea is to give investors the latest and most objective estimate of a company's true financial condition -- as opposed to a company's inevitably self-serving calculation based on original costs.

Now that the markets for mortgage-backed securities and derivatives have seized up, however, their market price is either distressingly close to zero or impossible to determine. Critics argue that marking-to-market when there is no market artificially and irrationally depresses banks' balance sheets, since the assets would fetch near face-value under normal circumstances. Ergo, they contend, the way to shore up bank capital is to relax or eliminate mark-to-market -- and it wouldn't cost taxpayers a dime.

The critics have a point. Undoubtedly the markets, out of irrational fear, are shunning some relatively solid assets as well as actual turkeys. Mark-to-market therefore does force banks to write their books in the panicky language of today's meltdown. Perhaps, once the crisis is over, it would be wise for the Securities and Exchange Commission and the accounting authorities to revisit this "pro-cyclical" aspect of the rule. The recent bailout legislation included a provision requiring the SEC to study mark-to-market's impact. We see no harm in that.

But the critics' arguments against mark-to-market may prove too much. If the rule requires banks to accentuate the negative during bust times, then presumably it is also to blame for all those wonderful financial statements the banks were issuing during the boom. We don't recall anyone demanding its suspension then. Actually, complaints about the rule probably overstate its impact, since financial institutions only have to use it for securities they intend to trade. Loans and securities held to maturity are not covered by mark-to-market; at big banks such as SunTrust, Wells Fargo and Bank of America, such long-term assets represent half or more of all assets.

Markets not only need transparent financial reporting, they need consistent financial reporting. To suspend or abandon mark-to-market now, in the middle of a panic, would simply deepen the confusion and suspicion that are already crippling the financial system. No, today's financial meltdown is not some accidental byproduct of misguided technical rules. It happened because too many firms made too many bad financial bets with borrowed money. Pretending otherwise won't solve anything.
Washington Post Editorial

European Accountants: Don’t Change Fair Value Rules

Hasty revisions to controversial accounting rules on how to value assets threaten to undermine investor confidence in company accounts, a group of senior investors and analysts has warned. Members of the Corporate Reporting Users Forum, a pan-European group of investors and analysts, urge the European Commission not to make more amendments to accounting rules.

The Commission is hosting a meeting on Tuesday involving regulators, banking and insurance representatives, investors and accountants to discuss changes to the rules. The resulting “wishlist” will then be presented to the International Accounting Standards Board, which sets accounting rules for more than 100 countries, including the European Union.

The so-called fair value accounting rules require companies to mark most financial instruments at their market value. In the present illiquid markets, values have plunged, forcing banks and insurers into enormous writedowns that have savaged their capital reserves.

The IASB has eased its rules to align them with US practice but many banks and insurers believe the standards misrepresent their true financial health and have called for immediate changes.

In a letter to the Financial Times, the CRUF pledges to oppose any steps by the Commission that could lead to a European “carve out” of the IASB’s rules or potentially lead to the creation of a new regional standard setter. “Now especially, investors need comparability and transparency, not further uncertainty and inconsistency,” the group said.

Although the final “wishlist” is not yet known, today’s discussions will cover calls for easing of fair value rules in illiquid markets and for more instruments to be accounted for not at fair value but at “amortised cost” – a practice that would smooth their effect on institutions’ balance sheets.

The list could, however, pose a threat to the IASB, which is likely to have previously dismissed many of the requests and could struggle to revisit them without damaging its credibility. Other countries that have adopted, or are adopting, the IASB’s rules include China, Hong Kong, South Africa, Australia and Canada.
By Jennifer Hughes in London and Nikki Tait in Brussels for The Financial Times

PricewaterhouseCoopers' Survey: Bank, other Financial Services Board Members Say Mark to Market is Not to Blame for Crisis

Pricewaterhouse Coopers recently completed a survey of 300 board members, two-thirds of whom sit on the audit committee of financial institutions, taken between September 22nd and October 4th at the 2008 PricewaterhouseCoopers Financial Services Audit Committee Forum.

Respondents were surveyed about mark to market accounting: Nearly two-thirds (65%) of financial services board members surveyed agree that mark-to-market accounting, also known as fair valuation, creates volatility in the markets. However, 83 percent disagreed with the statement that mark-to-market accounting is to blame for the current credit crisis.

About the current financial crisis:

• 30 % view the situation as a reminder of the need for more disciplined risk taking during periods of growth
• 20 % say it is a reflection of too much focus on the short-term (investing, reporting, compensation).
• 13% found the positive in the tumultuous economic climate and regard the situation as an opportunity that will eventually strengthen the financial services industry.
• 25%sees this as an example of the urgent need for modernization of the financial services regulatory framework to reflect today's global, integrated capital markets system.

Other findings:

• 96 percent of board members said they think that financial institutions that retain risks to off-balance sheet entities should in the future publicly disclose aggregate information on a regular and timely basis, including the quantity and sensitivity to credit, market and liquidity risks and any changes to those risk exposures over time.
• 65 percent of respondents feel that corporate boards lack the tools and transparency to properly assess risks and exposure.
• 88 percent said the scope of risk management for financial institutions does not adequately account for their exposure to off-balance sheet entities.
• 80% feel they could do more to reduce the chance of future industry instability, according to findings of a survey released today by PricewaterhouseCoopers' Financial Services Industry Group. However, the survey also revealed a desire for greater transparency to accurately measure exposure to risk.
• More than 95 percent of the board members asked said they believe greater clarity is required as it relates to what is and what is not reported on an organization's balance sheet
• 77 percent said existing valuation tools are not robust enough.
  

When asked to rank their four top priorities over the next twelve months, audit committee board members ranked them as follows (in order of importance):

• Transparency and financial reporting
• Internal controls and tightened margin/collateral controls
• Enterprise-wide risk management and buy-in from business lines
• Systematic risk management across the industry

Japan Calls for Change to Mark-to-Market Rules

Japanese Finance Minister Shoichi Nakagawa said on Friday he wants an emergency adjustment in mark-to-market accounting rules to avoid systemic risks emerging in the financial system. He said he had asked a body that sets accounting rules for Japanese companies to make a decision quickly on such a change.

'This has been discussed by the United States and Europe amid an emergency situation at previous G7 meetings,' he said. Japan is looking at easing accounting rules that require companies to assess financial holdings at market value, joining other global authorities in a bid to contain the fallout from the credit crisis.

The Accounting Standards Board of Japan said on Thursday it would closely watch changes in global accounting standards and would review Japan rules accordingly. Under mark-to-market or fair-value rules, companies are obliged to regularly adjust the valuation of assets they hold to reflect changes in their actual price on the market.
Yuzo Saeki at Forbes

FASB, IASB Get Together

*******************************************************

U.S., International Boards Abandon Plan to Drop Net Income Item
U.S. and international accounting rulemakers abandoned a proposal to eliminate the reporting of net income on financial statements, saying investors rely on the calculation to assess a company's health.

The International Accounting Standards Board and the U.S. Financial Accounting Standards Board ``have chosen to proceed with proposals that build on established practice,'' IASB Chairman David Tweedie said in a statement today. A staff proposal last year had included an option to replace net income with a line called total comprehensive income.

``Net income is clearly a starting point for many users of financial statements and therefore it was decided to leave it in,'' Mark Byatt, a spokesman for the London-based IASB, said in an e-mail.

The London-based IASB, which sets accounting standards followed in more than 100 countries, and FASB, the U.S. board based in Norwalk, Connecticut, are seeking to make financial statements clear and help investors identify potential risks. The groups today released a 126-page ``discussion paper'' and will seek public comment until April 14.

``This idea of eliminating net income was basically taking away the one key measure of performance that investors hang their hats on,'' Charles Mulford, an accounting professor at the Georgia Institute of Technology in Atlanta, said in an interview. ``You can't just take away net income and expect everyone to grab onto something else right away.''

The joint project on financial reports is part of a broader effort by the IASB and FASB to adopt a single set of standards. The U.S. Securities and Exchange Commission in August approved a ``road map'' that might require some U.S. companies to switch from U.S. accounting standards to international rules by 2014.

Separately, the IASB and FASB today said they will create a ``global advisory group'' of regulators, company executives, auditors and investors to discuss issues related to the current economic crisis. Members of the panel have not been named.
Ian Katz at Bloomberg

IASB and FASB create advisory group to review reporting issues related to credit crisis

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) today announced that they will create a global advisory group comprising regulators, preparers, auditors, investors and other users of financial statements. The advisory group will help to ensure that reporting issues arising from the global economic crisis are considered in an internationally co-ordinated manner.

At their forthcoming joint meeting on 20 and 21 October, the boards will discuss the initial topics for the advisory group to consider. They will also discuss how they can appoint the group and schedule its first meeting expeditiously. The boards will report on the first meeting and will consider the group’s discussions immediately thereafter. In developing their approaches on issues resulting from the discussions the boards will follow appropriate due process. In the interest of transparency, the advisory group will meet in public session with Webcasting facilities available to all interested parties.

Sir David Tweedie, chairman of the IASB, said: “Recent statements from the G7 and other world leaders highlight the need for an internationally co-ordinated policy response to the credit crisis. The IASB has acted quickly to issue amendments on reclassifications, fair value measurement guidance for illiquid markets, and disclosures. We are pleased that the European Union has acted quickly to accept our amendments on reclassifications. The new advisory group will help the boards to develop rapidly a co-ordinated response to the economic crisis, and will provide additional global perspective to both standard-setting organisations as we address the increasingly complex issues that investors are facing.”

Robert Herz, chairman of the FASB, said: “Ongoing developments in the global financial crisis and actions by governments and regulators are reshaping the financial markets here and around the world. All of this is likely to raise important issues in financial reporting, both here in the US and across the international capital markets. The advisory group that we and the IASB are establishing is aimed at helping both boards identify reporting issues arising from ongoing developments in the global financial markets so that we can develop common solutions that promote sound reporting and enhance transparency.”

Accountants, Auditors Fire Back at Bankers on Fair Value

Don't Suspend Fair Value, Cox Urged
Investors and auditors call on the Securities and Exchange Commission chairman to resist urgings to suspend mark-to-market accounting.
Two days after the president of the American Bankers Association asked Securities and Exchange Commission Chairman Christopher Cox to, in effect, weaken the Financial Accounting Standards Board's fair-value measurement rules, investor and auditor representatives fired off a letter to Cox urging him to let mark-to-market accounting stand as is. Note: You can read the letter here.

The current financial crisis has put the fair-value debate into bas relief: on the one side are the bankers, who contend that the FASB rules, especially FAS 157, have speeded up the downhill slide; on the other are accountants, investors, and others who feel that mark-to-market accounting should be upheld even in illiquid markets as a way of keeping financial reporting transparent.

Today's letter seems to be a direct response to the ABA's letter to Cox [read the ABA press release here]. "We are writing to express grave concern regarding recent calls for the SEC to override guidance issued by the Financial Accounting Standards Board (FASB) and the Commission’s staff that would effectively suspend fair value or mark-to-market accounting," according to today's letter, which was signed by Cindy Fornelli, executive director of the Center for Audit Quality; Jeffrey Diermeier, president and chief executive officer of the CFA Institute; Barbara Roper director of investor protection of the Consumer Federation of America; and Jeff Mahoney, general counsel of the Council of Institutional Investors. "We believe such urgings are decidedly not in the public interest."

In his letter to Cox on Monday, Edward Yingling, the president and chief executive officer of the ABA, Yingling attacked FASB's position that the risk of a lack of liquidity must be included in measuring the cash flow of distressed assets when they're sold. The recently enacted financial rescue law, the Emergency Economic Stabilization Act of 2008, affirms the SEC's power to suspend mark-to-market accounting "for any issuer" and orders the commission to launch a study of whether fair value contributed to the crisis.

To the mark-to-market advocates, however, a "move by the SEC to suspend fair value accounting would be a disservice to the capital markets, would be inconsistent with the views of investors, would harm the credibility and independence of the standards setting process, and would run counter to fundamental notice and comment principles," they wrote. "With third quarter financial statements now in process and year-end 2008 imminent, such a change could jeopardize already-fragile investor confidence."

Along with Sir David Tweedie, chairman of the International Accounting Standards board, and other advocates, they contend that "the current crisis of liquidity, credit, and confidence was not caused by fair value accounting; rather, sound accounting principles helped expose the problem."
David M. Katz, CFO.com

Following two Bloomberg reports refer to the two sides on this debate:

ECB's Noyer Says Accounting Rules May Deepen Market Crisis
European Central Bank governing council member Christian Noyer said asset-valuation rules may be deepening the financial crisis and should be reconsidered.

The mark-to-market rule, also called fair value, requires companies to review holdings each quarter and report losses when the values decline. Noyer said it should be shaped ``so as to set the right incentives throughout the economic cycle.''

``In adverse market conditions, marking to market, together with solvency regulations, may generate a feedback loop from expectations of market-price changes to portfolio and balance sheet adjustments,'' Noyer wrote in the Bank of France's October financial-stability review.

``This may reinforce price volatility and exacerbate financial distress,'' wrote Noyer, who is also the governor of the Bank of France.

Still, the fair-value rules shouldn't be changed in the middle of financial turmoil and have the advantage to spur ``ex ante discipline in financial institutions' risk and capital management,'' Noyer also wrote. Other methods, based on amortized historical costs ``are not clearly superior, not least because they tend to delay recognition of impaired assets.''
Sandrine Rastello at Bloomberg

Reverse Leverage of Mark-to-Market Wrecks Banks
The world's banking system is caught in a vicious trap, with a forced sale of assets at one institution wiping out capital at others holding similar assets. Think of it as extraordinarily high reverse leverage.

You can blame mark-to-market accounting, the advent of new indexes that supposedly track values of a wide range of assets, or a market mind-set that assumes every asset is part of a bank's trading book.

Like the old Pac-Man character, this combination is devouring financial institution capital at a voracious rate. The question is whether it will gobble up even the new capital injections into banks by the U.S. and foreign governments.

It's way past time to suspend mark-to-market accounting -- or somehow to make investors and analysts understand that fire- sale transactions aren't supposed to be having such broad implications.

Of course, suspending mark-to-market would be greeted by screams of outrage by its devotees, including those at the Financial Accounting Standards Board and the Securities and Exchange Commission. After all, the mark-to-market rules are supposed to provide investors with needed information about the true state of a company's balance sheet.

In the midst of this financial crisis, mark-to-market isn't necessarily telling the truth. The notion of pricing assets on the basis of what they would bring if sold today -- even if an institution doesn't have to sell them -- creates a paper loss that reduces capital and restricts lending.

Federal Reserve Chairman Ben S. Bernanke has expressed reservations about mark-to-market on these grounds.

Great Depression
Nobel laureate Milton Friedman and his co-author, economist Anna Schwartz of the National Bureau of Economic Research, describe in their seminal work, ``A Monetary History of the United States, 1867-1960,'' how a similar process forced the closure of many banks at the beginning of the Great Depression.

``The impairment in the market value of assets held by banks, particularly in their bond portfolios, was the most important source of impairment of capital'' that caused them to shut down, not ``defaults of specific loans or of specific bond issues,'' they wrote.

``Friedman and Schwartz argue that during financial panics, forced asset sales bring down good assets as well as bad,'' said Lee Hoskins, former head of the Cleveland Federal Reserve Bank.

Appropriate Assumptions

Instead of this mark-to-market approach, Hoskins said, ``What I would like to see is someone do a present-value calculation on mortgage-backed security holdings at banks using appropriate assumptions about future home prices and default rates.''

For individual loans or groups of similar loans, banks are supposed to set aside loan-loss reserves when questions arise about whether they will be repaid. If the risk of default is sufficiently high, interest payments, which normally are treated as income, are supposed to be booked as payments to principal.

However, adding to loan-loss reserves is a far cry from valuing a loan as if it were to be sold immediately -- which is the foundation of mark-to-market accounting.

For instance, on Oct. 9, some lists of highly leveraged loans being offered for sale were circulating in Europe. Included on them were assets seized from banks that had just been taken over by the Icelandic government.

The news that the loans were on the market caused the Markit LCDX, a benchmark credit default swap index used to hedge against losses on leveraged loans, to drop more than 6 percent over two days.

``This will affect the mark-to-market for all loans,'' Louis Gargour, chief investment officer at LNG Capital, a London-based hedge fund, who is setting up a distressed debt fund, said on Oct. 9.

The FASB staff on Oct. 10 issued additional guidance on the fair-value rules that could limit the fallout from forced sales. However, Gargour's view seems to be widespread in the market.

Saved by Forbearance

Back in 1982, when the world was a simpler place, the six largest U.S. banks -- Citicorp, Bank of America, Chase Manhattan Bank, Morgan Guaranty Trust Co., Manufacturers Hanover Trust Co. and Chemical Bank -- were in deep trouble. Collectively they had loaned more than $1 trillion to Latin American countries, which couldn't service their debts.

Had the banks been forced to recognize on their balance sheets how badly their loans were impaired, they would all probably have been declared bankrupt. Instead, the Federal Reserve and other bank regulators exhibited so-called forbearance -- letting the institutions continue in business without recording those losses. Had they done otherwise, it would have crippled the banking system in the middle of what was already the worst U.S. recession since the 1930s.

Added Capital

At the end of the 1980s, new international standards required banks to increase their capital bases substantially, though the current crisis has shown that the added capital wasn't adequate either.

Asset writedowns and credit losses are approaching $600 billion at the world's biggest banks and securities firms, and the $443 billion worth of capital raised to cover them hasn't been enough to reassure investors. I wonder what that balance would be if the world weren't fixated on mark-to-market accounting.

According to Bloomberg figures, Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. have all raised more capital than their writedowns and losses. Nevertheless, the stock prices of the first two have been hammered since the crisis began more than a year ago. (JPMorgan Chase has fared better.)

So one has to ask: How much capital will the U.S. government have to inject into these and other banks -- along with other actions -- to thaw the world's credit freeze? Given the mark-to-market climate, it may take more than the $700 billion authorized in the recent rescue package.

Harvard University economist Kenneth Rogoff said on Oct. 10 that it likely will take much more than that. If it does, the next president will have to demand that Congress provide it.
John M. Berry at Bloomberg

Fair Value: Current Developments and Long Run Ramifications

EU, IASB Change Fair Value
Rating Agencies Chime in on Fair Value Fight
Today the International Accounting Standards Board (IASB) published proposals to improve the disclosures around financial instruments including fair value measurements of financial instruments and liquidity risk. The changes are described here .

According to the IASB, the proposals form part of their response to the credit crisis and follow recommendations of the Financial Stability Forum, which had the support of the Group of Seven (G-7) Finance Ministers. The proposals also reflect discussions by the IASB’s Expert Advisory Panel on measuring and disclosing fair values of financial instruments when markets are no longer active—see

Sir David Tweedie, Chairman of the IASB, described the proposals this way: “The credit crisis has heightened concerns about liquidity risk and pointed to the need for entities to explain more clearly to the outside world how they determine the fair value of financial instruments, especially those that are particularly complex. The proposals build on the advice we have received from the IASB’s Expert Advisory Panel.”

Meanwhile committee of the European Commission (i.e. the people who run the EU) OK’d the IASB changes to mark-to-market rules. The changes allow firms some flexibility when applying mark-to-market rules where there is no an actively traded market for an asset. This follows guidance released last week by the FASB.

A few excellent articles on the subject of Mark to Market/Fair Value:

Excerpt from a WSJ article on regulation of the financial services industry:

Fair-value accounting
The issue: Should firms, including banks, value their assets at their market prices, no matter how illiquid they are?

The protagonists:
In favor: the International Accounting Standards Board; the Securities and Exchange Commission; accounting firms.
Against: some large banks and brokers; U.S. Republicans, including Republican presidential candidate John McCain; French President Nicolas Sarkozy.

The debate: Fair-value rules became a topic of controversy in Europe in 2005, when all listed European companies adopted International Financial Reporting Standards, which required them to record an extended range of financial instruments such as derivatives and bonds at fair value on their balance sheets. Companies had previously been able to value many such instruments at historical cost, allowing them to avoid the complexities of subjectively attaching a price to abstract or illiquid assets.

Many bankers and political leaders, including Messrs. Sarkozy and McCain, argue that fair-value accounting is exacerbating the credit crisis by requiring companies to report unrealized losses, forcing them to top up their balance sheets through asset sales that debilitate them further.

One reply, frequently made by accounting-standards bodies, is that fair-value accounting is exposing the scale of the problem at a time when transparency is vital. Fair-value also allows for comparisons between companies in the same sectors and gives investors a far better appreciation of risk management than would be possible under cost accounting.

Its detractors also argue that it heaps volatility on earnings. It also places a heavy emphasis on the judgment of a company's management, which ultimately decides on the fair price of the hardest-to-value assets. This means losses that may never be realized can bring down companies that are solvent, while companies can talk up profits that may never materialize. Think of Enron, they say.

Likely outcome: The International Accounting Standards Board is engaged on a project to simplify and replace the most complex fair-value rules after the Financial Stability Forum mandated it to look at the issue in April. It is expected to publish updated guidelines next year.
In the meantime, regulators won't want to indulge banks that are being pilloried for irresponsible behavior. However, international accounting boards have already moved to ease fair-value requirements and rules may be relaxed further until the credit crisis is perceived to be over.

The Financial Stability Forum, the body of central banks and financial regulators coordinating the global response to the turmoil in the credit markets, is also looking into tweaking fair-value rules to soften the forces that push the world economy into booms then busts.
By DOMINIC ELLIOT at the Wall Street Journal

Banks: The Fight over Fair Value
S&P Ratings tells why that's a bad idea for financial firms to suspend or change the rules concerning asset markdowns.

The current market disruption has triggered a chorus of complaints from many financial institutions and other market participants about the effect of fair value accounting, including an outcry to suspend or substantially modify the rules. The push to suspend and evaluate the accounting for fair-value measurements is evident in sections of the Troubled Assets Relief Program (TARP) legislation. The concerns relate primarily to accounting rules that force financial institutions to value securities at what they believe are overly depressed prices that do not reflect their true value. Further, they contend that reporting these depressed values has resulted in a loss of market confidence that has further exacerbated the current credit market disruptions.

This may seem to imply that fair-value measures should be dispensed with altogether. To the extent that fair-value accounting guidance is suspended or modified, in the absence of addressing analytical needs through greater disclosure and transparency, Standard & Poor's Ratings Services would view these changes as a significant step backward. However, we do believe the recently issued Securities & Exchange Commission and Financial Accounting Standards Board (FASB) guidance, which clarifies how companies should determine fair-value measurements in light of the current market conditions, is helpful.

We recognize that accounting for assets and liabilities at market prices can produce results that could mask the underlying economics for certain businesses and activities, especially during volatile and uncertain economic and market conditions. Yet, we believe the limitations inherent in fair-value accounting do not detract from the usefulness of fair-value measurements in providing a consistent starting point in analyzing financial statements. Rather, the imperfections underscore the need for financial statements to complement fair-value measures with additional information about uncertainties in the measurement of assets and liabilities. Thus, we recommended that certain refinements to fair-value accounting and disclosures be considered.

Fair Value: How Useful?
In the wake of the recent market stress, some market participants question whether fair value provides useful information for investment and credit decisions. Company executives contend that the performance measures produced using fair value create financial reporting that is misleading and disconnected from the reality of their business activities. They also say it creates unjustified and unexpected economic effects, including covenant and regulatory capital stress and liquidity shocks.

Further, there are bank analysts who don't agree that marking loans to market is the best way to assess loan portfolios because it presents a view of the portfolio valuations without giving effect to the expected future earnings that would help cover potential losses.
Many critics have faulted fair-value accounting for creating a spiral of declining valuations arising from forced asset sales. For many financial institutions, mark-to-market losses—coupled with the triggering of significant margin and regulatory capital calls—have forced rapid asset liquidation, exacerbating the loss of value, diminished counterparty confidence, and constrained liquidity.

Recent distressed asset sales by Lehman Brothers Holdings (LEH), Merrill Lynch (MER), and other distressed asset portfolio sellers set a precedent concerning asset valuations; the actual prices became benchmark prices for real-estate-backed assets and other asset classes. Lehman announced gross mark-to-market losses approximating $7 billion on residential and commercial mortgage-related positions immediately preceding the company's downfall. The impact of these marks on Lehman's financial results contributed to intensified efforts to offload its exposure in residential mortgages and commercial real estate loans and other less-liquid asset exposures.

Merrill Lynch sold a substantial majority of its collateralized debt obligations, incurring a $4.4 billion pretax loss (a 40% decline in its mark in a matter of weeks) in an effort to enhance the company's capital position and reduce risk exposure. The rapid and extreme portfolio devaluations that ultimately contributed to Lehman's failure and Merrill Lynch's loss of independence also became observable inputs for fair-value pricing by other financial institutions.

Also momentous was American International Group (AIG) capital raise of approximately $20 billion by the second quarter of 2008 to replace essentially all of the capital lost in the preceding two quarters because of market valuation losses and other-than-temporary impairments on mortgage-related securities. During the third quarter, however, liquidity demands increased, leading to AIG's unprecedented $85 billion secured loan facility agreement with the Federal Reserve on Sept. 16, and a subsequent securities lending agreement providing an additional $37 billion in liquidity.

The challenges faced by market participants struggling to determine representative fair values in volatile and illiquid markets, in the absence of further guidance, would have stressed any financial reporting system.

Proponents of reforming fair-value measures look to influence the U.S. Congress, the SEC, banking regulators, and accounting standard-setters, asserting fair-value accounting is faulty. They assert this is largely because of inadequate guidance and the impact of FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) on financial instrument valuations in distressed or illiquid markets. Similar calls are echoed globally.

The SEC and the FASB recently responded to this call by issuing guidance clarifying practical issues surrounding the application of SFAS 157 in determining market prices. We believe the additional guidance is helpful in clarifying the application of fair-value accounting during periods of market illiquidity. Yet, many other market participants call for the suspension of fair-value accounting altogether.

The recent SEC and FASB guidance emphasizes that fair-value measurements and the assessment of impairments are subject to significant management judgment. As a result, it reiterated the need for clear and transparent disclosures to provide investors with an understanding of the significant judgments management has made. In addition, the SEC issued letters in March and September providing further guidance and requesting enhanced disclosures surrounding fair-value measurements. The FASB has also taken steps to clarify how the fair value of a financial asset should be determined when the market for that asset is not active.

The SEC and FASB clarifications will potentially ease the greater weight placed on values derived from current market transactions for the valuation of similar or identical positions when markets are less active or distressed. Broadly, all other things being equal, we believe the effects of this guidance on financial institutions may increase GAAP [Generally Accepted Accounting Principles] equity and regulatory capital. There might also be a short-term earnings boost through a mark-up for some previously written-down assets, as values are based on greater use of intrinsic valuation assumptions.

Congress looks to the SEC
Section 132 of the TARP gives the SEC broad authority to suspend the use of SFAS 157 by issuer class or category of transaction, if it deems it necessary or appropriate in the public interest, and is consistent with the protection of investors. Section 133 requires the SEC—in consultation with the Federal Reserve Board and the Treasury—to study and report to Congress on SFAS 157 adoption and implementation and the impact to the markets within 90 days. It includes studying the impact and effects of SFAS 157 in the context of:
• A financial institution's balance sheet;
• Bank failures in 2008;
• The quality of financial information available to investors;
• The process used by the FASB in developing accounting standards;
• Advisability and feasibility of modifications; and
• Alternative accounting standards to SFAS 157.

The nature or extent of disclosure that would be required in the suspension of SFAS 157 or the absence of its disclosure requirements is unclear. However, suspension of the guidance could result in market participants questioning valuations. Under these circumstances, it seems analysts and investors will view the resulting valuations with greater skepticism, resulting in further erosion of investor confidence in valuations that could complicate recent efforts to stabilize the capital markets.

We reiterate our belief that fair-value accounting should continue to have a significant role in the accounting for financial assets and liabilities but that it should be reinforced and enhanced with more informative disclosures and revisions to the income statement to achieve desired financial reporting objectives.

To succeed in improving fair value measurement guidance, active participation and contributions by all affected constituencies (including companies, accounting standard setters, auditors, investors, regulators, and analysts) is essential. This ultimately could lead to an improved financial reporting discipline that will be capable of meeting the information needs of investors and creditors, and of supporting the evolving global capital markets, under varying economic conditions, for many years to come.
By Joyce Joseph-Bell, Ron Joas, and Neri Bukspan From Standard & Poor's RatingsDirect

Rating Agency Believes Future Impairments May Overshadow New Fair Value Guidance for U.S. Life Insurers
Recently, the SEC and FASB issued a joint statement (1) 'clarifying' guidance on mark-to-market rules for valuing balance sheet assets in the current market environment. The new guidance essentially gives management discretion to use their own estimates (Level 3 in the fair value hierarchy (2) in those cases where market observations (often classified as Level 2 in the fair value hierarchy) do not reflect orderly transactions in this illiquid market. However, management estimates must incorporate current market participant expectations of future cash flows and include appropriate risk premiums, which Fitch believes may limit any significant benefit in valuation.

Companies - including U.S. life insurers - have typically marked-to-market structured securities using broker quotes or related index pricing on a GAAP or IFRS basis, which has led to significant unrealized losses reflected on the GAAP/IFRS balance sheet as a reduction of shareholders equity. Although this guidance may be considered potentially positive from a current valuation perspective, any benefit could be overshadowed by the aging of existing unrealized losses on structured and other securities that may need to be recognized as other than temporary impairments (OTTI), in Fitch's view. Thus, the clarifying guidance may not ease future capital pressures for U.S. life insurance companies, and such potential capital pressures continue to support Fitch's Negative Outlook for U.S. life insurance ratings.

On a U.S. statutory basis, impairments have been moderate through the first half of 2008 due in part to the less onerous nature of statutory impairment tests for structured securities relative to GAAP/IFRS. Therefore, many insurers have recognized impairments on a GAAP/IFRS basis, but not on a statutory basis - this is an important distinction. Under statutory accounting principles, most bonds are carried at amortized cost. Under GAAP/IFRS, most bonds are carried at fair value. Fitch believes that over the next several quarters insurers will more closely align their statutory impairment practices to GAAP/IFRS as new regulatory guidance is introduced. This will likely mean increased statutory impairments. Therefore, Fitch believes that current statutory capital for the industry is overstated relative to economic capital due to the less onerous accounting for structured securities.

Under the SEC/FASB guidance, companies could measure fair value for structured securities using a discount of expected cash flows, which in Fitch's view is an approximation of true economic value of the securities. In Fitch's opinion, expected cash flows from certain tranches of residential mortgage backed security (RMBS) portfolios originated in particular years may be higher than the current market value indicates. Fitch also believes that expected cash flows from certain pockets of exposure are susceptible to significant losses - particularly Alt A and subprime RMBS originated in 2005, 2006 and 2007. OTTI on these securities should reflect the high level of losses expected.

The Troubled Asset Relief Program (TARP) may set future market prices for structured securities that will be used by all market participants regardless of participation in the program. This would constitute a Level 1 valuation in the fair value hierarchy that would supersede management's estimates.

In the near term Fitch believes RMBS market illiquidity is manageable. As long as life insurers have sufficient liquidity to meet near-term policyholder obligations, they can hold RMBS securities on their balance sheets. Life insurers' risk management programs typically include strict asset/liability matching of durations. In most cases, life insurers average liability durations are between 5 and 10 years, which gives life insurers flexibility in buying and selling securities when managing their investment portfolios. However, if market illiquidity persists and/or policyholders lose confidence in the industry, assets may have to be liquidated sooner than expected and at a significant loss. Regardless of market liquidity, if material cash flow losses begin to emerge on these securities, then the life insurance industry's capital adequacy will be adversely affected.
Notes
(1) The joint statement from the SEC and FASB on Sept. 30, 2008 was confirmed in a FASB Staff Position paper released on Oct. 10, 2008.
(2) The fair value hierarchy is described in FASB Statement No. 157, Fair Value Measurements.

SOURCE: Fitch Ratings

The Bankers’ Case Against Fair Value--Going Back 20Years

The American Bankers’ Association has launched its latest salvo in its long-running opposition to fair value use in financial institutions. The bankers have have written to Henry Paulsen asking for changes to the mark to market rules and have asked the SEC to force a change as well. The Bankers state that the most recent pronouncements of the FASB/SEC so not address current problems.

The Bankers’ case goes back a long way--at least as far as 1999 (and further) with the release of this comment letter, back when the the FASB first began to advance the case for greater fair value use in determining the income of financial institutions. Portions of their case from that letter (remember this is from 1999):

• Users of bank financial statements do not support the proposed change to full fair value accounting. This is because a full fair value system does not provide a sound basis for predicting banking book net cash flows and lacks relevance.
• Banking book income is earned on an ongoing basis over time and not from taking advantage of short term fluctuations in prices; the accruals accounting method provides a dynamic and faithful representation of both this earning process and the manner in which a bank’s management operates. It, therefore, provides a more relevant and reliable representation of this earning process. A notional fair value snapshot taken at a historic balance sheet date fails to achieve this.
• The reality is that fair values for a banking operation are significantly more subjective than values derived under the mixed measurement accounting model and this would reduce both the reliability and comparability of financial statements.
• Within any given accounting measurement model, it is not possible to encapsulate in a single measure everything that an investor needs to know. Both fair value and historical cost accounting need to be supplemented by appropriate risk-based and other disclosures in order to provide investors with a complete picture.
  

The Bankers' points in other older comment letters are eerily relevant to today’s dilemma: "Notwithstanding the development of securitization techniques and credit derivatives, it remains the case that customer loans are generally held to maturity by banks without variation of the original contractual terms of the loan. Accounting for these loans on an historical cost basis, therefore, most closely reflects the economic substance and cash flows, namely, that income is earned over the period of the loan. The bank is exposed to risk on the non-repayment of the principal advanced. "

"It has been argued that the fair value of a customer loan provides relevant information about the current credit quality of that loan; as a borrower’s credit standing deteriorates, the credit spread demanded rises and therefore the fair value falls and a loss occurs. However, this loss is theoretical because the widening of the spread neither has an impact on the existing loan contract nor on the ultimate repayment of the loan in the majority of cases. "

We do not support the FASB's move toward fair value accounting. This will have a significant impact on all industries and will significantly impair the comparability of financial statements. The indication on the FASB's website that the IASB " believes that the fair value option will enable constituents to become more familiar with using fair value as a measurement attribute for financial instruments" is frightening. Experimental accounting, without sufficient study, should not be used for financial reporting measurement purposes, particularly because it can have such a significant impact on an entire industry. If this is the goal, then the FASB and IASB should provide a discussion document for comment on fair value. This document would need sufficient study and consultation with industry and users prior to issuing a standard. Without sufficient study, this experiment could fail. The indication on the FASB's website that the IASB " believes that the fair value option will enable constituents to become more familiar with using fair value as a measurement attribute for financial instruments" is frightening. Experimental accounting, without sufficient study, should not be used for financial reporting measurement purposes, particularly because it can have such a significant impact on an entire industry.

International Accounting Standard Setters follow FASB on Fair Value

The International Accounting Standards Board stated in a press release this week that they agree with the FASB on their fair value guidance on applying fair value in inactive markets released last week. Just to avoid misinterpretation, the head othe IASB, Sir David Tweedie, added his own interpretation: “This press release says two things. First, that guidance within IFRSs is already clear that distress sales should not be included in fair value measurement. Secondly, that recent guidance from the FASB is consistent with the findings of our own expert panel on illiquid markets.”

As well, in response to political pressure, the IASB indicated that they would study the matter of reclassifying a financial asset from ‘held-for-trading’ to “another category”, presumably “held to maturity”.

Bad 'Ol Mark to Market

Reverse Leverage of Mark-to-Market Wrecks Banks
The world's banking system is caught in a vicious trap, with a forced sale of assets at one institution wiping out capital at others holding similar assets. Think of it as extraordinarily high reverse leverage. You can blame mark-to-market accounting, the advent of new indexes that supposedly track values of a wide range of assets, or a market mind-set that assumes every asset is part of a bank's trading book.

Like the old Pac-Man character, this combination is devouring financial institution capital at a voracious rate. The question is whether it will gobble up even the new capital injections into banks by the U.S. and foreign governments. It's way past time to suspend mark-to-market accounting -- or somehow to make investors and analysts understand that fire- sale transactions aren't supposed to be having such broad implications.

Of course, suspending mark-to-market would be greeted by screams of outrage by its devotees, including those at the Financial Accounting Standards Board and the Securities and Exchange Commission. After all, the mark-to-market rules are supposed to provide investors with needed information about the true state of a company's balance sheet.

In the midst of this financial crisis, mark-to-market isn't necessarily telling the truth. The notion of pricing assets on the basis of what they would bring if sold today -- even if an institution doesn't have to sell them -- creates a paper loss that reduces capital and restricts lending.
John M. Berry, Bloomberg

IASB Relents on Mark to Market Rules

The IASB has taken the unusual step of suspending its normal due process to deal with changes to mark to market rules. The change comes under pressure from European Union politicians such as Nicolas Sarkozy of France. The following excerpts from an article by John Rega of Bloomberg sets out the issues.

In step with U.S. rule makers, the International Accounting Standards Board plans next week to ease ``fair-value'' rules that have forced banks to take writedowns on losses in securities holdings. The IASB's supervising foundation today waived procedures, such as requesting comments from the public, to accelerate changes to the rules used in more than 100 countries.

European government leaders have called for the change to give their banks the same rules as U.S. companies, following a move to change U.S. Generally Accepted Accounting Principles. The IASB overseers, the International Accounting Standards Committee Foundation, said today that their action wasn't spurred by political pressure.

``Any weakening of the IASB's independence would be likely to reduce transparency,'' said the foundation, which oversees the board's working methods. Interference would ``potentially lead to a weakening of standards worldwide, and would ultimately undermine investor confidence at a fragile time.''
The European Union, the biggest group users of International Financial Reporting Standards, already plans to make a change to the same effect. The bloc's executive arm next week will propose changes to the rules for how IFRS applies in the 27 countries.

The IASB and EU moves will let banks reclassify some of their holdings as banking assets, a shift -- normally forbidden -- from the so-called trading book, where values are subject to more volatility from fluctuations in market prices. Securities, loans or other assets held as investments continue to be ``marked to market,'' or revalued with swings in market prices.

The change is ``as a matter of urgency,'' EU Financial Services Commissioner Charlie McCreevy said yesterday in a speech at the European Parliament in Brussels. He called on the lawmakers and national governments to sign off on the revision in time for banks to apply it in reporting third-quarter results, typically published as soon as the end of the month.

SEC Plays Fair on Mark to Market

SEC to CFOs: You Can Be Flexible on Fair Values
The SEC sent letters to about 30 CFOs of financial institutions last month outlining information they should include in financial statements if they're using measures other than market prices for valuing certain assets. As reported, the SEC also issued guidance last week to companies saying they needn't rely exclusively on market prices.

"It's not a get-out-of-jail-free card, but it's an opportunity to say 'here's a rationale as to why we're using an alternative valuation,'" said Brian Lane, a former director of the SEC's division of corporation finance. He said it will give companies flexibility to use other data, such as historical pricing, to come up with a value. "If you can lay out the case, you can try it. You have to put in some disclosure about how you arrive at that."
The letters, which are dated September 2008 and sent in the middle of the month, say executives should "continue to evaluate whether you could provide clearer and more transparent disclosure regarding your fair value measurements."

For example, if a company is relying on discounted cash flow instead of market prices to determine the value of a security, the SEC is urging companies to disclose whether assumptions were changed from earlier periods.
Companies are also being prodded to say whether they use quotes from brokers and explain if they picked a quote from a new broker -- which could indicate they were shopping around for a favorable number.
Kara Scannell at the Wall Street Journal