In Depth Analysis of SEC Report on Fair Value

Joey Borson at Conrollers' Leadership Roundtable has provided a detailed analysis of the U.S. Congress mandated SEC report on Fair Value accounting. It is quoted in full below.

SEC to Critics: Back Away

In a Congressionally-mandated report issued this week, the SEC found that fair value accounting was not the cause of the ongoing financial crisis, and that neither FAS 157, nor mark-to-market accounting, should be suspended or fundamentally changed. In addition, the Commission found that:

• Though imperfect, FAS 157 and fair value disclosures provide timely, valuable information to investors, and market confidence would be hindered should either be suspended.
• Fair value accounting was not a major cause of the financial institution failures; instead, high credit losses and dramatic increases in depositor outflows (so-called "runs on the bank") were the main drivers. Indeed, fair value proved to be a good signal of the decaying asset bases of these institutions.
• Accounting standards are properly focused on the needs of the investor. Regulatory capital, while important, neither is nor should be a significant consideration of US GAAP principles-and concerns that fair valued regulatory capital requirements requires ‘deleveraging,' and is thus pro-cyclical, should be addressed to bank regulators, not accounting standard-setters.
• Improvements can be made to FAS 157, particularly around additional guidance for illiquid markets, distinctions between credit and liquidity losses, the use of managerial judgment, and a much more simplified impairment framework.

Fair Value: Reflecting, Not Causing, A Very Bad Year

While the overall fair value of financial institution assets declined in 2008, the SEC found that this was caused by the general economic downturn, and increases in credit losses and high default rates, not fair value requirements themselves.

Approximately 45% of financial institution assets are measured at fair value, of which three-quarters were held at level 2, 15% at level 1, and only 9% at level 3, the so-called "mark-to-model" tier. This distribution has held fairly constant over the course of 2008.

For a more extensive analysis of these asset classes, please see the Roundtable's brief on the subject.

Critically, though, asset impairment charges have grown significantly between 2007 and 2008-in 2007, impairment charges totaled around 1% of equity, while in the first three quarters of 2008, those charges had jumped to 8% of equity-a change that many have blamed on the requirement to fair value these assets (as opposed to holding at historical cost, where those impairments could perhaps have been minimized or pushed off).

However, the SEC found that:

"While fair value is used to measure certain assets such as trading securities and impairment losses on AFS securities, such declines in value were directionally consistent with the losses on the underlying loans and the current economic conditions, which impacted the value of these securities."

Case In Point: Bank Failures

Focusing on the most public example of the financial crisis, failed banks and financial institutions, the SEC found that "fair value accounting was not a primary underlying cause," instead; abnormally high default rates and credit losses, a decline in the overall quality of the asset base, and the resulting dramatic increases in "runs on the bank" were the main problem.

Looking at banks that failed over 2008 (and focusing on Washington Mutual, IndyMac, and Downey Saving and Loan, the three biggest failures), the SEC found:

• Most loans were accounted for on an amortized-cost basis, not a fair value basis, and so would not be impacted by FAS 157 requirements.
• The banks that failed (most notably IndyMac) did so because they focused heavily in mortgage-backed securities which both had more concentrated credit risks and losses, and unexpectedly high default rates.
• As a group, failed banks had non-performing loans that "greatly exceeded the levels experienced generally for non-failed banks of similar sizes."
• The decline in regulatory capital which ultimately crippled most failed banks was thus a result of the deterioration in bank's underlying asset base-caused mainly by credit losses, and exacerbated by increases in depositor outflows. Fair value may have reflected the lower quality assets (and, the SEC speculates, may have served as an early warning, especially if fair value had been more extensively used), but it did not cause the failures.

Ultimately, the 2008 bank crises were similar to most other historic bank failures-caused by poor business decisions, unexpectedly high credit losses, and finally, "runs on the bank" that the institutions could not survive. The instruments may have been different in this case-but the mechanisms were not.

Investors: Fair Value Is a Useful Indicator-Don't Change It

Through a series of forums and comment letters, the SEC solicited a broad range of input on fair value-and with few exceptions, most investors and preparers support fair value generally (and FAS 157 specifically) as a useful tool, and feel that suspension would decrease overall investor confidence. A few included comments, called representative by the SEC, were:

"Fair value accounting with robust disclosures provides more reliable, timely, and comparable information than amounts that would be reported under other alternative accounting approaches."
[Joint Letter: Center for Audit Quality, CFA Institute, Consumer Federation of America, Council of Institutional Investors, Investment Management Association]

"We do not believe that fair value accounting was the cause or even a contributing factor to the current credit crisis. Fair value accounting did not create the losses, but rather reflected the market conditions by initially bringing to light the impact of poor lending practices and the resulting effect on the current lack of liquidity and overall crisis in the financial markets. Fair value accounting reflects the effects of a transaction on an entity's financial statements. It does not, however, drive the underlying economic activity."
[Credit Suisse Group]

Criticisms of fair value were mainly two fold. One group criticized the implications of fair value, mainly on regulatory capital, and here the SEC's basic response was that regulatory capital was a separate issue not really related to (nor appropriately governed by) GAAP rules.

The second criticism was on the application of fair value – mainly its role in illiquid or depressed markets. Here commentators agreed that more judgment and clarification would be helpful, and the SEC points to a series of coordinated guidance issued by the major standard-setters in late September, where they stressed that market values were not intended to be the sole determination of fair value in illiquid markets, and that other criteria could, and should, be incorporated into measurements.

Overall, the preparer and investor communities support fair value, and while they believe that modifications may be needed, they neither request nor desire systemic change.

What Should the SEC Do Next?

As required by Congress, the SEC considered (and broadly rejected) a series of possible alternatives to fair value standards:

• Suspend FAS 157: While the SEC has the legislative power to suspend FAS 157, they spoke out against this step, noting that FAS 157 does not require fair value, it merely consistently defines the term, and that a suspension would lead to inconsistent definitions, disclosures, and guidance. Instead, the SEC called for more clarification of FAS 157, calling for increased guidance to ensure that their truly is a single consistent measurement framework.
• Modify Fair Value (e.g. return to historical cost): The SEC argues that fair value has generally proven to be helpful to investors, and that other methodologies have their own set of unique comparability problems (such as how historical cost can assign identical assets different values based on different purchase prices).
• Reduce Volatility through a "Rolling Average": Proponents of a "rolling average" argue that by spreading the value over a longer period of time (rather than a single point value), volatility would be reduced. However, the SEC argues that this would only lead to a debate about the proper time period for the rolling average, as well as shifting towards more prescriptive rules when the standard-setters are already committed towards a more principles-based approach.

The SEC did issue a series of tactical, and unsurprising, recommendations, including:

• FAS 157 and other fair value/mark-to-market requirements should be improved (mainly through additional guidance and disclosure) but not suspended. Fair value was not the cause of the financial crisis, and it serves as a valuable tool for investors.
• Additional measures should be taken to improve the applicability of existing fair value standards. Standard-setters need to issue more guidance around inactive, illiquid, and distressed markets, as well as promote education and training around fair value for preparers and investors.
• Readdress financial asset impairment frameworks. There are too many asset impairment frameworks, and they are not compatible with one-another, leading to significant comparability issues. A single, global model should be developed.
• Improve guidance around managerial judgment. Fair value, especially around level two and three assets and liabilities, inherently requires preparer judgment. Guidance should be issued about how to evaluate the reasonableness of accounting judgment.
• Accounting standards should continue to meet the needs of investors. Regulatory capital is important-but it's not the job of accounting standard-setters.
• Establish additional formal measures to address the operation of existing accounting standards. Implement post-adoption review processes and formal policies for situations requiring near-immediate responses. The ad hoc standard-setter responses of late September should not become the norm.
• Simplify the accounting for investing in financial assets. The IASB and FASB should work to create a single, simpler, standard.

Conclusions: Nothing Surprising

The SEC's report is not surprising, and is completely consistent with their policies and statements over the last four months. Fair value, and FAS 157, will remain US accounting policy, and while they may (and probably should) be modified on the margins, the core principles will probably survive the financial crisis intact.