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A Matter of Interpretation

By : Vipal Monga | January, 8 2009
  Companies Struggle to Come to Terms With Writing Down Troubled Holdings "What's the price of a house?" asks Howard Marks, chairman of Oaktree Capital Management LP. The simple question, he says, has no easy answer. Is the price of a house what you paid for it? Is it the price for which you can sell it today? Is it the replacement cost, assuming the house was destroyed, or the amount it would fetch, discounting taxes and other fees, if you held on to it and then sold it in ten years? Marks suggests each of those is the price of the house. The one you pick depends on your perspective and your need. "In fact, there is no one price for anything," he says. "Price is a gaseous cloud." For financial market regulators, auditors and accountants, however, the answer is clear. There is only one price for an asset: the price for which it can be sold, right now. This accounting regime, popularly known as mark-to-market and officially as fair-value accounting, has been the standard in financial reporting since the early 1990s. Its predominance over other forms of valuation has expanded over the past 20 years, and the Financial Accounting Standards Board confirmed it in September 2006 with the issuance of Financial Accounting Standards No. 157, which defined how to measure fair value. Although questions of accounting are often arcane and technical, and consequently often ignored by investors (not to mention the general populace), few subjects have received as much attention in recent months as marking to market. If the past year is any guide, few topics will receive as much focus in the months ahead. Already, the fair-value accounting rule has been the subject of countless editorials, columns and blogs, either loudly defending it as the only thing keeping the U.S. from sliding into a Japan-style, decade-long economic morass or decrying it for unnecessarily making a bad financial crisis much worse. Voluminous analyst reports have dissected each loophole and exemption the rule offers, academics have analyzed its effects on liquidity and leverage and even Congress itself has plowed into the issue, officially mandating as part of its $700 billion bailout package a study by the Securities and Exchange Commission on how mark-to-market accounting is affecting the economic crisis. The rule has become a flash point for fundamental questions about our financial system. In fact, the debate around fair value has taken on the air of an ideological struggle, touching on matters of fairness, judgment, truth and the role of the markets in the economy. "It is horrendously bad accounting," says William Isaac, a former chairman of the Federal Deposit Insurance Corp. who now runs Vienna, Va., financial services consulting firm Secura Group LLC. Isaac says he first became opposed to fair-value accounting in the early 1980s, when he was still FDIC chairman, and has emerged in the current crisis as perhaps the most vocal critic of the standard. "Market-value accounting is based on highly emotional market swings that can reverse themselves quite easily once the emotion wears off. We can destroy bank earnings and capital in massive amounts based on such wide temporary swings in market prices." To understand Isaac's criticism, it is necessary to understand how fair-value accounting works. As it has been structured by the FASB, a private-sector group that acts as the SEC's proxy in accounting matters, fair-value accounting forces companies to value many of their assets at the price they would fetch if they were sold in open markets. According to FASB's rules, if a security is sold in an orderly manner (meaning not as part of a fire sale or liquidation), then the sale establishes a mark, or a price, effectively setting valuations for anyone who holds the same securities. The standard was first issued in September 2006 and came into effect for financial assets and liabilities for fiscal years beginning after Nov. 15, 2007. Most companies adopted the standard early. The rules are applied differently for different sorts of financial firms. All broker-dealers, for example, must use fair-value measurements, while commercial banks only have to do so for securities or loans they are looking to trade or sell. Assets held to maturity can be carried at cost but must be written down if they are deemed impaired. Of course, this doesn't mean that the financial industry is unaffected. There is the reality that a move toward the market-driven ethos has changed the fundamental nature of banking from a long-term, value-driven approach to one emphasizing speculative activity. As former Comptroller of the Currency Eugene A. Ludwig put it in congressional testimony in October, "We have today turned every transaction in our capital markets into a 'trade.' People, customers, relationships are secondary if they exist at all; everything is a valueless, faceless trade. This somewhat desiccated system in my view breeds outsized risk and runs counter to the fundamentals of a sound financial system where service and the customer should matter a great deal." Aside from this secular shift, fair-value accounting has complicated mergers in banking. And the largest commercial banks, such as Citigroup Inc. and J.P. Morgan Chase & Co., have large trading and investment banking arms and consequently need to mark a large portion of their assets and liabilities to market, which directly affects their earnings and consequently their capital. Despite the complexities of the accounting, the debate over mark to market hangs on a relatively simple argument about the essential nature of the market. At the heart of fair-value theory is the efficient-market hypothesis. This is the belief that market prices are the best gauge of value because they reflect the collective judgment of the investing universe and thus the most relevant and accurate information about securities available at any given moment. The crowd opposing broad use of mark to market takes the opposite tack: That the market is often skewed, swept by emotion or prone to bubbles, dislocations and breakdowns. But is the market always right? What does it mean to be "right?" These questions capture the conflict between pro and con factions in the mark-to-market debate today. Put it another way: Does the market price always accurately reflect fundamental value? And what about those extreme circumstances where markets are illiquid and barely function, beset by a lack of buyers and sellers? Take, for example, Merrill Lynch & Co.'s decision last July to sell a notional $30.6 billion portfolio of mortgage-backed securities to Lone Star Funds for 22 cents on the dollar. At the time of the sale, the housing crisis was well into its second year, and the market for mortgage-backed securities had all but collapsed. That sent valuations, even for super-senior tranches of asset-backed collateralized debt obligations that Merrill was peddling, to extremely low levels. In fact, before the sale, Merrill had already written down the securities to 36 cents on the dollar. But Merrill was a motivated seller, betting that taking a write-off now, even at such distressed levels, would be better than watching its capital continue to deteriorate if the securities kept falling in value. According to Merrill's third-quarter earnings report, it booked a loss of $4.4 billion on the sale but reduced its exposure to the asset class by $11.1 billion. Still, there is some reason to believe the price set by the Merrill sale was an inaccurate estimation of its value, at least in fundamental terms. According to Franklin Allen, a finance and economics professor at the Wharton School of the University of Pennsylvania, if 100% of the mortgages backing the Merrill CDOs defaulted, the houses that ultimately backed the securities would have to sell at 22% of their original price to meet the value implied by the sale. In other words, housing prices would have to fall 78% for the mark to accurately reflect the fundamental value of the securities sold by Merrill. "Even today, it's difficult to take the numbers and believe it is going to be that bad," Allen says. At the time of Merrill's sale, home prices nationwide had fallen about 22% from their peak, according to the Standard & Poor's/Case-Schiller Home Price Index. As of October, prices had slipped 25%. But, as Glenn Schorr, an analyst for UBS, put it at the time: "While these are Merrill-specific deals, they do have the potential to create marks and put pressure on some other companies to derisk their balance sheets and take their lumps in an effort to move forward." Following Merrill's sale, several large banks absorbed heavy losses, based largely on mortgage-related write-downs. The most dramatic, of course, came from Lehman Brothers Holdings Inc., which announced a $3.9 billion third-quarter loss on Sept. 10. According to the firm, the loss came on the back of a $7.8 billion write-down on its commercial and real estate mortgage-related securities. The announcement was Lehman's last before it filed for bankruptcy on Sept. 15. This is not to say that Merrill's CDO sale led directly to Lehman's bankruptcy, but the undeniable broader effect of Merrill's transaction is indicative of one of the main criticisms of mark-to-market accounting today. "Some observers suggest that fair value promotes a downward spiral in prices and investor confidence," wrote Raymond Beier, strategic analysis group leader at PricewaterhouseCoopers LLP in a white paper on the subject published in September. "As financial institutions take write-downs when prices drop, they may be forced to sell off assets to maintain compliance with regulatory capital requirements. The result is continuing downward pressure on pricing." This phenomenon of heightening market cycles, both on the way up and the way down, is known as procyclicality. Downward procyclicality, prompted by fair-value rules, presents a huge problem, while fair value in rising markets arguably promotes an upward procycality that may contribute to the inflation of market bubbles. "Both are highly procyclical, and both are very harmful to the banking system and the economy," Isaac says. For the large banks, continuing write-downs have seriously damaged their earnings, which has eroded their capital bases. This has created a scramble to raise capital, either through the banks selling assets, further dampening prices, or by selling stakes in the institutions themselves, often at onerous terms. The result: a self-reinforcing negative cycle that has shown no signs yet of bottoming out. "Mark to market creates that appearance of instability in the financial system that maybe shouldn't be there," says John Castle, chairman of New York private equity firm Castle Harlan Inc. In the case of smaller banks, which are not as directly affected by fair-value measurements, at least in terms of the securities and loans they hold on their books, the use of a mark-to-market-based purchase accounting has made it more difficult for institutions hurt by the decline in the broader economy to find merger partners. "This contagion is a nightmare," says one attorney who specializes in banking mergers. He says that in more normal times, struggling banks hit by losses on real estate loans might have looked to merge with stronger institutions as a way out of their problems. But mark-to-market rules are even complicating that potential solution, as acquiring banks are forced under purchase accounting to mark the target's assets and liabilities to market. In today's environment, this is forcing acquirers to immediately raise more capital to cover the paper losses they would assume. This is what happened when Pittsburgh's PNC Financial Services Group Inc. acquired Cleveland-based National City Corp. for $5.2 billion in October. PNC had to borrow about $7.7 billion from the federal government's Troubled Asset Relief Program to bolster its capital after the purchase. In fact, sources say PNC would not have been able to complete the deal without the TARP funds. The accounting regime, another banking attorney adds, is forcing a regulatory response based not necessarily on the banks' fundamental strength, or lack thereof, but on the market perception of the business. The two, the attorney argues, are not necessarily the same thing. "Fundamental issues of policy shouldn't be decided by the people in Norwalk," the attorney says, referring to FASB's Norwalk, Conn., headquarters. "The markets are so thin today, they're totally inaccurate." Isaac, for his part, put it this way at an SEC roundtable in August: "We have one hand of the government, the Treasury, handing out capital just about as fast as the SEC and FASB is destroying it with mark-to-market accounting." But what are the alternatives? For fair-value proponents, there aren't any, even though some acknowledge the difficulties the accounting system is creating. As Treasury Secretary Henry Paulson said in a Nov. 20 speech, "mark-to-market accounting is clearly procyclical. Yet I know of no better accounting method." That no other accounting system works as well seems to be taken for granted among fair-value boosters. "There is a clear bias against marking to market," says one lawyer who advises corporate boards. "But the strongest argument for mark to market is that there isn't a strong alternative." Proponents defend the system by claiming that it provides greater transparency to investors and shouldn't be blamed for exposing problems on the banks' books that might have been ignored otherwise. "Ignore current market/fair value at your peril for it may provide a critical signal of underlying problems and truths," FASB chairman Robert Herz said in a Dec. 8 speech. "So can we handle the truth? Side-stepping the truth by blaming the accounting as misportraying reality and causing 'procyclical' effects is tantamount to trying to 'shoot the messenger.' " Herz's call to truth is very suggestive. It implies that fair-value accounting is the only clear looking glass through which the reality of companies' balance sheets can be revealed. But this was not always seen as the case. In fact, the move to fair-value accounting is less than 20 years old, when it was reintroduced by regulators as a reaction to the system that had been in place for 40 years prior, that of historic cost accounting. Under the historic method, financial instruments were valued at the price at which they were bought. Only when they were sold, or deemed impaired by auditors, was the price changed. As FAS 157 states, "The definition [of fair value] focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price.)" Ironically, regulators initially installed historic cost accounting during the Great Depression as a reaction against mark-to-market principles and as a way of encouraging conservative investment practices. They felt that mark-to-market accounting, which banks were then using to value their investment portfolios, encouraged them to chase speculative gains at the expense of long-term value. Like many of the New Deal-era markets and banking regulations that have been steadily rolled back since the early 1980s, historic cost accounting was seen as a way of saving the market from its own excesses. But that changed in the 1980s during the rise of the free-market ethos that placed investors above every other economic actor. Financial regulators blamed historic cost for allowing the country's savings and loans to hide real estate losses on their books from investors and reintroduced mark to market through a series of FASB statements. These culminated in statement 157, which defines fair value and provides guidelines on how to measure it. The Japanese experience in the '90s illustrates the main problem with historic cost accounting. Fair-value proponents regularly bring up the specter of Japan's lost decade as an example of what might happen here were it not for the discipline imposed on companies through mark-to-market practices. As the theory goes, Japanese regulators did not impose fair-value methods upon the banks after the real estate bust that ended the 1980s boom. Because of this the banking system was able to stumble along holding bad loans on its books at cost. While this kept the banks from failing, it also discouraged them from shedding their bad loans. In effect, the banks were not well capitalized, regardless of what the accounting said.The poison of bad loans remained in the system for years, effectively sapping Japanese economic growth. According to this view, mark to market would have forced a reckoning for the country's banks, outside of any political or earnings-related pressures. "I question those who say that hiding things will solve our problems," says Espen Robak, president of New York-based Pluris Valuation Advisors LLC, which values illiquid securities for hedge funds and broker-dealers. "I hope we don't get stuck in the muck like Japan." hat seems unlikely, however. Even Isaac admits that a return to historic cost accounting would be difficult to implement, given that investors already have some sense of the market values of the assets and liabilities on banks' books. "I concede that, having made this colossal mistake, it's really difficult to unscramble the mess," he says. However, he continues to advocate a suspension of fair-value accounting in favor of a government-led effort to value banks' books. "We can start by having regulators go in and do an economic analysis of the portfolios and mark them to that analysis," he says. "It's a big job, but they clearly have the resources to do it." There are few indications that regulators are willing to consider Isaac's proposal. In fact, the opposite seems to be happening, at least on the surface. The SEC on Dec. 31 issued a congressionally mandated report on mark-to-market accounting in which the agency recommended against suspending fair-value rules. The SEC argued that fair-value accounting increases transparency and helps investors make better decisions. In fact, the report went on to deny any effect from fair-value accounting on the financial crisis. "Fair-value accounting did not appear to play a meaningful role in the bank failures that occurred in 2008," the SEC said. "Bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and in certain cases, eroding lender and investor confidence." Accounting industry group Center for Audit Quality hailed the SEC report. "I am pleased to see that the SEC staff has concluded that a suspension of fair value or 'mark-to-market' accounting is inadvisable," executive director Cindy Fornelli said in a statement. But, despite the SEC's seeming intransigence -- for now, it's unclear whether the agency's stance will change after Mary Schapiro takes over from Christopher Cox in the Obama administration -- there are indications that FASB is moving to some sort of a hybrid reporting structure. Accounting and tax adviser Robert Willens says recent amendments to fair-value rules suggest the accounting body is walking back from strict fair-value interpretations. In particular, he says a December amendment to FAS 107, which mandates disclosures of financial instruments, now allows corporations to reveal not only the fair value of the assets, but also the expected cash flows from their assets. In the current environment, this could allow companies to show higher valuations than the market is signaling. "There's no question they're backing off from a strict mark-to-market application," Willens says, although he doesn't expect the accounting board to repudiate its application of the standard. Rather, he argues, the board will keep amending it, allowing managers and auditors greater flexibility in how to apply the market standard. "It's a face-saving thing." Whether auditors or accountants agree to any easier application of fair-value rules, however, is another question. Oaktree's Marks says auditors have taken a hard line since Enron Corp. went bankrupt and its managers were implicated in accounting fraud. This, he says, has made auditors look askance at attempts to apply subtlety to interpretations of balance sheets. "Your subtlety is my subjectivity and someone else's wiggle room," he says. There is great irony, however, in Enron influencing auditors to take a hard line in interpreting fair-value measurements. After all, the company benefited from a 1992 SEC ruling that allowed it to use mark-to-market accounting to value its long-term gas and derivatives contracts. This ultimately allowed Enron to overstate its earnings for years and eventually helped produce the company's collapse. Charles Niemeier, former chief accountant at the SEC and a member of the Public Company Accounting Oversight Board, put it this way in a speech delivered in December 2004: "The most disturbing aspect of Enron and similar scandals was not what was done that was wrong, but what was done that was right. Enron did not ignore the rules and regulations, but instead it took them and used them to achieve results that were never intended." Right. Wrong. Benefit or bane. Objective versus relative standards. The market or the regulators. These are fundamental differences. And because of them, the now venerable debate over how to account for financial assets does not appear to be fated for resolution anytime soon. Too bad.

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