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Marking to Magic: Interview with Lynn E. Turner

by Michael W. Stocker
Eyes On Wall Street |

Eyes On Wall Street welcomes Lynn E. Turner, the former Chief Accountant of the U.S. Securities & Exchange Commission. Mr. Turner offers Eyes readers some trenchant insight on controversial new rules for fair value accounting, and their long term implications for investors.

Eyes: Many investors may not be familiar with fair value accounting. Can you give us a thumbnail sketch of what it involves?

Turner: In its simplest form, fair value accounting is nothing more than having a company report its investments in terms of what they are worth today rather than what they paid for them when they bought them in past years or even decades.

Eyes: Why should investors care about the way investments are accounted for?

Turner: Well, as an investor you're always interested in how management is stewarding the assets that you've given them to use. One good measure of how they've done with those assets and dollars is looking at the value that management has subsequently created. And looking at the value of those investments today, rather than some time ago, gives you a much clearer indication as to whether management has wisely invested the assets and got a return on the investments or instead has losses that they might like to hide and not be held accountable for.

Eyes: Why did fair value accounting come to be so controversial during the financial crisis of 2007 and 2008?

Turner: You know, I've been around for about three decades now and the whole debate over fair value accounting is nothing new. It was a major debate during the first half of the Seventies, when we had the '72-'73 bear market; it was a major debated item during the savings and loan and banking crisis in the late '80s and early 1990s; and again it's returned as a hot item in the subprime financial crisis. So it's nothing really new. The arguments are always the same: the bankers say in the down times that they shouldn't be made to take their losses, or it will destroy their businesses. But in the good times, they always come back and ask to use fair value accounting and take the write-ups.

The reality is that these financial institutions, some of which have been dismally managed, don't want to have accountability for the poor management decisions that they've made when they've invested the assets, the money from investors.

Eyes: And that's why the financial sector now has so much antipathy for fair value accounting?

Turner: Well, the crisis was created when banks made a lot of bad home loans that were never going to be repaid.. We know that for a fact now. When the loans defaulted a lot of homes came on the market that couldn't be resold, or had to be resold at much lower prices than what they'd been bought for or what people felt they were worth.

As a result, investments in those loans and those mortgages declined in value significantly. The financial industry, which had packaged and sold the loans and had a significant amount of these assets on their own balance sheets, really didn't want the public to learn about the magnitude of those losses. The public would be upset that they were sold bad investments by the finance companies. In turn the companies didn't have enough capital to reverse or to sustain those losses and would become financially unstable requiring taxpayer and government support.

Eyes: The financial sector has had some recent success in undermining the fair value accounting rules in both the E.U. and the U.S. Can you describe those changes?

Turner: What the Financial Accounting Standards Board ("FASB") in the U.S. and International Accounting Standards Board ("IASB") in the E.U. have done, interestingly enough, is somewhat interconnected. Initially, the European Commission and the President of the E.U., Sarkozy, put tremendous pressure in October of 2008 on the IASB to relax its rules and give greater latitude to financial institutions in how they go about figuring fair value, and in particular what type of assets they've got to apply fair value to. In part in response to what the E.U. did, earlier this year, under pressure from the US Congress, the FASB relaxed some of the accounting rules to give greater latitude in how you would calculate those fair values. These changes allow the banks to manipulate what they report as fair values. As one person said, under the new rules it's really not "mark to market," it's "mark to magic."

Eyes: Now, what do you make of the argument that fair value accounting just doesn't work when there isn't a market on which you can assess the value of some of these mortgage-backed assets?

Turner: Well, first of all, the vast majority of these assets do have a market, so it's not as big an issue as what some people make it out to be. For those where there isn't a market - that is, those investments aren't traded day in or day out - you can still make an assessment, and accounting rules allow you to make an assessment, of what the cash flows are going to be coming off those investments, and ultimately what someone else is going to be willing to pay you for that. Smart managers should have made that exact assessment when they initially decided to purchase them in the first place and put them on their balance sheet.

Eyes: There's certainly been a lot of debate earlier this year, and then maybe ongoing next year, about legislative proposals that might undercut the independence of standards boards like the FASB. How important is it that these boards remain independent?

Turner: It is very important that both the Financial Accounting Standards Board and the International Accounting Standards Board be able to go through a due process that allows them to develop standards that will in fact provide investors with the very high quality information they need to make sound investment decisions. When members of Congress here in the US, or when the European Central Bank or Parliament put tremendous pressure on either of these two bodies to serve special interests like the financial lobby instead of investors, then there's hundreds of millions of investors that get short changed.

In the long run, good investment decisions can't be made without good information. And unfortunately both the European Central Bank, the European Parliament and the US Congress throughout this year - and it will continue into next year - will continue to try to break the arms of these standards setters to provide standards that are more favorable to the banks, which will do destructive damage to the US capital markets and investors.