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The Economic Storm

by Lynn Turner
Lead Counsel |
Is Fair Value Accounting To Blame?

I have been asked by a number of people about my views on fair value accounting. The bankers are launching a full scale attack on this accounting even as we speak, and despite their failure to get a moratorium placed on it, the bailout bill is going to cost each of us Americans a sizable chunk of money.

Below is a plain English, non technical discussion of what has transpired in our economy and fair value accounting.

First of all, regardless of whether or not we have fair value accounting, we would still have the current crisis. The crisis was brought on by the fact that banks and investment banks have leveraged up, having borrowed many times more than the typical business, and have run out of cash-a liquidity crisis as some say. Think of it this way. If you go out and make a $100 loan, that the borrower can only repay say $60, then you have something worth less than a $100. But if you do that hundreds of thousands of times, as was done by the banking industry and Wall Street, it doesn't take a rocket scientist to figure out that sooner or later one runs out of cash. You can't just keep paying out more than what you get back in without running out of cash and eventually going bankrupt.

In the crisis at hand, too many bad loans were made and put on the books at $100. But they weren't worth that, despite credit rating agencies giving them a AAA rating on paper. In addition, because so often the money used to make the $100 loan with was borrowed, but only $60 was repaid, there also wasn't enough money left over to repay those from whom money was borrowed to make the loan in the first place.

Unfortunately, not all the banks and those on Wall Street told everyone, including investors, what they had been up to. And certainly they didn't at first tell them the loans were not worth $100. But as liquidity and cash ran short, the losses became apparent and some institutions began to report losses.

When investors of companies such as Bear Stearns and Lehman began to doubt the value of the assets that were reported in their balance sheets, uncertainty and a lack of trust developed. Investors chose to move their money and investments elsewhere. In the case of Lehman, investors had already lost money and been burned on their investments in Bear Stearns. As a result, institutions sold shares in Lehman before they incurred the types of losses that had occurred by holding the investments in Bear Stearns until the bitter end. This left a market for the Lehman stock where there were a lot more sellers than buyers, and as anyone who has taken Econ 101 knows, that results in the price of the stock going down-quickly.

While this occurred, others (like AIG) had agreed to provide credit protections on these loans. As people found out that the loans were only worth $60, investors also began to wonder what the credit protection was going to cost those who agreed to provide it. And with trillions in credit protection granted through contracts that had to be honored, an agreement that could call for collateral or cash if the insurer's own credit worthiness was called into question was now a serious risk to the insurers. And of course, as the subprime loans did not pay off, then the insurance would kick in, and someone would have to pay up for the shortfall in the original $100 loan or put up collateral.

As we have seen with all the foreclosures and defaults, the subprime loans predictably did not pay off-(that is why they are called subprime). People or financial institutions who put up the money for the loans were not receiving payments back equal to what they had paid out, thereby creating a shortfall that was insured. And the insurers ran short when called upon to make good on their insurance. So regardless of whether one used fair value accounting or not, the lack of cash and liquidity crisis would have occurred.

But if institutions were allowed to continue to report the value of their loans as worth a $100 when only $60 was being repaid, this is just flat out misleading, if not lying to those who own the company or might be buying the company's stock. Some lobbyists in Washington, DC apparently think that is ok. It certainly results in less accountability.

What occurred as far as poor transparency is very much like what happened during the S&L crisis when reporting of bad loans was delayed, and with Enron, when so much off-balance sheet debt was hidden from investors and the markets. Now we are seeing a repeat performance yet again. The question is how often is Congress going to permit this to occur, at great cost to the individual American. The S&L bailout cost taxpayers somewhere between half a trillion and trillion depending on whose estimates you use. During the Enron corporate scandals, the capital markets bottomed out after losing around $7 trillion in market cap, and today, the Nasdaq index is still less than half of what it was in 2000. And now we are facing a price tab of one and half trillion.

Nonetheless, bankers are once again asking for a suspension of accounting that requires them to report to investors and depositors what their assets are worth including declines in values when they occur. This comes at a time when the IMF and Bridgewater Associates reported mortgage-related losses will balloon to between $945 billion and $1.6 trillion. But with institutions only reporting a little more than $500 billion in losses to date, it is apparent that more losses should be forthcoming if data from the banks is reliable. To suspend further reporting of these losses to investors and depositors is akin to a student asking for suspension of a report card when a failing grade is coming.

I note the banks are requesting a moratorium on their fair value report card. But they also requested $700 billion of Americans' money to bail them out for the bad loans they made. They want both. But if the problem was as they assert, fair value accounting, a moratorium on it should solve the problem without the need for a bailout. Yet they are still asking for ALL the cash. A true red flag that the problem isn't fair value accounting at all, but rather a lack of cash in the banks themselves, because they spent more on assets bought or created, than they are subsequently getting paid back on. Ultimately, it is no different than someone who spends more than their paycheck each month. Sooner or later you end up in foreclosure, just as we are seeing with the banks themselves.

Some say we are experiencing a "distressed" market with abnormally low and unjustified prices that will in time return to higher values. That is like saying the markets in some years is up, and some years is down, but we will ignore the down years and only use the prices in the up years. I never have heard anyone say you shouldn't use inflated bubble level prices because certainly they will fall when the crash comes. I do think prices currently are "distressing" but then they always are when they are not rising. But that doesn't mean we should give an exemption to companies permitting them to go out and say the markets and the values of their assets are up, when in fact they are not.

As the issues relate to problems with accounting rules, I think they fall into two camps. First of all, the FASB and IASB accounting standard setters have done a very, very poor job and get a failing grade for their standards that permit companies to treat financings as off-balance sheet and out of the view of investors. This includes financings such as are typically done through securitizations, SPE's, SIV's and leasing. As a recent FASB board member has told Congress, the FASB was aware of this and did nothing, which is inexcusable.

The second thing is that accounting rules are only good if they are enforced. However, as the FASB chairman recently told a senator in a letter, it looks like some of the recent, post-Enron FASB rules designed to bring greater transparency to the capital markets by bringing some off-balance sheet transactions on-balance sheet were not followed. To that extent, the FASB is not the enforcer nor does it have any powers in that regard. That all rests with the SEC.

Finally, some people don't understand what FASB standard No. 157 is all about and their lack of an informed understanding shows. They often want a moratorium on that standard. This standard accomplishes two things in addition to greatly enhancing transparency in the current crisis. However, what it is not is a requirement for using fair value accounting. That requirement actually rests in other standards.

The two things FASB No. 157 does is that it (1) tells accountants HOW to do fair value accounting when it is required by another standard, and (2) requires some very excellent disclosures on the fair values that have been determined. In fact, this is the standard that requires a company or financial institution to put their investments into three buckets depending on how "hard" or "soft" or independently verifiable those valuations may be. The company must then tell investors how much is in each bucket, so one can understand with greater confidence the nature and types of investments and where greater judgments are required to come up with good and solid valuations. Without such a standard, as we saw during the S&L and banking crisis of the late 1980's, accounting sleight of hand is all too common when assets are reported at much more than they are/were worth. To that end, investors can thank the FASB for greatly improving the disclosures.

In closing, transparency-the ability to get information needed to make fully informed investment decisions-is critical to gaining investors trust in markets. Unless that information is accurate and reliable, investors will not trust it. When investors are provided misleading or incomplete information, they rightfully steer clear of investing in the markets because all too often it leads to losses, as we saw with Enron and more recently, financial institutions. To bring investors back to the markets, they must once again be convinced they are getting reliable information upon which to base informed, not misinformed decisions. Until then, they may prefer Las Vegas where at least the word "Casino" appears on the entrance.