Marking to myth

Scott Friedland is a senior managing director in the forensic and litigation consulting practice of FTI Consulting. He can be reached at scott.friedland@fticonsulting.com

The subprime credit crisis has had and will continue to have economic, social and political ramifications of historic proportions. Fallout from the crisis and the larger global credit crisis is also expected to impact US generally accepted accounting principles (GAAP). Critics of the existing accounting standards have argued that GAAP, and in particular fair value accounting rules, have exacerbated the economic impact of this crisis. Investors in subprime related financial instruments have recorded losses of hundreds of billions of dollars on their books over the past several quarters from marking these instruments to market in accordance with the fair value standard. Already we are seeing one change in accounting principals: the Financial Accounting Standards Board (FASB) ? the standards setting board in the United States ? is moving towards eliminating off-balance sheet treatment for the special purpose vehicles (the bankruptcy remote investment trusts) that are at the center of securitizations. The question has arisen if the accounting standards setters will loosen the requirements surrounding valuation.

Companies are struggling with valuing their portfolios at market when those markets are illiquid. Their external auditors cannot offer much assistance in providing valuations, as they are precluded from auditing their own numbers for independence reasons. The Securities and Exchange Commission (SEC) and other regulatory bodies are involved in numerous investigations relating to subprime mortgages ? investigations of lenders, financial institutions, insurers and investors. Though the targets and issues of the SEC's ongoing investigations have not been publicly disclosed, it is safe to say that an important focus of the investigations is the valuations and related disclosures made by the reporting entities.

Complexities in fair value measurement
Fair value accounting is not new. It has been a requirement in some form for many years. For instance, investment companies such as mutual funds and hedge funds, and brokers and dealers in securities have always been marking financial instruments to market. As a result of the FASB's emphasis on fair value, mark-to-market accounting for financial instruments has been promulgated in many accounting pronouncements. The FASB added a broad-based project concerning the appropriate accounting for financial instruments to its agenda in 1986 and subsequently concluded that fair value information is relevant in many accounting pronouncements.

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, became effective recently and addresses concerns about a lack of consistency and limited guidance in applying the fair value objective. Previous guidance evolved piecemeal over time and, as a result, was applied inconsistently. The new pronouncement defines fair value (?the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date?) and provides a uniform framework for measuring fair value. Financial assets and liabilities are categorized into one of three buckets based on a hierarchy (levels) of available valuation inputs. Level 1 assets or liabilities, such as (most) exchange-listed securities, have observable market prices in active markets. Level 2 assets or liabilities, while not actively traded, have inputs that are based on observable market prices, including quoted prices in inactive markets or of comparable financial instruments. Level 3 assets or liabilities are not traded actively and do not have inputs based on observable market prices. It is these Level 3 assets and liabilities that have caused most of the heartburn for those responsible for recording the financial instruments (marking to model, or derogatorily, ?marking to myth? or ?marking to make-believe?).

Problems with illiquid markets
In the wake of the credit crises, critics have focused on the complexity of valuing Level 3 financial instruments, the difficulties investors have in understanding these valuations, the earnings volatility such valuations cause, and the belief that use of the prescribed valuation methodology has exaggerated write-downs. However, though the FASB has been sympathetic to criticisms of its pronouncements before, industry observers believe it is unlikely that it will eliminate fair value accounting or that the SEC or Congress will step in to suspend its use. Defenders point to the recent survey conducted by the CFA Institute which concluded that the majority of professional investors believe that the fair value requirements improve transparency and market integrity. The CFA Institute also stated its opposition to alternative valuation methodologies that result in smoothing of price changes as ?unfortunate and not a responsible way to manage real risks.? Members of the accounting standards board point out that no one has proposed a better alternative.

Those who are suggesting the use of cost basis accounting for such hard to value securities may have forgotten the lessons learned from the savings and loan crisis of the late 1980s. At that time, banks that recorded assets at historical cost began selling appreciated assets for a gain, while retaining those that were worth less than their book values, in an effort to improve their reported financial condition. As a result, many banks were left with asset portfolios dominated by weak and underperforming assets. A good number of these banks eventually went insolvent. Many felt that a balance sheet based on market values would have provided earlier warning of a bank's financial weakness. It was in this environment that the FASB began its Fair Value project.

Market implications
Firms confronted with the task of marking their portfolios for book purposes, that is, to fair value, in accordance with generally accepted accounting principles are facing challenges. From our vantage point, as an advisor to many firms in the headlines, we see that these challenges usually fall into one of the following categories:

Observable inputs are not representative of prices in an active market
Firms wish to dismiss low current prices observed in the market as representative of forced or distressed sales. Accounting guidance issued by the Center for Audit Quality in time for auditor reviews of third quarter 2007 filings provides that ?if orderly transactions are occurring between market participants in a manner that is usual and customary for transactions involving such assets, then those transactions are not ?forced? sales? and should be considered Level 1 inputs. The burden is on the firm valuing its portfolio to establish that an observable transaction is a forced sale. If it is established that there is no market and observed transactions were in fact distressed sales, or if there are principal-to-principal transactions where no public information is disclosed about the transaction, these observable prices should be considered to be Level 2 inputs.

Current prices are not reflective of fundamental value
Alternately, firms have argued that there is a temporary imbalance between supply and demand (more sellers than buyers forcing prices down), the marketplace is temporarily irrational (prices do not reflect fundamental value) and that the security prices will rebound. Though such points of view may have merit, current prices still must be used in valuing financial instruments. This issue was addressed by the SEC in a 2004 accounting and auditing enforcement release in which the SEC objected to the practice of ignoring current marks. Though recommended as an investment strategy, ?taking the long view? is not an option for valuation.

Firm's view differs from view of other market participants
For Level 3 assets and liabilities where there are unobservable inputs, we have seen firms use their own assumptions and proprietary valuation models, based on management's belief that their staff have judgments and models that are superior to their competitors and counterparties. While management's faith in its staff is admirable, this is not what is appropriate under the fair value standard. The objective under the fair value standard is to estimate the exit price ? the price that the company would receive under existing market conditions for the asset (or receive to assume the liability). It is incumbent that the assumptions used in a valuation model be consistent with the assumptions that other market participants would use to price the security and not the firm's own proprietary methodologies. Likewise, Level 2 (observable) inputs cannot be ignored in favor of the firm's own assumptions. Standard setters have expressed concern about giving management the leeway to use unrealistic assumptions, particularly in valuing long duration derivative contracts, which would overstate earnings.

desire to smooth volatility
Firms have historically gotten in trouble for trying to smooth or manage earnings through inappropriate accounting. Attempting to smooth out the bumps in valuation arising from market turbulence should be viewed no differently. One suggestion is to consider presenting core earnings and carefully communicate to the marketplace the soundness of their business and approach to market risk, especially if they are reporting large losses caused by write downs of financial instruments.

Reliance on valuation specialists
Firms may have hired outside experts to value complex financial instruments. Management may have been encouraged to do so by their auditors. It is important that such appraisers understand the definition of fair value and the fair value hierarchy or the firm may find that it has bought a very expensive valuation (and, possibly an economically sound valuation) that does not comport to generally accepted accounting principles.

Inadequate systems
It is understandable that firms would want to avoid the high cost of investment in systems or experts to value complex instruments for accounting purposes. Unfortunately, based on our experience, such costs may actually be significantly less than the costs of regulatory investigations and related litigation.

The credit crisis has created new challenges for firms required to follow fair value accounting rules. However, the accounting guidance for valuing financial instruments in times of market dislocations cannot be ignored. Generally accepted accounting principles require estimates of fair value to be made at times of market illiquidity. They also provide a framework to do so.