Lynn Turner: Fair value accounting didn’t cause banking crisis

by Kurt Schulzke on September 22, 2008

As fur flies in Washington over technicalities of the government’s proposed bank bailout, ordinary mortals may feel left out of the conversation if for no other reason than the rarified vocabulary of the debate. What, for example, is this thing called “fair value accounting”? Why should anyone but accounting geeks care?

One answer comes courtesy of Lynn Turner, former SEC Chief Accountant, who today circulated a message reproduced below with his permission:

I have been asked by a number of people today on my views on fair value accounting. Apparently, the bankers are launching a full scale attack on this accounting even as we speak and trying to get a moratorium placed on it in the pending bailout bill that is going to cost each of us Americans a sizable chunk of money. Below is a plain-English, non technical discussion of 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 is brought on by the fact the 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 of which the borrower can only repay say $60, then you have got something worth less than a $100. 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. Some, such as Goldman Sachs, had been much more transparent reporting fair values and losses much more timely, and have proven to be more astute and successful managers.

Unfortunately, when investors in 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. Much quicker than if there are just short sellers.

While this had 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 sub prime 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 sub prime loans – predictably — did not pay off. That is why they are called “sub prime”. 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 misleading if not lying to those who own the company or might be buying the company’s stock. Some lobbying in Washington, D.C. apparently think that is ok. It certainly results in less accountability.

Only by reporting the loans or investments at what they were worth could the market and investors learn of the fact managers were making loans they shouldn’t thereby allowing the market to discipline the companies early on when the loans first started going bad. With that information in the public domain, investors will challenge management and pay less for the stock.

Market discipline works, but only when there is transparency, not a shroud of secrecy. On the other hand, if this is all done without disclosure, management is able to get away with unsound business practices for much longer, especially when there is lax or void in regulation as certainly has occurred in recent years.

What occurred here 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, after these instances, we are seeing a repeat performance.

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. At some point, Americans will lose faith in their government if this continues.

And the voice of those who created the problem always becomes loudest when there is a downturn in the markets. We seldom hear such screaming and complaining as loud when the markets are rising and gains, not losses, are being recorded under fair value accounting,. But when the value of assets have become impaired, managers often don’t want to tell their investors the assets under their stewardship have lost value.

This raises questions about what investors are getting in return for the compensation being paid and about the decisions and competency of management. Management would just as soon report inflated values. They argue the stock market will turn around and they will recover the values of their investments. I think that is an argument I heard AIG make – that they would not incur losses. Reality has shown that argument and approach does not always work out for investors.

Others argue that you can’t value investments, especially in illiquid markets. These however, are not the vast majority of investments for which prices are readily available. But for those in illiquid markets, one can look to the expected cash flows, using historical data as a guiding light, to determine what cash is expected to be paid, which is ultimately always the determining factor in setting valuations. If a security or loan is one for which cash payments cannot be determined, one must ask why is it being sold into the public markets or being bought by a bank with depositors’ money in the first place.

I don’t recall seeing an prospectus or offering memorandum with disclosure to the prospective investor saying the seller of the sub prime loans didn’t have any idea about what the cash repayment streams would be. Of course such a disclosure would have been a red flag to investors and certainly would not have resulted in a AAA credit rating from the credit rating agency, as many of these investments were rated.

I think problems with accounting rules fall into two camps. First, the FASB and IASB accounting standard setters have done a very, very poor job and deserve a failing grade for 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 leasings. As a recent FASB board member has told Congress, the FASB was aware of this and did nothing. This is inexcusable. The accounting profession adopted guidance in 1974 and 1980 requiring such transactions to be on balance sheet. The FASB reversed this guidance in 1983, permitting the transactions to be taken off the balance sheets and clothed in secrecy.

Second, 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’s rules designed to bring greater transparency to the capital markets by bringing some off balance sheet transactions on balance sheet were not followed. The FASB is not the enforcer nor does it have any powers in that regard. That responsibility rests with the SEC.

Finally, some people don’t understand what FASB standard No. 157 is all about and their lack of understanding shows. They often want a moratorium on No. 157. But the reality is that this is a standard which, beyond greatly enhancing transparency in the current crisis, accomplishes two additional things. However, No. 157 does not require the use of fair value accounting. That requirement actually rests in other standards.

FASB No. 157 (1) tells accountants HOW to do fair value accounting when it is required by another standard, and (2) requires some excellent disclosures on the fair values that have been determined. In fact, No. 157 requires a company or financial institution to put investments into three buckets depending on how “hard” or “soft” or independently verifiable their valuations may be. The company must then tell investors how much is in each bucket, so they 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 required disclosures.

Bottom line: Despite political pressure to do so, Congress might be best advised to stay away from mandating changes in accounting principles like FASB Statement No. 157. Arguably, had the banks been following this standard — or if investors had understood it and used it to their advantage — we would not be facing such a crisis today.