5/19/2008: Fair-Value Accounting's "Atmosphere of Fear"

Excerpts from Fair-Value Accounting's "Atmosphere of Fear"
by David M. Katz

Senior finance executives at some of the biggest financial institutions are calling on the Financial Accounting Standards Board to reassess its new fair-value standards in light of the banks' experience in the subprime crisis.

The shift to fair-value accounting in the midst of the crisis spawned an "atmosphere of fear" that lead to a "lockdown" in the use of judgment in valuing securities, they said last week at a Standard & Poor's conference provocatively titled "Is it Time to Write Off Fair Value?"
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One part of the controversial new mark-to-market standard, FAS No. 157, Fair Value Measurements, that needs a second look is a provision that says that market prices must be assessed on the basis of market participants that are "willing" to buy or sell the asset or liability but are not "forced or otherwise compelled to do so," according to Bob Traficanti, head of accounting policy and deputy controller of Citigroup.

Traficanti, a former FASB project manager who worked on FAS No. 133, the board's hedge-accounting standard, suggested that some of the prices that the bank had to come up with indeed felt coerced. One of the "unintended consequences" of the new rules has occurred at Citigroup "in situations where we have securities with little or no credit deterioration, and we're being forced to mark these down to values that we think are unrealistically low," he said. "I would ask the FASB to ... back-test to see how this really worked."

Similarly, Christopher Hayward, a Merrill Lynch senior vice president and finance director, asked FASB to go back and look at the results of the standard with an eye to the "almost borderline panic" that beset many companies at the prospect of gauging the fair value of securities with no semblance of a market. Many firms in the financial-services industry lacked the models to create hypothetical markets when the real ones dried up, he added.

But not only the financial firms were unprepared, Hayward said. Their auditors also found themselves fumbling in the dark. As result, the Merrill executive said, they advised their clients, "Let's just mark [an asset or liability] down; there's no question if we mark it down heavily."

The intense conservatism that ensued eclipsed the role of judgment in marking instruments to market, according to David Johnson, the outgoing CFO of the Hartford Financial Services Group. He called papers issued last fall by the Center for Audit Quality (CAQ), an offshoot of the American Institute of Certified Public Accountants, "basically a shoot-to-kill order for anyone who would exercise judgment."