I found this excellent article on the website of CFO magazine: "Everything we learned about the financial crisis, again", by Tim Reason and Marie Leone (December 9, 2008). It describes the views the chairman of the Financial Accounting Standards Board, Robert Herz, on the financial crisis, and his take on the banking industry's (ultimately thwarted) attempts to roll back fair-value measurements, on the grounds that such practices exacerbated the meltdown.
The summary of the speech touches on many important points, such as the "'misplaced investor enthusiasm' for securitized loans, which [Herz] said was the result of 'widespread financial illiteracy in our country'" [emphasis added], as well as "how dependent the investing public has become on the financial markets", due to the looming insolvency of Social Security and defined-contribution retirement plans. The next paragraph of the article mentions again Herz's view that such an approach can only work if the public becomes more financially literate. Unfortunately, he provides no guidance regarding how the public is supposed to do that.
Herz, an accounting guru, naturally spent a subtantial amount of time commenting on the place of accounting in the crisis. In particular, he took a swipe at "America's 'continued addiction' to off-balance sheet treatment, particularly via securitization." Securitization is, of course, the process by which financial assets are pooled, repackaged and then sold to investors. In the words of the Wall Street Journal, July 10, 2008 ("The Future of Securitization"), "Securitization involves transferring a loan or pool of loans into a trust and then having that trust issue securities, or bonds, that are rated by the large rating agencies and purchased in the institutional bond market." The procedure became hugely popular due to the returns on equity it offered.
Both Herz and the author of the WSJ article point out that the issue with securitization is the duration mismatch between assets and liabilities, i.e., the fact that long-term commitments are financed with short-term debt. Both also note this was one of the factors underlying the S&L (Savings & Loan) crisis, which shares many features with the current mess (reading this 1989 article in TIME ["The Savings & Loan Crisis"] brings about an eerie feeling of having been catapulted twenty years in the past, as many sentences resonate today; the fact that the President back then was also called Bush doesn't help in keeping the two epochs separate) - this similarity explains the title of the CFO.com article.
Going back to the topic of fair-value and mark-to-market accounting, so dear to the FASB chairman: despite pressure and intense media coverage dating back from the summer ("In Bear Stearns Case, Question of an Asset's Value", New York Times, June 20, 2008, "How to Start the Healing Now", Wall Street Journal, October 1, 2008, "Bipartisan Bailout Folly", Salon.com, October 1, 2008, "The Accounting Rule You Should Care About", CNN.com, October 1, 2008, "Momentum Gathers to Ease Mark-to-Market Accounting Rule", WSJ, October 2, 2008, "Has the Crisis Ended the Fair-Value War?", CFO.com, November 21, 2008), a report by the Securities and Exchange Commission recently recommended no change in the fair-value accounting rules [the famous FAS 157], but suggested "the number of impairment models [the models used for a downward revaluation of assets] could be reduced" (WSJ, December 31, 2008).
Banks had lobbied for a change because "mark-to-market accounting requires companies to value financial assets at their fair value -- the price they can fetch in the market. That has led companies to take big write-downs on thinly traded securities, even if the underlying assets aren't severely troubled" (WSJ, December 8, 2008) The full SEC report is available here; the part on impairment models is most closely related to Recommendation #4, summarized on page 19 and described in more details on page 204. I wish there had been a more thorough description of the actual models (can't help myself!), but I guess they are proprietary and bank-dependent.
The relatively recent FAS 157 has undoubtedly ushered a new era of fair-value accounting, as described in this other CFO.com article: "Fair-Value Revolution", September 1, 2008, which describes among other things how local company PPL Corp. (based in Allentown, Pa. and employer of many Lehigh University alumni, in particular at the treasury level) is dealing with the new regulations: "The initial challenge in meeting the requirements of FAS 157 entails sorting each fair-value estimate into one of three levels, or "buckets," as Paul Farr, CFO of PPL Corp., calls them. [...] In bucket 1, the value of an asset or liability stems from a quoted price in an active market; in bucket 2, it is based on 'observable market data' other than a quoted market price; and in bucket 3, fair value can be determined only through 'unobservable inputs' and prices that could be based on internal models or estimates. It's that third bucket that critics say has some serious holes."
The role of information systems in regulatory compliance represents an interesting side note, rarely broached upon in the mainstream media: "PPL's accounting and technology staff had to go back and "force" its computer system to plug in "literally thousands of energy transactions in a given year" into one of the three buckets." (Of course, the mainstream media, even at the height of the lobbying efforts in the Fall, does not print 3,000 words on an accounting rule either.) High-profile areas that should be soon affected by fair accounting are mergers and acquisitions (FAS 141(R)) and hedging (FAS 133 - "considered by many to be the most notorious example of the complexity of U.S. financial reporting" - I don't even want to think about what that looks like.) FAS 157 has managed the rare feat of putting accounting rules in the limelight.
Herz, who finds relaxing fair-accounting standards much too convenient for the banking industry, and problematic for investors, concluded his speech with the following piece of advice (paraphrased by the journalist): "Don't make industry exceptions. They are invariably abused, which ultimately forces standard setters to eliminate them." Which might be the reason why companies had lobbied for the exception in the first place.
Main two articles quoted in this post:
- "Everything we learned about the financial crisis again," by Tim Reason and Marie Leone, CFO.com, December 9, 2008.
- "Fair Value Revolution", by David Katz, CFO.com, September 1, 2008.