As the President signed the $700 billion Bailout package last week, the Big 4 were voicing their opposition to the proposed suspension of fair value or "mark to market" accounting. Meanwhile, many others in the financial industry are calling for just that. In fact, it's been suggested that the first draft of the Bailout package was defeated in the House primarily because of it lacked any mention of a fair value suspension.

Why the controversy? 

To understand this, let's try to understand what fair-value accounting is. Fair-value is a method of accounting for assets, based on the value of that asset in its current market. This takes the place of the previously used method known as historic value accounting, which based the value of an asset on the price it was originally purchased at.

A recent article in the online journal CFO.com used a great analogy to describe fair value. 

"Under historic cost accounting, your earnings would consist of your salary.  Under fair value accounting, your earnings consist of your salary, plus the increase (or decrease) in the value of your house and other assets. During the housing boom, you were richer because your house was worth more, even though you didn't plan to sell it. When the housing market crashed, you became poorer."

 

The controversy seems to be stemming from the bitter pill of the subprime market collapse. 

Many of these subprime securities are what is known as a Level 3 asset. That is, they are difficult to value due to their illiquidity. They require valuation specialists using complex mathematical models who estimate what the current value of an asset would be if there were a common market for it. 

This seemed to be great while the chips were up. Subprime securities had been valued as Level 1 assets, and trading was brisk. Companies were reporting gains, and everyone was happy. However, after the subprime market collapsed, suddenly these Level 1 assets became hard to value Level 3 assets. Companies that were holding hundreds of billions of dollars worth of these Level 3's began to draw scrutiny from their investors.

As investors lost confidence, they pulled their assets out of the market. Firms were forced to liquidate these Level 3's at a time when there was simply no model to reflect fair market value. The lack of confidence reached near panic levels as banks and financial institutions stopped lending funds to one another, after sustaining staggering losses due to the plummeting value of what many once thought of as a sure thing.

 

Many executives at these institutions were left holding the bag, so to speak, and weren't at all happy about it.

Retirement and college funds dried up almost overnight. Fortunes were lost in what seemed to be the blink of an eye. Murmurings of a second Great Depression started to circulate among the more panic-prone. According to some on Wall Street, the method of fair value accounting left them too vulnerable to market volatility.

The dissolution of the subprime market is also symptomatic of what Alan Greenspan once referred to as "irrational exuberance." The subprime market was too inflated... the high returns on these relatively new financial instruments were simply too good to be true. It had to collapse. Companies that were holding a huge amount of these types of assets were doomed to fall. Arrogance, greed and complacency are powerful market factors, but cannot outweigh fear and paranoia. It is not the method we should be blaming... it is the madness.

 

Suspension of fair value accounting would be a suspension of transparency and relevance.

In the simplest of terms, when you purchase a car, you can't sell it five years later for the same price just because that's the price you originally bought the car at. The car may be worth more, or it may be worth less, depending on the current market for that car.  Granted, our understanding and application of fair value can benefit from guidance and interpretation. Simplification of the valuation process would benefit everyone, except those valuation experts who get paid to create models to account for non-existent markets.

 

But, if our option is essentially ignoring current market conditions and claiming irrelevant value on our assets, doesn't that essentially amount to negligence and/or fraud?

Shouldn't our failing institutions simply own up to their over-leveraging and learn a lesson about consequences? Sure, that may sound a little idealistic. But when the average taxpayer is left to pay the bill for the failure of these institutions while Wall Street executives are given a go-ahead to return to Enron-style creative accounting, perhaps some ideals are in order.

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