Reform of “Fair Value” Accounting

Testimony of Alex J. Pollock,Resident Fellow,American Enterprise Institute.

To the Subcommittee on Capital Markets, Insurance and GSEs, Committee on Financial Services,U.S. House of Representatives,March 12, 2009

Mr. Chairman, Ranking Member Bachus, and members of the Subcommittee, thank you  for the opportunity to present testimony on the immediate need to reform “fair value” accounting, which has made and continues to make the financial crisis worse than it needs to be.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI in 2004, I spent 35 years in banking, including 12 years as President and CEO of the Federal Home Loan Bank of Chicago.  I am a director of three financial services companies.

Reform of the “Fair Value” Accounting Theory is Needed Immediately

“Fair value,” also called “mark to market,” is an accounting theory.  We need to understand as a fundamental point that it is a theory, not a fact.  It is a theory which has had enormously damaging real world unintended results.

“The mark to market mechanism is pernicious,” Gene Ludwig, Comptroller of the Currency under President Clinton, has stated.  Fair value accounting is “a major cause of the world-wide financial crisis,” Bill Isaac, the Chairman of the FDIC during the 1980s financial crisis and a distinguished witness today, has observed.  He has added that the application of fair value accounting on top of the other problems of the 1980s would have been disastrous.

“Bank investments should be considered in the light of inherent soundness…and should not be measured by the precarious yardstick of current market quotations which often reflect speculative and not true appraisals of intrinsic worth.”  This was the conclusion of the Federal Reserve in 1938, as it put an end to the former mark to market practices of the day, which had helped drive the banking system down, then as now.  (There are no new ideas in finance.)

What does “intrinsic value” mean?  Fundamentally, it means the principal and interest that you are going to collect.  If you are not going to collect it, it should of course be written off.  But should you write it off when you are going to collect it, because a panicked market has put a panicked price on it?  That way, which is the fair value way, creates a downward spiral in which everybody except short-sellers and vulture buyers loses.

A FASB defense of its fair value accounting theory, which has cycled into becoming the dominant accounting fashion only during the last couple of decades, claims that “Fair value reflects losses that have been incurred, it does not cause losses.”  But in a big financial bust, with a self-reinforcing downward spiral of panic and illiquidity, this is manifestly untrue: accounting has real world effects.  These include freezing funding markets, heightening uncertainty, triggering defaults on debt covenants, and changing customer and regulatory behavior.  This all creates further uncertainty, which further lowers asset prices, which triggers accounting losses…and so on down.

The perverse effects of fair value accounting in a market panic are why almost all banking regulators oppose it.  It is too easy for them to think of distressed situations which the banking system would not have survived if it had had to mark to market at the time.

Accounting is Always a Theory

Apologists for FASB and fair value accounting say they are only insisting on “the facts” of market prices, although they of course admit that in many cases there is no active market or no market at all, and that panicked conditions can result in fire sale prices that will be judged by later observers as irrational.  Nonetheless, they say, we must not hide from “the facts.”

But accounting is always a matter of theory.  It never is and never can be simply facts.  It is and can only be certain facts as treated according to some theory.  Within the theory, it generates the projections, estimates and guesses needed to calculate what the theory defines as its results—for example, the defined concepts of “profit” and “capital.”  As the Institute of Chartered Accountants of England and Wales so rightly observes:

“Financial reporting attempts to measure inherently abstract and debatable concepts such as income and net assets, and it has particular features that make it to some extent inevitably subjective.”

Thus accounting theories are debated over years and decades without the ability of one side or the other to prove it is right.

What kind of a theory is fair value accounting when applied to debt instruments?  It is an OK theory in a stable period when prices of debt instruments are equilibrium-seeking.  But in a period of disequilibrium and discontinuity, like a panic, it adds to the disequilibrium and makes the problems worse.

Debt instruments (unlike equities or houses) have a principal to be repaid at maturity and interest payments until then.  Consider the principal and interest that is indeed going to be paid.  What is the right accounting representation of these future cash flows in today’s balance sheet?  This is the same question as asking what discount rate should be applied to them, and how that should affect the defined concepts of profit and capital.  To discount the cash flows by the exaggerated illiquidity premiums of a panicked market, and by doing so to exaggerate losses and erase capital, is both theoretically unsound and feeds the panic.

Many observers therefore say we should “suspend” fair value accounting.  This seems to me to give it too much credit.  I say it should not be suspended, but reformed.

The way to do this is to produce balance sheets and income statements as before the fair value days, that is, based on the principal and interest you are going to collect.  This should define profit and capital.  Then add a separate fair value balance sheet, completely “marked to market,” using whatever market prices there are or estimates of what they might be if there were markets trading.  This would give the proponents of fair value accounting all the information they desire, while not driving the financial system into the perverse downward spiral.

HR 1349

The  FASB has been very slow and reluctant–even when confronted with the financial crisis– to fix what seem to be the obvious problems with fair value accounting theory.  Therefore a new oversight board to govern accounting rulemaking seems like a good idea to me.  With its proposed membership, I believe this new board would provide a more balanced forum to address the problems I have discussed.

But such a board needs to be promptly created, get in business, and act quickly.

Thank you again for the opportunity to share these views.

3 Responses to "Reform of “Fair Value” Accounting"

  1. SHAUN   March 19, 2009 at 1:24 am

    Does that mean that valuations wouldnt be raised sharply to expand balance sheets if there is an upturn his theory should work both ways with only moderate rises allowed in boom times,like thats going to happen.It seems like alot of people who derive bloated incomes from the financial sector when things are going well want to have their cake and eat it too,maybe they should cop it on the chin ahd start running honest businesses like the small business sector has to and actually run the business on real facts and figures instead being bailed out when times are tough and pocketing huge money basically derived from reporting through rose-coloured glasses.

  2. Conrad Richter   March 20, 2009 at 8:37 am

    The recent wild swings in markets such as oil and other commodities, housing, equities, etc. struck me as artificial and unrepresentative of what real consumption and production was (as opposed to strict demand and supply, which are subject to the actions of speculators). How is it possible for a commodity everyone on this planet uses, like oil, to go from $30/b to $150/b and back down the $30/b? Did we all suddenly use that much more oil? Speculative valuation and real valuation are two different things, and it’s the former type that drives these wild swings. Separating out real valuation is what investors who invest on fundamentals do, while traders using derivative math are largely drive up and down the speculative type. Fair value accounting very much feeds the speculative type in all markets, not just debt instruments. Pollock’s argument on the reform of debt valuation could be extended to all assets. Trouble is, separating the speculative value from the real value is an impossible, subjective task, even for debt instruments, and is open to massive abuse. But I agree with Pollack that more regulatory flexibility in valuation is sorely needed. Anything that allows decision makers and regulators to decouple from the speculative markets is (perhaps) a good thing.

  3. Anonymous   March 20, 2009 at 10:06 am

    I have spent nearly a lifetime as a commercial real estate appraiser working with this difference between “intrinsic” value and “market” value. They are simply two different concepts [with different associated methods of calculation]. The former represents – depending on your investment strategy and values – the fundamental strength of a set of financial holdings [“rights and interests”]; the latter represents the current ratio of effective demand to supply. Underwriting equity or debt investments [public or private] requires awareness of both concepts of value; unfortunately, there is a long heritage of arguing about “value” that leaves the dialogue locked onto the semantics of this term rather than dealing with underlying economic issues. When firms are locked into illiquid assets that cannot be sold but need to be sold then the emphasis is on their “fundamental” strength; when these assets were appreciating through the roof well beyond the rate of change in fundamentals then the benchmark of the “market” dictated value. The need to consider both is actually blocked by well-meaning regulatory rules and rating agencies that choose [often without well defined terms or purposes] one or the other mandating both a specific “point estimate” as well as a specific concept as the “benchmark” of value.