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Wall Street Crisis: Another inconvenient truth
By Xin Lian (chinadaily.com.cn)
Updated: 2008-11-21 15:18 On the night of Sep. 23rd, Cox, Chairman of the Securities and Exchange Commission (SEC), was walking on his way to the Congress Hall. Although prepared for the incoming hearing, he felt upset about the upcoming debate over fair value. The plunging stock market had already put him under great pressure. To make things worse, some Wall Street bankers and congressmen had started to challenge the Federal Accounting Standards (FAS). They blamed FAS 157 (on 'fair value' of financial assets) for worsening financial crisis and the pricing mechanism did not work. Cox had a mixed feeling towards this Federal Accounting Standards 157 passed less than a year ago. The unique feedback effect of FAS 157, plus the extreme prudence employed by accountants and auditors after the Enron scandal had all come together to fuel the ongoing crisis. All these seemed to underpin the appeal by bankers and congressmen to abolish or suspend FAS 157. As the boss of SEC, Cox felt badly embarrassed by the growing pressure. How should he respond--- remain unbudged or pass the buck onto the Congress? Cox expected to find the answer after entering the Congress Hall. In this unfolding financial crisis, accounting received so much attention that it reminded everyone of the Enron scandal several years ago. How can FAS 157 stir such a storm on the Wall Street? Is the fair-value accounting principle the culprit or just a scapegoat? A close-up of the provision is badly needed. Enacted by FASB two years ago, FAS 157 was designed to standardize the measurement of "fair value" of financial instruments. Fair value was no coinage. It was first introduced in the middle 1990s due to a savings and loan crisis. Back then, some financial institutions covered up their bad loans with doctored accounting. The problem spiraled out of control and the Federal government had to purchase US$160 billion of mortgage assets from the failed banks. Since then, fair-value accounting had gradually gained popularity. Ironically, the current financial crisis, also triggered by problems in the housing market, exposed the fair-value principle to widespread skepticism. Though devised more than a decade ago, fair value had remained largely a theory until the introduction of FAS 157, which grouped financial assets into 3 levels. Level 1 (assets of high liquidity) defines fair value according to market quotes, Level 2 (assets of limited liquidity) according to the pricing of Level 1 instruments of similar structure and objective valuation models, and Level 3 (assets with no liquidity) according to subjective observation and assumption-based valuation models. The numbering of the three levels suggest the order of preference in measuring asset value. Since the onset of the subprime crisis, price of asset-backed securities like MBS and CDO has continued to fall as a result of rising default. Financial institutions were forced to announce massive writedowns and asset devaluation, encroaching upon capital adequacy ratio. Under the pressure to replenish capital, they had to sell assets at major discount. The market was caught in a vicious circle of "falling price - asset writedown - panic sale - further price decline". FAS 157 turned out to be a catalyst for this process. With little liquidity, asset-backed securities were moved from Level 1 to Level 3, where banks' holdings were measured against the discounted prices in the market. Daunting floating losses were thus recorded, scaring the stock market into panic sales of financial institutions which held a portfolio of prime assets. One obvious victim was AIG. According to its former CEO Robert Willumstad, AIG's CDS position only had a loss of US$900 million, as measured by its proprietary valuation model. However, after PWC pointed out major defects in the model, AIG had to own up to a loss of US$11 billion. This unique feedback effect of fair value was thought to be the last straw for the insurance giant. Wall Street bankers were the first to point the finger at FAS 157, alleging that market failure meant a shortage of benchmark prices. They claimed that the losses from subprime assets were temporary because falling house prices would rally in time. If banks had been allowed to measure asset value with their internal hold-to-maturity estimates, the market wouldn't have been so volatile. Nor would the credit crunch have been so malign. Congressmen joined the campaign against the fair value principle. A bipartisan group composed of over 60 legislators wrote a letter to SEC, urging them to suspend the FAS standard. John McCain, the republican presidential candidate also appealed for a review of fair-value accounting in a recent speech. This powerful lineup imposed unprecedented pressure on Cox. Luckily, Fed Chairman Ben Bernanke came to Cox's rescue. "Doing this (abandoning fair-value accounting) would only hurt investor confidence because nobody knows what the true hold-to-maturity price is," Bernanke said during a senate hearing. The accounting community represented by FASB and IASB also lined up with Cox. FASB President Robert Herz argued that the fair value provision was in the interest of investors. IASB chairman David Tweedie echoed more pointedly in an interview, "Unable to give a convincing solution, the financial community does nothing but rebuke fair value blindly." Analysts and the American Consumer Alliance stood behind FASB and IASB. JPMorgan Chase & Co analyst Dane Mott said, "blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick." As the debate between bankers, congressmen and accountants intensified, the bail-out plan gave SEC unprecedented discretion to suspend fair-value accounting and required an across-the-board review by SEC on the impact of fair value on the financial industry within the next 90 days. Cox found himself trapped in a dilemma. On one hand, he had no intention to step on the already fragile nerves of bank tycoons and congressmen and be accused of exacerbating the crisis. On the other hand, he was unwilling to anger those accountants by "undoing the progress of accounting". After weighing the pros and cons, Cox decided to try out the response of the market. On Sep 30th, SEC released the guiding opinion on FAS 157, which, though not suspending FAS, stipulated that enterprises can decide the fair value of their financial assets through internal pricing in illiquid and irrational markets. The SEC emphasized that in an inactive market, the trading price was but one input in determining fair value. Others were the duration and percentage of price decline, liquidity, internal pricing model and assumptions. Cox knew that this guiding opinion was a double-edged sword. The new regulation offered the financial sector an opportunity to improve 3rd quarter's financial reports. By applying reasonable assumption to fair-value identification, companies may seek a remedy for overly stringent writedowns in the past, and escape from the vicious cycle between distorted market prices and shrinking asset value, and hence have a better-looking bottom line for the last 3 months. However, greater flexibility may be abused to unreasonably overprice assets, reducing transparency and information reliability in the market. That would be least needed when confidence is a luxury. After all, when the tip of the ice-berg becomes obscure in the new accounting culture, no one can foretell whether investors will turn around or keep sailing on. It is indeed a hard choice for Cox. With the quarterly report of financial institutions available soon, will the market respond as expected? Is it possible for him to develop an alternative within three months? Time will tell. |
