Fair Value Accounting: A Contributor To the Financial Crisis Or a Convenient Scapegoat?

1. By Baruch LevNew York Universitywww.baruch-lev.com Fair Value Accounting:A Contributor To the Financial Crisis Or a Convenient Scapegoat? September 2009

2. The Prosecution “It’s not mark-to-market, rather mark-to-myth.” (Warren Buffett). “Fair value accounting amplifies the losses of banks by forcing them to take unreasonably large asset writedowns and losses, diminishing their equity and eroding public confidence in banks.” (Stephen Swarzman, cofounder of Blackstone Group.

3. Prosecution - Continued “Mark-to-market rules must die so that banks will live. Avoiding the writedown of unrealized losses will give banks time to recover. Suspending fair value will prop the economy at no cost.” (Wesbury Brian and Robert Stein, in Forbes).

4. The Defense Don’t kill the messenger. Accounting just reports the facts. Japan experienced a “lost decade” [the 1990s] mainly because banks did not face up to huge loan and investment losses. Fair value accounting, though imperfect, is superior to the alternative—irrelevant historical cost.

5. The Truth, As Is Often the Case, In Between So, what were the consequences of fair value accounting? • Accounting is definitely not just a messenger. Accounting/Financial Reporting have important, sometimes serious consequences. The feedback effect. • The recording of a liability for post-retirement employee benefits in the early 1990s and subsequent cuts in these benefits. • The avalanche of managers/employee stock options in the 1990s and early 2000s, and the fast decline of this compensation, once the expensing of stock options was required (2005).

6. Back to Fair Value Accounting: What Exactly Is It? The essential elements of fair value accounting (from: Stephen Ryan, May 8, 2009 presentation):

7. Measurement of Losses on Financial Instruments • Various specific standards govern the accounting for different types of positions • When these standards require measurements at fair value, FAS 157 provides the guidance as to how to do so

8. FAS 157 Definition of Fair Value • The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date • exit value • highest and best use • principal or most advantageous market • “orderly” means unforced, unhurried • “market participants” are knowledgeable, unrelated, willing and able to transact • “at the measurement date” means given market conditions existing at the time • Is the increasing temporal slippage among the aspects of the definition troublesome?

9. FAS 157 Fair Value Hierarchy • Hierarchy of fair valuation inputs, from most to least reliable • Level 1: quoted market prices (unadjusted) in active markets for identical items • Level 2: other directly or indirectly observable market inputs • Some inputs yield mark-to-market valuations with adjustments • Quoted market prices in active markets for similar items or in inactive markets for identical items • - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - • Other inputs yield mark-to-model valuations • Yield curves, correlations, etc… • Level 3: unobservable inputs • Yield mark-to-model valuations • Should reflect assumptions that market participants would use • Is a level 2 mark-to-model always better than a level 3 mark-to-model? If not, under what conditions?

10. Applying FAS 157 In the crisis • Increasing illiquidity of markets and unobservability of trades imply fair value measurements likely rely on level 3 inputs • May be true even if level 2 inputs exist (e.g., because bid-ask spread is very wide or principal-to-principal transactions are opaque) • Migration of measurements down the hierarchy

11. Applying FAS 157 (2) • Level 3-based fair valuations require assumptions that are difficult to make • For example, for mortgages most of the historical data still reflects robust house price appreciation and very few uncorrelated defaults • House price depreciation • Future interest rates • When will subprime mortgagees be able to refinance again? • Q: Should disclosures of estimates of these primitive valuation inputs (e.g., house price appreciation) be required?

12. Recent FSP Involving Other-than-Temporary (OTT) Impairments of AFS and HTM Investment Securities • Prior GAAP: An AFS or HTM investment security is OTT impaired if it is probable that the firm will not receive the promised cash flows. An OTT-impaired security is written down to fair value (i.e., there are no partial impairment write-downs) • FSP FAS 115-2 and FAS 124-2 (April 2009): If a firm does not currently intend to sell an OTT-impaired security and it is more likely than not that the firm will not have to sell the security before a recovery of the cost basis, then the firm records only the expected decline in cash flows on the security in net income, not the losses due to increases discount rates, which are recorded in AOCI • This guidance is to be applied retroactively, with a cumulative transfer of previously recognized non-credit losses from retained earnings to AOCI • This retroactive treatment substantially increases many banks’ regulatory capital, which is not affected by AOCI

13. Disclosure examples Bank of America, Q2 2008 Levels Disclosure: Level 1Level 2Level 3 Assets 67,156 917,160 39,527 Liabilities 52,750 540,628 9,675

14. Bank of America, Q2 2008 Level 3 Changes Disclosure: Opening Balance 28,309 Included in earnings (331) Included in other comprehensive income 78 Purchases, issuances, and settlements (928) Transfers in to (out of) Level 3 2,724 Ending Balance 29,852

15. Capital One Corporation, Q1 2008

16. Capital One Corporation, Q1 2008 Level 3 Changes Disclosure: Opening Balance 1,760,846 Gains (Losses) 77,995 Purchases, issuances, and settlements (111,643) Transfers into (out of) Level 3 (54,757) Ending Balance 1,672,441

17. The Evidence: Is Fair Value Accounting Useful to Investors? The proof of usefulness—fair value data affect investors’ decisions, as reflected in share prices and returns. Focus on the novel aspect of SFAS No. 157: The three levels of fair-valued assets and liabilities.

18. Investors' Valuation of Fair Value Information in Q1 2008

19. Investors' Valuation of Fair Value Information in Q2 2008

20. Focus on Liquidity Risk: * Source: Baruch Lev and Nan Zhou, “Unintended Consequences: Fair Value Accounting Informs on Liquidity Risk.”

21. The Verdict • Fair value information, even in a crisis environment, is undoubtedly useful to investors. • Of particular usefulness is the three-level separation on liquidity risk; an unintended, positive consequence of SFAS No. 157. • These findings, however, don’t rule out a certain irrational reaction of investors to fair value data and contribution to the crisis.

22. Appendix: Detailed research results* * Source: Baruch Lev and Nan Zhou, “Unintended Consequences: Fair Value Accounting Informs on Liquidity Risk.”

27. TABLE 6. Regressions on Individual Levels 1–3 Fair Value Variables for Five Groups of Events and All Events Panel A. OLS Regressions with MCR as Dependent Variables