Suspend Disbelief: How Fair Value Could Be Modified for Geithner's Plan

The U.S. Treasury Department’s public engagement schedule released on Friday evening for the upcoming week says that Treasury Secretary Tim Geithner will present a “Speech outlining [a] new comprehensive financial stability plan” at 12:30 pm EST on Monday. (He is then scheduled to testify before the Senate Banking Committee and the Senate Budget Committee, respectively on the following days.)

Citing a “well-informed source,” Albert Bozzo of CNBC reported Friday night that Geithner’s financial stability plan “will include an aid package for the banking industry.”

Plan Expected to Include Ring Fence, Bad Bank
CNBC’s Bozzo further explains in Treasury’s Geithner to Unveil Financial Plan Monday that:

- the banking component of the rescue plan will be "smaller" than originally expected
- the plan will include some "bad bank" component [i.e. in which the government purchases ‘toxic assets’ such as mortgage-backed securities from banks, leaving them – the good banks - with less risky assets, and placing the toxic assets in a separate entity or ‘bad bank’], and
- the plan will be centered around government guarantees and insurance of troubled assets—what's called a "ring fence" concept.

Bozzo further reports that while there is general agreement around the ring fence concept, there is less agreement on the bad bank, adding, “Other sources told CNBC that the ‘bad bank’ would be able to buy up to $500 billion in troubled assets from financial institutions.”

Why Fair Value (Mark-to-Market) Accounting Could Impact Bailout
“At this point, the Obama administration appears to have settled on the most controversial aspect of the bad bank: pricing the toxic debt,” reports CNBC’s Bozzo. He explains in broad terms how the pricing mechanism is expected to work, and the fact that accounting rules may be modified to retain the desired benefit of setting up the bad bank without triggering unintended consequences.

Citing once again his unnamed source, CNBC's Bozzo states:
- The government will buy toxic assets below the banks' ‘carrying value,’ which is basically market value, but not at fire-sale levels, the source said, representing something of a compromise.
- Such a pricing approach will likely placate both taxpayer and Congressional concerns about the government overpaying for the assets.
- But, the source noted, it could ‘trigger an accounting problem for the banks,’ presumably because the institutions will have to report a loss on the transactions.
- The Obama administration is now working on ideas to address that, which might entail a temporary suspension of certain accounting rules. It is unclear what that might be, said the source.

Regarding Bozzo’s reference above to how the government’s purchase of toxic assets at a price below carrying or ‘book’ value could ‘trigger an accounting problem for the banks’ – to clarify, I don’t think the issue is so much about whether a particular bank selling a particular portfolio of assets into the bad bank would have to recognize a loss on the sale of those particular assets (although I could be wrong, and I welcome those with other views on this or other issues to post a comment on this blog). Although those losses will likely be huge, there would presumably be an offsetting gain in confidence – by investors and depositors - in the strength and stability of the remaining ‘good bank’.

I do, however, believe there is a significant issue to be addressed with respect to the application of FASB Statement No. 157, Fair Value Measurement, on the remaining portfolio of similar assets in the particular banks that transact with the government as part of the bad bank plan, and more broadly, on all other entities holding similar assets. That is because FAS 157 requires a ‘market participants’ or ‘exit value’ approach to valuing assets that are required by U.S. Generally Accepted Accounting Principles (U.S. GAAP) to be recorded at ‘fair value.’

[Note: FAS 157 does not specify which assets or liabilities must be recorded at fair value - it only specifies how to determine fair value - other accounting standards issued before or after FAS 157 set forth the measurement basis (e.g. historical cost, lower of cost or market, or fair value) for particular types of assets, liabilities, transactions or events.]

FAS 157 not only requires entities to look to current market transactions as being indicators of fair value, it requires entities to consider the price that would be obtained in a hypothetical transaction in current markets, when there is a dearth of actual transactions. The requirement to look to a current or hypothetical market price – as applied even in the current illiquid markets – has been the central criticism of FAS 157 for well over a year now.

Published in September 2006, roughly a year ahead of the market downturn, FAS 157 became effective in fiscal years beginning after November 15, 2007, just as the subprime crisis and its broader effects on the housing, credit, and stock markets accelerated. This point about when FAS 157 was issued vis-à-vis the then-unforseen financial crisis which arose, some say, from a perfect storm of black swan or unlikely events, is extremely significant in why I, for one, believe that some modification of FAS 157 may not be that outlandish of an idea.

But, its not just because of unforeseen events that I have this view - i.e. I do not believe accounting standards are made for when the sun shines, only to be abandoned in a storm; no, my belief is also due in significant part to the very wording underpinning FAS 157. Read more here about what FAS 157 says, and how I believe it could potentially be modified, if that route of action were to be chosen by the regulators and FASB.

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FEI Financial Reporting Blog provides highlights from SEC, PCAOB, FASB, IASB, and other regulatory news, including reporting under Sarbanes-Oxley Sect 404. It is written by Edith Orenstein, Director of Technical Policy Analysis at FEI

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