Legislators Debate "Fair Value" Again -- But Don't Expect a Suspension of the Accounting Rule

There's yet another hearing on "fair value" accounting today, this time in the House subcommittee on capital markets. But don't expect a suspension of the rule that requires to mark-to-market valuation of financial instruments held by financial institutions.

Earlier this week, Federal Reserve chairman Ben Bernanke said he doesn't support such a suspension. SEC chairman Mary Shapiro echoed that statement.

There are several reasons for keeping the fair-value rule. First, it provides transparency regarding exactly the assets banks and other financial institutions hold on their books. This is especially important for investors and other users of financial statements -- including federal regulators.

Although quite painful to banks when asset values are plummeting, fair value forces institutions to write down bad assets and raise more capital if necessary. It also helps banks clean up their balance sheets and get rid of toxic assets such as collateralized debt obligations and asset-backed securities faster.
In the 1990s, for instance, Japanese banks -- so-called "zombie" banks at the time -- dragged the country further into recession because they were kept alive by the government, but weren't in any shape to lend again. That's mostly what proponents of fair value want to avoid.

On the other hand, those opposing fair value have a good point when they raise the issue of procyclicality. That essentially means that fair value makes bad times worse by forcing financial institutions to sell securities at fire-sale prices and to raise new capital at dilutive prices. Fair value can also help bubbles expand by inflating the value of assets bank balance sheets. While a valid point, the need for transparency in financial markets and for banks to come clean seems to win over.

So what is House Financial Services Committee chairman Barney Frank, D-Mass., looking for by holding this hearing? My sources tell me he wants more guidance in determining fair value and more disclosure.

Fair value is easy to figure out when markets are functioning in an orderly manner. But when security markets freeze up, as a lot of them currently have, the Financial Accounting Standards Board allows companies to switch to "mark-to-model" prices (PDF link), also known as level 3 assets. It's still considered fair value, but since market prices aren't available, financial institutions have little choice but to rely more on models and assumptions to determine fair prices.

And since using models and assumptions requires more subjective judgment, that's where more guidance is needed. For instance, regulators -- perhaps prodded by Congress -- will have to rule on which models are acceptable, how many models to use, and what kind of assumptions are allowable. Additional disclosures from banks on which models and assumptions they use are also necessary so that outsiders can have some faith that the banks aren't wildly overstating their held-asset values.

FASB and the SEC have already taken some steps in this direction, and FASB continues to work on additional guidance and disclosures. Frank and his subcommittee may well ask FASB to speed up its work, and could also ask for specific rules related to assets sold through the stimulus package or other government bailout funds such as the Troubled Assets Relief Program. At least, that's what Barry Melancon, president and chief executive of the American Institute of Certified Public Accountants, expects. Melancon spoke on a conference call Wednesday.