r-value accounting, or so-called mark-to-market accounting,[/b] has come under intense scrutiny in the wake of the current global financial crisis. Although the Securities and Exchange Commission (SEC) oversees accounting standards, it typically outsources this responsibility to the Financial Accounting Standards Board (FASB). The FASB was designated in 1973 as the private-sector organization responsible for establishing financial and accounting standards. The FASB is intended to be independent of other business and professional organizations and, thus, insulated from political whims. However, the FASB has felt increasing pressure in the wake of the financial crisis from politicians and others who are intimately familiar with the crisis to alter or suspend altogether the Statement of Financial Accounting Standards (FAS) No. 157. FAS 157, which went into effect Nov. 15, 2007, defines "fair value" of assets, and attempts to establish a framework for measuring fair value, while expanding disclosures about fair value measurements. Fair-value accounting requires institutions to price assets on their balance sheets based on a hypothetical, orderly market transaction for that asset on a measurement date. In other words, the asset is marked to the market price for that asset – hence, the name "mark-to-market" accounting. The current criticism of FAS 157 developed due to concerns about the lack of available market data for illiquid assets (i.e., those assets that are not heavily traded and for which there is little or no current market). The question is how to value these assets when there is no market in which to construct the hypothetical transaction on which mark-to-market valuation is based. For example, when the credit crisis began in 2007, the market in which mortgage-backed securities (MBS) traded all but disappeared. Other types of securities, such as asset-backed securities backed by consumer loans, student loans and other debt securities, have also fallen victim to decreased or nonexistent market activity. The mark-to-market accounting standard appears to provide a method for valuation in situations with little or no market data for assets like MBS. The valuation models base the hypothetical transaction on market assumptions, or "inputs." The input range includes Level 1 inputs, which are actual, active market prices; Level 2 inputs, which include prices that may be indirectly observed (such as prices obtained for similar assets in active markets); and Level 3 inputs, which allow for "situations in which there is little, if any, market activity for the asset or liability." Generally, a company must use the highest level of inputs available (i.e., Level 1 or Level 2 inputs must be unavailable before a company can move to a Level 3 input analysis). In the current market environment, it appears that banks and investors should be permitted to utilize Level 3 inputs, given the lack of market data with which to conduct Level 1 or Level 2 input valuations. However, a problem arises when an occasional sale of a similar asset does occur in the marketplace, albeit under circumstances that would constitute a forced or distressed sale and result in a fire-sale price. A determination that a market is "non-functioning" is necessary, however, to determine whether banks or investors should use a Level 2 input valuation or a Level 3 input valuation, allowing management to consider certain assumptions and factors, such as the character of the securities and the amount of credit enhancements in place. In light of the ambiguity of the standard, regulators and auditors took the most conservative approach by pressing banks and investors to use the Level 2 analysis utilizing the market information that is available for the assets, even though the market price may be the result of a forced sale and have produced a fire-sale price. The result is that such institutions have taken huge book losses after writing down these assets on their balance sheets to these artificially low, fire-sale type prices. Moreover, these book losses experienced by banks and other financial institutions negatively impact capital ratio requirements for lending. That is, a bank with otherwise sufficient cash to extend credit is unable to do so, because the book losses for the undervalued assets would leave the bank unable to meet its capital ratio requirement. [b][i]FAS 157 and loss mit[/i][/b] Lenders' resulting inability to extend credit has a significant impact on the servicing industry. With tighter underwriting guidelines, fewer loans will be boarded by servicers, resulting in a potential decrease in servicing income over time. In addition, the restriction on the flow of capital will limit certain borrowers' options with respect to refinancing, short sales and other loss mitigation alternatives. Furthermore, since non-agency lending has virtually dried up, borrowers have been left to apply for Federal Housing Administration loans. Government loans are much more labor-intensive to service, which could drive up both direct and indirect servicing costs. Losses from these write-downs have contributed to one of the worst financial crises in U.S. history, and the servicing industry is caught in the cross fire. Thomas Bailey, in his statement on behalf of the Pennsylvania Association of Community Bankers and the Independent Community Bankers of America before the House Financial Services Subcommittee on March 12, equated the application of the mark-to-market "rigid" accounting standards in the current economic environment to "throwing gasoline on a raging inferno." As a result, commentators have strenuously argued in favor of actions ranging from amending FAS 157 to exempt mortgages and other illiquid assets, to suspending the application of mark-to-market accounting altogether. The FASB and the SEC, in an attempt to address the concerns over mark-to-market accounting, jointly issued more guidance on the application of fair-value accounting in illiquid markets in September 2008. However, this guidance did not go far enough in providing meaningful assistance in the application of the standards, as it did not provide concrete, specific guidance on when Level 3 data may be utilized and how decisions to use Level 3 data would be evaluated in hindsight by the regulating bodies. Due to the mounting pressure on lawmakers to solve the economic crisis, and with respect to the intense scrutiny on mark-to-market accounting, the U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises held a hearing on March 12 and heard testimony from, among others, FASB Chairman Robert H. Herz. The FASB and the SEC, as well as key lawmakers, have opposed suspending the rule, arguing that it provides much-needed transparency in the markets by revealing to investors the true value of the securities. The Commercial Mortgage Securities Association argued in its statement to the House Subcommittee on the issue that the under-valuations resulting from the current application of the mark-to-market accounting standard, however, do "not provide the kind of transparency investors and the market need" and result in "severe economic stress," even when securities are projected to ultimately "experience little or no real economic loss." Bailey, in his statement to the House subcommittee, agreed, arguing that the current mark-to-market accounting rules "hinder transparency and distort the true value" of those financial institutions holding MBS, asset-backed securities and other debt securities. He also pointed out that through the Troubled Asset Relief Program and other initiatives, "unprecedented amounts of funds are pouring into the financial services industry to replenish the capital lost as a direct result of this accounting rule." He argued that this is merely a "paper loss" that does not reflect reality and that community bankers "do not believe the American taxpayers want their tax dollars used to cover up a "paper loss.'" [b][i]The FASB vote[/i] [/b] As a result, on April 9, the FASB issued a Final Staff Position (No. FAS 157-4) titled "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly." In it, the FASB attempts to provide guidelines for estimating fair value measurements more consistent with the principles set forth in FAS No. 157. The FASB again emphasized in its objectives that fair value should be based on the price that would be received in an orderly transaction. This guidance, however, went further than the guidance the FASB previously issued on the subject by listing specific factors banks and investors should evaluate when determining whether there has been a decrease in market activity. These factors include whether there have been few recent transactions, whether price quotations are based on currently available information, whether price quotations have varied substantially over time and whether little information has been publicly released. Based on – but not limited to – the factors enumerated, if the bank or investor concludes that there has been a significant decrease in market activity for a specific asset, the FASB directs that further analysis of the transactions are needed "and a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value in accordance with [FAS No.] 157." The FASB goes on to recognize that these types of valuations still involve the use of "significant judgment" and provides an additional list of factors banks and investors should use to consider whether a transaction is orderly or forced (and thus resulting in a fire-sale type price). Among those factors is whether there was adequate exposure to the marketplace before a transaction was recorded, whether the seller was at or near bankruptcy at the time of the sale or whether the transaction price is an outlier when compared to other recent transactions for similar assets. This latest guidance by the FASB is effective for periods ending after June 15, 2009, but banks and investors are permitted to adopt it for periods ending after March 15, 2009. It remains to be seen whether this new guidance has adequately addressed the concerns over mark-to-market accounting. However, if the stock market is any indication, the FASB report will have a positive impact on lending and earnings – many banks' share prices rose significantly on the day the report was issued. [i]Kelly Bouldin Roney is an attorney and Stephen G. Collins a shareholder at Sirote & Permutt PC in Birmingham, Ala. Roney represents clients in the areas of business and finance, real estate law and corporate law, and can be contacted at (205) 930-5757. Collins represents lenders in the areas of mortgage banking law, real estate litigation and title insurance law, and can be reached at (205) 930-51
