Did Obscure Rule Cripple Economy?

In the wake of Lehman Brothers' collapse and the financial turmoil that roiled Wall Street in late September and early October, a federal accounting rule, FAS 157, which addresses how to value corporate assets when the market for those assets is nonexistent or distressed, has come under fire.

Executives at American International Group (AIG), which was bailed out by the feds in September, blamed the company's downfall largely on FAS 157 at an Oct. 7 Congressional hearing. Former CEO Martin Sullivan told Congress AIG was forced to downgrade its credit default swaps based on their current, distressed market value even though AIG had no plan to liquidate those assets.

Daniel DiDomenico III doesn't buy that argument. “It's not 157 that's the problem, but the way mortgage-backed securities were packaged so investors couldn't tell what the underlying assets were,” says Daniel DiDomenico III, a CPA and senior vice president at Murray Devine & Co., a financial valuation firm in Philadelphia. “FAS 157 is helping bring to light risks that were hiding on institutions' balance sheets.”

Measuring value in distress

David Sherman, a professor of accounting at Northeastern University in Boston and author of FAS 157 Manager, says mark-to-market accounting requires corporations to disclose the value of assets based on their current fair value.

FAS 157 provides a three-level framework for valuing assets depending on how active the market is for the asset. Level one applies to an active market, such as for a stock. Level two fits an active but impaired market, such as for a bond at mid maturity. At issue is how to value assets for which the market is illiquid or distressed, as the market for mortgage-backed securities became in 2008.

“When house prices were up, mortgage-backed securities were an active market,” explains Sherman. “When the market became soft, those assets were reclassified, and some were transferred from level-one to level-two assets. Now that there's no active market for those securities, they've become level-three assets, which are the least reliable from an investor's standpoint.”

Perfect storm?

Though few analysts want to abolish FAS 157, some say its implementation occurred when the market could least absorb losses. The auction market for mortgage-backed securities dried up in late 2007, which left many institutions holding assets that couldn't be sold.

When it was implemented in January, FAS 157 required assets to be valued based on their current market price. That same month, Merrill Lynch announced $16 billion in write-downs on its mortgage-backed securities. Nine months and more write-downs later, the nearly 100-year-old investment bank collapsed and was acquired by Bank of America.

“It was perfect timing,” says Carl Jenkins, a CPA and managing director of UHY Advisors LLP in Boston. “Even though there were foreclosures and many mortgage holders were unable to pay their mortgages, that didn't mean all the mortgage-backed investments therefore became worthless or were reduced dramatically in value.”

Joe Bartlett, an attorney at Sullivan & Worcester in New York City, says that “FAS 157 radically changed how institutions valued illiquid securities.”

But Peter Brooks, an appraiser and executive director at Ernst & Young in New York, doesn't buy the scapegoating. “The underlying issue is whether you think using fair value to value assets is a good idea,” he says. “If you're an investment or financial services company whose assets don't fit the mold of traditional book value, fair value is a good standard.”

Meanwhile, the role of FAS 157 in the market meltdown and its future is being evaluated by Congress, the Securities and Exchange Commission, and the Financial Accounting Standards Board.

Many appraisers believe abandoning FAS 157 would be a mistake. “Don't throw the baby out with the bathwater,” says Brian Glanville, managing director of Integra Realty Resources and a member of the Royal Institution of Chartered Surveyors' valuation council. “FAS 157 is new here in the United States, but it's been used overseas for years. It's a good step toward an open, transparent marketplace.”

G.M. Filisko is a reporter and attorney based in Chicago who writes regularly on legal and real estate issues. You can contact her at [email protected].

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