“I have problems with fair value accounting,” said Paul Volcker, former Chair of the Federal Reserve Board (and former Chair of the International Accounting Standards Board Committee Foundation), in his remarks last week to the U.S. Treasury’s Advisory Committee on the Auditing Profession (ACAP). While many have seized upon fair value as the panacea of accounting, “to solve all problems,” he said, it clearly is no such cure-all—and in fact, fair value may create a few problems of its own, especially among financial engineers. In particular, “there is a real question how to blend insights of mark-to-market accounting where there is no market,” Volcker observed, “and it may lead to exaggerated movements in the markets.”
Bear Stearns bailout, for example? Volcker’s comments preceded this week’s rescue of Bear Stearns by JPMorgan Chase & Co. (via Fed financing). But the FEI blog that reported the ACAP meeting was quick to recall that it (and other Wall Street commentators) first predicted the looming crisis in the credit and accounting worlds last summer, in “Bear Stearns Hedge Fund Crisis: The Fallacy of Fair Value?” Indeed, newsmakers worldwide are characterizing this latest financial crisis as a crisis of confidence in valuations. “Transparency is in short supply in the U.S.,” says a current Stratfor podcast, which recalls the $22 billion market valuation of Bear Stearns just fourteen months ago—and its buyout this week at $230 million, or nearly 100 times less.
Sovereign wealth funds that paid respectable prices in helping recapitalize famous Wall Street brands will be looking at the fire sale of Bear Stearns and concluding they overpaid. In fact, the low valuation offers a good example of why there’s a credit crunch. Banks don’t trust market valuations or book valuations or any valuations that aren’t based in cast-iron collateral, and they don’t trust each other, either.
“There may be more forced sales,” this source predicts. But, “putting the blame on fair value for current conditions is misguided,” says CFA Institute Centre director Georgene Palacky, in a statement released Monday. Corporations that have made poor decisions or are not complying with accounting standards are using fair value as a “scapegoat.”
Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors. Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures…[do] not create losses but rather reflect a firm’s present condition.
The CFA Institute also disagrees with those calling for a watered-down version of fair value. “This ‘shoot the messenger’ mentality will not restore investor confidence,” Palacky predicts. “Only when fair value is widely practiced will investors be able to accurately evaluate and price risk.” For the Institute’s current recommendations, see its Comprehensive Business Reporting Model: Financial Reporting for Investors.