-
The Financial Times – Sullivan blames ‘mark to market’ for AIG’s woes
But above all, Mr Sullivan said, the so-called “mark to market” accounting rule had played a central role in the company’s rapid deterioration. The rule, known as FAS 157, requires a company to declare the value of assets on a quarterly basis at the price such assets could be sold on the market at that point in time – even if the company has no intention of selling the assets. “In a distressed market where assets cannot be readily sold, companies are forced to declare the value of those assets at fire-sale prices. Just last week, the SEC made changes with respect to the application of FAS 157 when entire markets stop functioning,” Mr Sullivan said.
Comment Let’s remember that mark-to-market (FASB 157) became the rule because of the way Andy Fastow (CFO) and Jeff Skilling (CEO) used the old rules to perpetuate the fraud that was Enron. Now that we do not like the answers we are getting with mark-to-market, we all seem ok with going back to the rules Enron successfully gamed.
Regarding the application of FASB (or SFAS) 157, let’s remember how it is supposed to work. Assets are divided into three levels, 1, 2 and 3. The controversy is in Level 3 assets, the “hard-to-value” asset. The rule says that they should be valued using “management’s judgment.”
However, Level 3 securities are not being valued by management as per FASB 157, but by liquidation value. Why? When Enron blew up, we felt it necessary to impose the death penalty on their accountant, Arthur Anderson (Anderson was liquidated because of the sins of Enron). Accountants would like to keep their jobs, so they are using the most conservative marks possible (distressed liquidation value) when pricing these securities. The Enron/Arthur Anderson debacle has shown that the auditor will not be around long if the financial firm understates losses, so no auditor is going to be put into this position.
Back in March 2008 the SEC released a letter about FASB 157, which said:
Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157.
Additionally in October 2007, the AICPA said:
A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).
So, both the AICPA and the SEC told management that they did not have to use forced liquidation levels. However, this continues to be the practice. Why? Again, the accountants fear they will be liquidated should a financial firm fail because of Level 3 marks that were too liberal. The actions of the Enron/Anderson episode speak louder than the words of the SEC/AICPA.
This is important to understand. If the SEC changes the rules back to the Andy Fastow rules of “hold-to-maturity” and “available-for-sale”, there is no guarantee that the auditors are going to play along. Then we have the worst of all worlds, less transparency and the same distressed valuations on Level 3 assets.
For a more detailed discussion of mark-to-market, see our March 31, 2008 comments