Banking Industry's Fair Value Accounting (FVA) Conundrum

Every company and almost every individual holds fixed assets. Over time, these assets change in value. For example, real estate tends to increase in value, while vehicle values decrease.

In the US, as in most countries, the global crisis has resulted in declines in the real-estate market and employment sectors. These declines result in housing and business property holdings dropping in market value. Some unemployed households are obliged to walk away from their properties. These worldwide problems are on the slippery slope downward, and the consequences affect all banks.

In particular, US banks wish to not show the drop in value on their books for the following reasons:

a) A great portion of their subprime mortgage holdings have become essentially unsecured collateral, with the risk of foreclosures due to massive employment layoffs. There is a housing market glut which means house values are not sufficient to cover mortgage loans.

b) Purchasers who bought homes with zero-down-payment purchase plans (subprime mortgages) are walking away due to job loss, adding to the housing glut.

c) Hostile takeover bids due to reduced asset holding values would allow for a bargain takeover below the true value of the institution.

d) Goodwill value could be argued against, and if it established as a percentage of the asset holdings then this value will be substantially reduced. Goodwill recognizes the value of assets held as well as revenue and expenses to establish a fair share market price.

e) Some business arrangements, such as takeovers initiated before the financial crash, have clauses in them allowing for back-outs. An example of this was the $57.1 billion walk-away purchase by the Canadian Teacher’s pension plan for the purchase of Bell Canada. Current market conditions caused the auditors to signal that Bell Canada was insolvent.

f) With fair value accounting, due to economic declines, many American Banks are insolvent, i.e., the share values are not supported by revenues or asset-based mortgage holdings.

g) With the drop in sales, many companies are unable to make loan repayments against inventory or unsecured loans and are heading for Chapter 11 protection (bankruptcy protection). Banks are facing major unrecoverable losses.

What the banks are asking of the Securities and Exchange Commission (SEC) is for relaxation of "fair value accounting," which has to do with classifying assets.

The SEC is resisting, though sympathetic to the finance industry requests. The door was left slightly ajar if companies would consider the following statements in their audited annual statements:

  • financial statement disclosures when fair value accounting measurements rely on unobservable inputs

  • the institution’s valuation models used to determine fair value

  • the significant inputs into the models

  • the assumptions that could have the greatest impact on the valuations

  • how, why, and when those assumptions have changed from prior periods

Bank requests that were reported include the ability to use some averaging method against assets--for example, to allow a moving average evaluation, based on a five-year period, with a heavier weighting of numbers for the current year.

Banks are the gods and goddesses of the finance industries. If banks fail, every company or household around them fails due to the domino effect. As the SEC has to be firm about its FVA rules, world governments become the saviors. Although the world’s largest consumer products country was one of the major causes of the world crisis, it is the world leader for the cure. Congress and the Senate are injecting funds (bailout money) to prevent world economic collapse. Only time will tell about FVA decisions regarding the banks wishes.

January 2009 update: In December, the SEC decided not to suspend fair value accounting. As a consequence, many banking executives are cringing with worry about their institutions' fiscal well-being to be represented in forthcoming financial statements.

Notwithstanding all the concerns, the SEC advised the FASB to observe a set of guidelines to help soften the impact.

From the SEC website:

  1. the effects of such accounting standards on a financial institution's balance sheet

  2. the impacts of such accounting on bank failures in 2008

  3. the impact of such standards on the quality of financial information available to investors

  4. the process used by the Financial Accounting Standards Board in developing accounting standards

  5. the advisability and feasibility of modifications to such standards

  6. alternative accounting standards to those provided

The site goes on to say
Among key findings, the report notes that investors generally believe fair value accounting increases financial reporting transparency and facilitates better investment decision-making. The report also observes that fair value accounting did not appear to play a meaningful role in the bank failures that occurred in 2008.

Given the above thought processes and conclusions, the SEC is looking for a way to permit the banks to defer fair market value evaluations for some asset classes based on a reasonable idea of the future liability or asset value (if the bank does not have to liquidate certain classes of collateral, then fair market value interpretation can be stretched to soften the impact).
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