Peeling away financial reporting issues one layer at a time

SFAS 157: ‘Fair Value’ is Not Fair Measurement for Illiquid Assets

I am finally ready to contribute my two cents to the debate as to whether SFAS 157 is at least partly responsible for the subprime mortgage mess. I have pointed out in other contexts (here and here) the serious shortcoming of SFAS 157 as a rules-based standard, but the widespread coverage of the subprime mortgage crisis, and the allegations that accounting has caused much of it, may be the best chance I will get in a long while to explain how much better a principles-based standard would work.

The issues are well-articulated in an article that recently appeared in the New York Times (July 1, 2008), entitled “Are Bean Counters to Blame?,” by Andrew Ross Sorkin. Sorkin constructs his story around the much-publicized critiques of Stephen H. Schwarzman, co-founder of the private equity firm Blackstone Group. Basically, Schwarzman argues that SFAS 157 exacerbated the subprime mortgage crisis; because among other things, inappropriate write-downs by public companies somehow all by themselves induced companies to raise new capital at onerous rates. The example held highest is the required accounting for those collateralized debt obligations (CDOs) that were completely written off because markets in which to sell them had dried up. As quoted by Sorkin, Schwarzman says, “the concept of fair value accounting is correct and useful, but the application during periods of crisis is problematic. It’s another one of those unintended consequences of making a rule that’s supposed to be good that turns out the other way.”

The phenomena that poor quality accounting leads to poor quality decision-making by financial statement issuers has been demonstrated far too often to be plausibly denied, and problems with SFAS 157 are also self-evident. In that sense, Schwarzman’s complaint has merit; however, if he is right, it is for the wrong reasons. So, I’m going to presumptuously do him the favor of making the right argument—and at the same time show him that he is not as right as he thinks he is.

The very beginning is the right place to start: wealth is defined by economists as the ‘command over goods and services.’ A corollary principle is that the utility of an asset is derived from the amount it would cost to replace it. (For acknowledgement of this in the accounting literature, see ARB 43, on the accounting for inventories). Hence, the fundamental flaw in SFAS 157 is that its concept of ‘fair value’ is built around the notion of an ‘exit price’, but the economic definition of wealth is built around the concept of a replacement cost, or ‘entry price’.

The distinction between the ability to demand cash and command over goods and services becomes critical when an asset has value in use (or in the case of a financial asset, by holding on to it and collecting the cash flows), but little or no current value through sale. If there exists no current market in which to sell a CDO, there is no one else from whom one can currently demand cash in exchange for the asset. Is the CDO worthless? Absolutely not.

To see why the replacement cost approach is principles-based, now ask yourself what it might cost today to replace an illiquid CDO that was acquired, say, three years ago. Since it’s a financial instrument, the question could even be more general: what would it cost to replace the contracted-for stream of future cash flows from counterparties of the same creditworthiness? Asking the right question will almost certainly give you an answer that is less than the amount paid to acquire the CDO before the subprime mess hit the fan, but it is certainly greater than zero, which is the wrong answer that SFAS 157 would give.

Although this doesn’t explicitly come out in Sorkin’s article, I infer that Schwarzman would argue that balance sheet carrying amounts for CDOs would most appropriately be based on their historic costs. While I do agree with Schwarzman that zero would be wrong, historic cost-based management would be equally wrong. It is also the reality that, like SFAS 157, replacement cost-based measurement can require significant doses of judgment, but often less so. But most critically, estimating replacement cost is the only process out of which there is some chance of coming up with a logically valid result.

So, Schwarzman is right to claim that we should not be subjecting ourselves to an accounting rule that can destroy shareholder value, especially if it can be demonstrated that application of the rule will yield a ludicrous result under conditions when it is most important that it yield something better. But, he would be wrong to suggest that measuring CDOs at anything close to their historic costs would solve any problem at all. If there is any hope of gaining agreement on this point among Schwarzmans, accounting standard setters and investors, it is only through the use of clear and convincing economic logic, and not by a futile defense of the hash of rules that is SFAS 157.


  1. Reply Bob Jensen July 2, 2008

    Hi Tom,
    It would seem that Paragraph 30 of FAS 157 offers an alternative on this that allows departure adjustments for circumstances such as you describe. The firm seems to have more latitude in measuring fair value in unusual market conditions.
    What do you think?

  2. Reply Tom Selling July 2, 2008

    It doesn’t seem that there is any wiggle room, because “the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset or owes the liability.”
    Based on press coverage of the illiquidity problem, it appears that ‘practice’ doesn’t see room for another interpretation either.

  3. Reply charles July 3, 2008

    I don’t agree with the implication that exit price equals zero if a market does not exist. My understanding of FAS157 is it allows a theoretical exit price when markets do not exist. For any asset or liability for which markets do not exist, it doesn’t really matter whether you call it an exit price or replacement costs or entry price. The valuation needs to be a equi-probability stochastic projection of cash flows reflecting all the risks and discounted at risk free rates like the swap curve. That’s all it is. Call it what you like. Of course the selection of assumptions (underlying probability distributions and calibtration of parameters to whatever market or historical data is judged to be relevent) is difficult and that is where the real focus should be, not the exit/entry name for it. Even when a market has some degree of liquidity this valuation approach is still appropriate and will demonstrate the premium the market is charging for the ability to transact. These premiums for the right to transact do not belong on the balance sheet. The problem with applying this valuation approach is the lack of trust investors will have in letting a firm decide the valuation assumptions itself. What is really needed is a dedicated professional status (like an independent auditor) for Level 3 asset and liability valuations. In the insurance industry we call these people actuaries.

  4. Reply Jeff Watson July 5, 2008

    I just listened to a conference call last week on SFAS 157 and the individual who led the discussion is a CPA/valuation expert and deeply involved in various AICPA committees. He was explaining that with a level three security you would need to create a market to value the security, assuming one doesn’t exist. Under that approach, I don’t see how anyone in their right mind would value the security down to zero. He was very clear you would still use an exit value concept, but you create a market – if one is needed.

  5. Reply Independent Accountant July 7, 2008

    I read the article in question and have my own post coming on it. As far as I’m concerned, Schwartzman is full of balogna. I keep reading about inappropriate applications of SFAS 157. I challenge Schwartman, Traficianti, McTeer et. al. to an “experiment”. You’ll see it in my posts to come. My conclusion based on all the special pleading going on: the BANKS ARE IN MUCH WORSE SHAPE THAN ANYONE LET’S ON. Fred Cederholm is right. The mortgage related losses will exceed a trillion dollars.

  6. Reply fred vernon July 9, 2008

    Agree with Charles and Jeff that FAS 157 doesn’t call for a zero valuation for assets for which there is no active market. Rather, reporting entities are required to look first to trading in similar assets to come up with a value, and second to delve into Level III mark to model valuations, which would include various market inputs (say, the ABX index for certain untraded CDS contracts).
    Also agree with Independent Accountant in that Schwarzmann is full of baloney. If you look at an early version of Blackstone’s S-1 from last year, they early adopted FAS 159 – the fair value option – and applied it to future carried interests the firm expected to earn on their managed PE funds. Obviously this was an aggressive use of 159 (PV’ing expected future earnings and putting on the balance sheet as an asset), and Blackstone decided against it in their final S-1 before the IPO.
    Its unclear what made them relent on this issue, but what seems apparent is that Schwarzmann was willing to take full advantage of fair value accounting when it benefited his balance sheet, but once things turned sour historical cost is all of a sudden preferable.

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