Fair-Value Accounting Reform Debate Heats Up

Securitization took center stage last week in a debate that appears likely to ease the accounting standards that some claim were partly to blame for the CMBS freeze. Former Commercial Mortgage Securities Association president Lee Cotton told House members Thursday that current fair-value accounting standards work in a normal, functioning market. “However, CMSA strongly believes that the (fair-value accounting standard), as currently implemented, has negative unintended consequences when the markets are illiquid and/or highly volatile,” Cotton said, speaking at a hearing of the subcommittee on capital markets, insurance and government-sponsored enterprises. He asked accounting policy makers like the U.S. Securities and Exchange Commission and the Financial Accounting Standards Board to offer stronger guidance on implementing fair-value accounting during times when capital markets are unable to function properly.As a case in point, Cotton argued that current fair-value accounting standards bear some responsibility for the near-collapse of the CMBS market in 2008. New securitization volume plummeted from a record $240 billion in 2007 to just $13 billion last year, nearly dismantling a financing vehicle that provided nearly half of all commercial real estate debt just two years ago. Cotton contended that the lack of CMBS financing stems in part from fair-value accounting’s requirement that asset values must be based on observable data. For CMBS, this requirement has led to a reliance on derivatives, or synthetic instruments, to establish pricing. The most-often used CMBS derivative is the CMBX index. At times the index’s prices have fallen to a level that suggests 99 percent default rates—a complete distortion, since CMBS generally continue to perform well. “A small number of these sales results in such fire-sale prices being used as a benchmark upon which FVA determinations are made, creating an unrealistic, and self-perpetuating, downward pressure on valuations for CMBS,” Cotton argued. Testimony from Cotton and other finance leaders appeared to find sympathetic ears. Subcommittee chairman Paul Kanjorski, a Pennsylvania Democrat, said that Congress would have to take action unless rule-makers revised the standards. FASB Chairman Robert Herz, who described multiple initiatives under way to re-visit the fair-value standards, said that a proposal for improvements would be ready in three weeks. Several of those who testified last week, however, defended the existing principles of fair-value accounting. James Kroeker, SEC’s acting chief accountant, cited the results of a recent study of the practice conducted by the agency. Stakeholders offered a wide spectrum of opinions; still, many investors in particular believe that the fair-value accounting’s hallmark transparency that shores up confidence, especially during troubled economic times. Fair-value accounting played no significant role in bank failures last year, SEC’s study found. Fair value accounting reduces uncertainty more quickly than other existing strategies, concludes white paper commissioned last year by the Council of Institutional Investors, according to the group’s chief counsel, Jeffrey Mahoney. The group’s 130-plus members are public, corporate and labor pension funds that collectively have assets valued at more than $3 trillion. “Many experts agree that Japan’s failure to embrace fair value accounting for the financial assets for its troubled financial institutions in the 1990s unnecessarily exacerbated that country’s economic woes for an entire decade,” Mahoney told the legislators.