FASB accounting rules and standards

FASB Accounting Rules

Did FASB 157 Cause the Financial Crisis?

Since the financial crisis began in February 2007, there has been an ongoing debate in the financial community over the causes of the crisis. One target that has come under fire for its role in the financial meltdown is FASB 157, which created new rules for valuing mortgage-related assets. Wall Street analysts and others blame 157 for implementing mark-to-market accounting standards. They believe that financial institutions took unnecessary losses to accounting rule changes that created billions in paper losses.

This study scrutinizes the role of accounting in general and FASB 157 in particular in creating the crisis. The authors review a number of reports, as well as financial accounting standards 142, 144 and 157. Having reviewed those, the study offers reasons to explain the impact of 157 in the context of other developments in the markets. They also examine how the guidelines apply to the asset categories that were created. The authors discuss fair value methodologies, and highlight problems with level 3 asset valuation. Prior to 157, level 3 assets were valued using a mark-to-model approach that was subject to manipulation and unrealistic assumptions. FASB 157 requires that a fair market value be assigned and that that derivation be disclosed.

The study discusses repercussions to the investment community of exaggerated write-downs and losses to level 3 assets. The authors explain shortcomings in the mark-to-model approach that are mitigated by 157. They highlight ratios of level 3 assets to stockholders' equity for several financial institutions; these ratios demonstrate the magnitude of the problem posed by level 3 assets.

This analysis also presents advantages of FASB 157, discussing the guidelines that bring about greater transparency for investors. Requiring companies to take losses on a yearly basis provides a disincentive for further Wall Street engineering and greed. The authors posit that eliminating fair value accounting following the crisis would have actually increased market instability, thereby making the crisis worse.

The study concludes that FASB 157 played only a small role in the financial crisis. The authors propose several areas for future research to analyze issues around FASB 157 and its impact on financial markets.

Thesis

FASB 157 was not responsible for the financial crisis. The study explains its role and makes the case that 157 may have been a contributing factor, but was not the primary cause of the crisis.

Arguments Supporting the Thesis

The Financial Crisis Inquiry Report (Financial Crisis Inquiry Commission, 2011) undertook a massive investigation into the causes of the financial and economic crisis. The report determined the most significant causes. The following is a partial list of their conclusions:

Widespread failures in financial regulation and supervision devastated the stability of the nation's financial markets.

Dramatic failures of corporate governance and risk management at systemically important financial institutions were the primary cause of the crisis.

A combination of excessive borrowing, risky investments, and lack of transparency made the crisis inevitable.

The Report does not list FASB 157 as being a primary cause of the crisis.

Arguments Opposing the Thesis

Critics of 157 argue that fair value accounting forced financial institutions to report unnecessary losses, which in turn, they claim, led to bank failures and distressed financial circumstances. According to Matt Hudgins in his article FASB 157: Warning Light or Smoking Gun? (2008), marking-to-market at a time when there is no demand for a security may cause punitive pricing; the few bonds that do trade in that period are likely to be underperforming or to be sold by distressed sellers, or both. In Hudgins' opinion, basing the value of securities on a small number of fire-sale transactions results in undervaluing a bank's balance sheet.

Other critics of 157 claim that its implementation created its own self-fulfilling prophecy. They argue that marking-to-market creates a cycle of self-perpetuating lower marks, amplifying the effects still further.

Siyi Li, financial analyst, makes the argument in Fair Value Accounting and Analysts' Information Quality: the Effect of SFAS 157 that 157 negatively affected information quality for financial institutions holding proportionately higher levels of level 3 assets. The analyst argues that financial analysts serve the capital market as information intermediaries. They are tasked with evaluating the effect of FASB 157 from the perspective of investors, so it can be argued that any circumstance that negatively affects information quality ultimately does a disservice to investors. Li's analysis found that information quality measures declined over the two-year study period that followed FASB 157 adoption.

Summary

Harris and Kutasovic's report studies how fair value accounting and FASB 157 affected the financial crisis. The authors present an analysis of factors preceding the crisis, and describe how the difficulty in determining the true value of mortgage-related assets caused accounting rules to become a lightning rod for controversy.

It seems clear that 157 did not cause the financial crisis. The handwringing and assignment of blame typified in this quote by Chicago billionaire Sam Zell, "Without mark-to-market fair value accounting, this crisis would never have reached this level" is misplaced; toxic assets that were written down when 157 was implemented were already devalued.

Blaming FASB 157 for the crisis is illogical; it is analogous to shooting the messenger. All the factors were already present in the run-up to the crisis, 157 simply exposed them to the light of day. To achieve that transparency, 157 established a methodology for reporting the previously misstated loss of value in mortgage-related assets. Proponents of 157 argue that it accomplished exactly what it was supposed to, which was protecting investors, by providing greater transparency and a basis for confidence in balance sheet valuations. Even more, many analysts believe that greater transparency created by 157 was actually a catalyst in moving the market forward, because it worked to restore investor confidence.