Fair Value Accounting for the Financial Crisis
Western Michigan university | Is It Fair to Blame Fair Value Accounting for the Financial Crisis? | By Robert C. Pozen | | Luma Raha | 10/12/2011 |
The article from the Harvard Business Review, "Is it Fair to Blame Fair Value Accounting for the Financial Crisis?" , author Robert Pozen stipulates that the fair value accounting principles did not cause the financial crisis of 2008, but certainly aggravated it by common misconceptions about accounting standards. The article defines mark-to-market valuations as the "practice of revaluing an asset quarterly according to the price it would fetch if sold on the open market, regardless of what was actually paid for it." The practice exaggerated the large problem of mortgage securities because a large percentage of those securities were still performing but eroded the capital base, making the banks insolvent.
The author indicated that accounting principles allowed banks to use a “Level 3” rule which allowed valuation to be “marked to model” rather than mark-to-market in cases of illiquid assets. In this model, the executives could have used their own “reasonable assumptions to estimate fair market value.” The issue with this model is that it would not provide comfort to bankers and investors that the assumptions were accurate when the market was plummeting around them. Could executives be trusted to provide reasonable assumptions? If so, on what basis? Would historical values be used? Would optimistic models be used? Would skepticism amongst investors breed even further plummeting stock valuation because of distrust?
The author revealed three myths surrounding accounting valuation. The first is that historical accounting has no connection to current market value. The second myth is that most assets of financial institutions are marked to market. And, the third myth is that assets must be valued at current market prices even if the market is illiquid. Each of these myths do penetrate the
The article from the Harvard Business Review, "Is it Fair to Blame Fair Value Accounting for the Financial Crisis?" , author Robert Pozen stipulates that the fair value accounting principles did not cause the financial crisis of 2008, but certainly aggravated it by common misconceptions about accounting standards. The article defines mark-to-market valuations as the "practice of revaluing an asset quarterly according to the price it would fetch if sold on the open market, regardless of what was actually paid for it." The practice exaggerated the large problem of mortgage securities because a large percentage of those securities were still performing but eroded the capital base, making the banks insolvent.
The author indicated that accounting principles allowed banks to use a “Level 3” rule which allowed valuation to be “marked to model” rather than mark-to-market in cases of illiquid assets. In this model, the executives could have used their own “reasonable assumptions to estimate fair market value.” The issue with this model is that it would not provide comfort to bankers and investors that the assumptions were accurate when the market was plummeting around them. Could executives be trusted to provide reasonable assumptions? If so, on what basis? Would historical values be used? Would optimistic models be used? Would skepticism amongst investors breed even further plummeting stock valuation because of distrust?
The author revealed three myths surrounding accounting valuation. The first is that historical accounting has no connection to current market value. The second myth is that most assets of financial institutions are marked to market. And, the third myth is that assets must be valued at current market prices even if the market is illiquid. Each of these myths do penetrate the