Did fair-value accounting contribute to the financial crisis?
Useful information extracted from the
paper:
Critics argue that fair-value accounting
exacerbated the severity of the 2008 financial crisis. The main allegations are
that fair value contributes to excessive leverage in boom periods and leads to
excessive write-downs in busts. The write downs set off a downward spiral,
which in turn leads to contagion.
However, based on Laux and Leuz’s research
and analysis, there is little reason to believe that fair-value accounting
contributed to U.S. banks’ problems in the financial crisis in a major way.
1.
Fair value play only a limited
role for banks’ income statements and regulatory capital ratios except for a
few banks with large trading positions. For these banks, investors would have
worried about exposures to sub-prime mortgages and made their own judgments
even in absence of fair-value accounting.
l “Trading assets” are reported at their fair value, and fair value
changes are recognized in Income Statement. (33% for large investment banks and
12% for large bank holding companies, but very small fraction smaller bank
holding companies)
l In 2007 and 2008 only a negligible fraction of nontrading assets were
reported under fair value option provided by FAS 159.
l For large bank holding companies, about 36 percent of assets are
reported at or close to fair value, another 50% are subject to fair value
disclosure. For investment banks, the fraction of assets reported at fair value
turn to be higher. Among assets recorded at fair value, level 2 inputs comprise
the largest category. Level 1 and level 3 play a much smaller role.
l For investment banks, outside investors would have been concerned
about fair value even if the assets had been recorded at historical cost. Banks
seemed to overstate the value of their assets. Increasing haircuts in a
downturn are sufficient to produce procyclical leverage.
l For bank holding companies, income statement and regulatory capital
are already shielded from many fair-value changes. The biggest position, the
held-for-investment loan is not subject to fair-value accounting. For the
second biggest category, available for sale, FV changes are in OCI. Temporary changes
will not affect regulatory capital. By selling and repurchasing securities,
banks can get around historical cost accounting restriction to writing up
assets if banks want to increase its leverage.
2.
Various safeguards exist in
extant rules, and banks have offered substantial discretion to avoid marking to
distorted market prices.
l FAS 157 explicitly states that prices from a forced liquidation or
distress sale should not be used in determining fair value.
l Banks choose how to classify their securities at the outset (under
FAS 115).
l When markets become inactive and transaction prices are no longer
available, banks are not forced to use dealer quotes that are distorted by
illiquidity. FAS 157 allows banks to use valuation models to derive fair
values.
l By the first quarter of 2009, for bank holding companies, level 1
inputs decreased from 34% to 19%, level 3 inputs increase from 9% to 13%. For investment
banks, level 3 increase from 7 to 14 percent, level 1 decrease from 27 to 22
percent.
l Mortgage-related assets are rarely Level 1 assets. At the beginning
of the crisis, Level 2/3, and many moved to level 3 early in crisis.
3.
Little evidence suggests that
prices were severely distorted due to fire sales of assets or that banks were
forced to take excessive write-downs during the crisis.
l Coval, Jurek and Stafford(2009), the repricing of credit risk
appears consistent with the decline in the equity market, and increase in its
volatility, and a better pricing of the risks embedded in structured product.
l Longstaff and Myers(2009), bank equity prices and equity tranches
from collateralized debt obligations were priced consistently between 2004 and
2009.
Conclusion: the claim that fair-value
accounting exacerbated the crisis is largely unfounded.
It may be more appropriate to loosen
regulatory capital constraints in a crisis than to modify the accounting
standards, as the latter could hurt transparency and market discipline.
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