Wave of Write-Offs Rattles Market
Accounting Rules
Blasted as Dow Falls;
A $600 Billion Toll?
By DAVID REILLY
March 1, 2008; Page A1
The massive write-downs that financial firms are posting have begun to spur a
backlash among some investors and executives, who are blaming accounting rules for
exaggerating the losses and are seeking new, more forgiving ways to value investments.
The rules -- which last made headlines back in the Enron era -- require companies to
value many of the securities they hold at whatever price prevails in the market, no matter
how sharply those prices swing.
Some analysts and executives argue this triggers a domino effect. The market falls,
forcing banks to take write-offs, pushing the market lower, causing more write-offs.
The rules' supporters, however, make a stark counter-argument: They can help prevent
the U.S. from suffering the kind of malaise that gripped Japan in the 1990s -- as banks
there sat on mountains of dud loans for years without writing them down.
This debate gained new urgency Friday as the Dow Jones Industrial Average fell 315
points, or 2.5%. Driving stocks lower was insurance giant American International
Group Inc.'s announcement of an $11.1 billion write-down that led the firm to post a
$5.3 billion loss for the fourth quarter, the biggest loss in the firm's 89-year history.
Also rattling investors was a report by UBS that said losses among financial institutions
could top $600 billion as the turmoil in global credit markets continues to unfold.
No one, including the chairman of the Federal Reserve, Ben Bernanke, knows with
certainty what would be a better approach than using market prices for valuing holdings
like these. "I don't know how to fix it," Mr. Bernanke said during testimony Thursday
before the Senate banking committee. "I don't know what to do about it."
Mr. Bernanke added that "I think the accountants need to make the best judgment they
can."
Despite the grim developments, many investors actually doubt that firms like AIG will
suffer the full force of the losses they are now booking. Instead, these investors argue that
the market has overreacted and will recover once the current panic subsides.
Indeed, Martin Sullivan, AIG's chief executive, said Friday on the firm's conference call
that he doesn't expect the losses to be permanent. "We are obviously witnessing and
living through extraordinary market conditions," he said. "We are trying, as are many
others, to value very complex instruments."
Tumult also spread further in the normally staid market for municipal bonds -- debt
issued by states and municipalities -- which is suffering one of its biggest crises in its
history. Several hedge funds were hit with big losses after betting wrong on the
direction of muni-bond prices, and as traders rushed to sell and exit their positions,
portions of the market effectively froze.
On Friday, muni-bond-prices fell for a 13th straight day, pushing yields significantly
higher. (Bond yields move in the opposite direction as price.)
For hundreds of muni-bond issuers, ranging from New York's Port Authority to the North
Texas Tollway Authority, this tumult could cause borrowing costs to soar. That's a
particular problem at a time when tax revenues are coming under strain from a slowing
economy.
AIG's argument that its write-downs were "unrealized" -- in other words, they may never
actually result in a true charge to the company -- echoes points made by a number of
other major financial firms. It's a sore point because companies feel they are being forced
to take big financial hits on holdings that they have no intention of actually selling at
current prices.
The firms argue they are strong enough to simply keep the holdings in their portfolios
until the crisis passes. Forcing companies to value securities based on what they would
fetch if sold today "is an attempt to apply liquidation accounting to a going concern," said
Charles Thayer of Chartwell Capital, a financial advisory.
The market-value accounting approach is "exaggerating" the market turmoil, leading to
write-downs that are "excessive," said Neal Soss, chief economist at Credit Suisse.
"Many people would take the view that price and ultimately value have disconnected."
Even analysts who are generally supportive of the market-value approach acknowledge it
can make things tougher for investors in the current environment. It "increases the
volatility of the accounts and it makes comparisons from quarter to quarter difficult," said
Jeremy Perler of RiskMetrics Group, a research and strategy firm. "It certainly turns the
world on end a little bit.
Alternative accounting strategies don't offer much for markets to cling to. One alternative
is to value a security based on what the buyer originally paid for it. However, that risks
giving investors outdated information.
The use of pricing models that don't pay heed to market values was discredited after
Enron Corp. used them to book phantom profits earlier this decade.
Enron, for example, would book a profit on a contract to buy or sell energy years in the
future based on its own expectations of how much the contract would be worth over time.
But Enron never tried to gauge what others in the market might think the contracts were
worth.
As the Fed chairman acknowledged in his recent Senate testimony, a move away from
market values could in fact worsen current market turmoil. "The risk on other side is that
if you do too much forbearance, or delay mark-to-market, that the suspicion will arise
among investors that you're hiding something," Mr. Bernanke said.
Buyers are already lacking trust and that has been a reason they have balked at buying
securities that were typically seen as safe havens.
But these market seizures are what have made market values so contentious. Robert Herz,
chairman of the body that sets the accounting rules governing the use of market values,
the Financial Accounting Standards Board, acknowledged the difficulty investors and
companies are facing.
"But you tell me what a better answer is," he said. "Is just pretending that things aren't
decreasing in value a better answer? Should you just let everybody say they think it's
going to recover?"
Others who favor the use of market values say that for all its imperfections, it also
imposes discipline on companies. "It forces you to realistically confront what's happening
to you much quicker, so it plays a useful purpose," said Sen. Jack Reed (D., R.I.), a
member of the Senate banking committee.
Japan stands out as an example of how ignoring problems can lead to years-long
stagnation. "Look at Japan, where they ignored write-downs at all their financial
institutions when loans went bad," said Jeff Mahoney, general counsel at the Council for
Institutional Investors.
In addition, companies don't always have the luxury of waiting out a storm until assets
recover the long-term value that executives believe exists. Sometimes market crises force
their hands. Freddie Mac, for instance, sold $45 billion of assets last fall to help the
company meet regulatory capital requirements.
Investors can no longer take a firm's survival for granted in today's environment. Fed
Chairman Bernanke in his testimony noted that it wouldn't be surprising if there were
some bank failures due to the current market crisis.
Write to David Reilly at david.reilly@wsj.com1