The Securities and Exchange Commission (SEC) issued a study on Dec. 30 recommending that mark-to-market and fair value accounting - including Financial Accounting Statement 157 or FAS 157 - be kept.

Before the results of the study were released, there were objections that mark-to-market and fair value accounting caused some of the current financial market instability by requiring what were potentially inappropriate write-downs in the value of investments that financial institutions were holding.

Market players were concerned that these write-downs stemmed purely from market prices that were based on illiquid, inactive and irrational markets. In other words, the values placed on these bonds did not truly reflect the ongoing cash flow of the securities.

However, some came to fair value's defense.

Investors, specifically, suggested that this type of accounting actually enhanced the transparency of financial data and served a purpose in volatile times.

Some members of the buyside said that getting rid of FAS 157 - which offers a common framework for the application of fair value - would further erode investor confidence, making the financial markets more volatile.

It appears that the SEC agrees. The SEC, in its study, expressed the concern that eliminating fair value and mark-to-market accounting - which have been entrenched in the financial system - would indeed eat away at investor trust.

The SEC report further stated that, judging from comments it has received, many market players still think that fair value remains useful in evaluating the current financial health of a firm.

The solution, it seems, is not to get rid of mark-to-market or fair value accounting. The SEC, rather, believes that the implementation of these rules should be improved.

The SEC requested that the Financial Accounting Standards Board (FASB) develop added measures to improve the applications and practices related to existing fair value requirements.

It also asked the FASB to develop added guidance and other tools to dertermine fair value when relevant market information is not readily available in an illiquid or inactive market. It would be helpful, for instance, to know when to declare markets inactive and when a deal is forced or distressed.

"It's very hard to develop an objective rule for determining when there is an illiquid market," said Amy Moorhus Baumgardner, an of counsel at Morrison & Foerster. "It's a grey area especially since there are instances when there's a precipitous decline in value such as what happened in the auction rate securities market. The question is whether the market has become shallow or illiquid to the point where you cannot rely on it to value the securities in a portfolio, so the SEC is asking the FASB to establish additional guidance for when the market is illiquid."

The thing that those opposing fair value accounting fail to note is that it not the root cause of bank failures - leverage and the accompanying problems that come with it are the greater culprits.

Because even though the fair value measurements significantly impacted the reported income of these firms, the SEC report concluded that there were other causes that caused these financial institutions to fail, including growing probable credit losses, concerns regarding asset quality, as well the loss of investors and lender confidence.

"Leverage certainly had a major impact on these financial institutions," Moorhus Baumgardner said. "There are so many factors at play here, including the ability to both ramp up leverage and to quickly de-lever. Leverage played a role on every level of the economy - from consumers all the way up to the largest financial institutions."

It's banks' willingness to incur so much debt, and not how assets are accounted for, that is at the root of all the evils that currently beset us.

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.