"A Judgment Too Important to be Left to the Accountants"

Picture Source

The Harvard Law School Corporate Governance Blog is often good for some interesting discussions and points of view. With all due respect to some of the distinguished commenters and the fact that they have linked to me once, I don’t always agree with the opinions expressed.

Take Mr. Peter Wallison’s op-ed piece from the Financial Times of May 1, 2008, reprinted in the HLCG blog yesterday. Mr. Wallison argues that banks, in particular, are seeing their balance sheets “distorted” by fair value accounting because many of of the securities they hold are falling in value.

So what?

It’s disingenuous to be fine with fair value accounting when asset values are rising and to proclaim it the villain when asset values are falling. He says that, “rising housing values made banks and other mortgage lenders look flush. Inflated balance sheets and income statements supported more borrowing and more leverage; suddenly, the markets were awash in liquidity and risk premiums fell to unprecedented levels.”

One may have also blamed fair value accounting for the inaccurate picture of bank’s balance sheets and income statements when asset values were rising, but interestingly enough, no one was complaining. Were the bankers making exorbitant profits and paying unprecedented bonuses complaining? Was the previously happy investor in bank stocks, which I suspect Mr. Wallison is, complaining? Were those who were riding the gravy train of inflated housing values, such as the mortgage companies and those that invested in the derivatives instruments derived from these soft securities, complaining? I do not recall any whining then.

Mr. Wallison says the judgment is too important to be left to accountants. I agree with this, at least. Even with the rules at their fingertips, the accountants, the Big 4, did not accurately interpret and enforce them. As a result, you now see the dramatic corrections as failures and collapses such as New Century, Northern Rock, and Bear Stearns make paying the piper impossible to put off any longer.

But the judgment is not too important to be left to accounting.

Mr. Wallison: Instead of principles and standards, consistent over time, who are we to leave this judgment to?

Fickle politicians, think tank pontificators and self-serving business leaders?

Judgment Too Important to be Left to the Accountants

The Financial Times recently published the following op-ed piece of mine, entitled Judgment too important to be left to the accountants.

By Peter J. Wallison
Financial Times
May 1, 2008

Two serious asset bubbles–the dotcom explosion of the late 1990s and the recent dizzying ascension in housing prices–have developed in the US economy within the past decade.

Given their damaging consequences, it is time to look for causes. One area that merits attention is fair value accounting, which was adopted as policy by the accounting profession in the 1990s.

This accounting convention requires financial intermediaries to carry their assets at market values, even if those assets are not being held for trading purposes.

When the dotcoms were in vogue, the assets of securities firms and other equity intermediaries were inflated, just as, more recently, rising housing values made banks and other mortgage lenders look flush. Inflated balance sheets and income statements supported more borrowing and more leverage; suddenly, the markets were awash in liquidity and risk premiums fell to unprecedented levels. It could be argued, then, that fair value accounting was the hothouse in which these bubbles bloomed; when prices are rising this system seems both to stimulate and ride the wave of irrational exuberance.

But matters look much less agreeable when the same asset values are falling. Then, the process works in reverse, and the spiral points downwards…