How to Restore Trust in Wall Street
By Arthur Levitt Jr. and Lynn Turner
26 September 2008
The Wall Street Journal – A17
The events of the past two weeks constitute the next chapter in a fundamental crisis in financial reporting that has plagued our markets for the past decade. There is a direct line from the implosion of Enron to the fall of Lehman Brothers — and that’s an inability for investors to get sound financial information necessary for making sound investment decisions.
Only by fixing financial reporting will we be able to restore investor confidence and the health of our capital markets.
That’s why it’s both dismaying and puzzling that as Washington debates the Treasury’s bailout proposal, some of the largest banking and financial services trade groups are aggressively lobbying the SEC to suspend the mark-to-market, or fair-value, accounting standard currently in place, and to oppose any expansion of it.
To ask for a suspension in fair-value accounting is to ask the market to suspend its judgment. These trade groups claim that the fair-value accounting standard has distorted banks’ balance sheets, and has contributed significantly to the market’s volatility.
On the contrary, that gets things backward. It is accounting sleights-of-hand that hid the true risk of assets and liabilities these firms were carrying, distorted the markets, and have caused investors to lose the confidence necessary for our markets to function properly.
The only way we can bring sanity back to the credit and stock markets is by restoring public trust. And to do that, we must improve the quality, accuracy, and relevance of our financial reporting. This means resisting any calls to repeal the current mark-to-market standards. And it also means expanding the requirement to the securities positions and loan commitments of all financial institutions.
Fair-value reporting, when properly complied with and enforced, will simplify the information investors need to make informed decisions, and bring much needed transparency to the market. By reporting assets at what they are worth, not what someone wishes they were worth, investors and regulators can tell how management is performing.
This knowledge in turn is fundamental to determining whether or not an institution has sufficient capital and liquidity to justify receiving loans and capital. It’s like your personal balance sheet: If you say everything you own is worth twice as much as it is in today’s market, then you are misleading those who are relying on the data you give them, and you will ultimately destroy their trust and willingness to do business with you.
To be sure, just setting the fair-value standard is not enough. Investors need to realize that these valuations are point estimates, often in need of other information to get the full picture.
Companies also should disclose how fair value was determined, including the key assumptions they used, the risks they present, the range of movement of these assets, why the company expects the fair value to recover if the asset’s value has shrunk, and a track record and outlook for the investment horizon.
In addition — and contrary to what the critics claim — fair value is not liquidation value. It does not reflect ultimate settlement amounts, but the current value in arms-length transactions. It is an accurate reflection of the value of an asset or cost of a liability, and what taxpayers should pay for assets.
Ultimately, those who blame fair-value accounting for the current crisis are guilty of the financial equivalent of shooting the messenger. Fair value does not make markets more volatile; it just makes the risk profile more transparent.
We should be pointing fingers at those at Lehman Brothers, AIG, Fannie Mae, Freddie Mac and other institutions who made poor investment and strategic decisions and took on dangerous risks. Blame should not be paced on the process by which the market learned about them.
We do recognize that bringing the full extent of the risks of these assets and liabilities to light may be a shock to the system. To many this shock may seem unthinkable. But the unthinkable has happened.
It may be painful for some companies, and even for the markets as a whole, as we transition to fair-value accounting. But it is the tough medicine we must take in order to vastly improve financial reporting, bring transparency to the markets, and restore investor confidence.
Mr. Levitt was chairman of the Securities and Exchange Commission from 1993 to 2001. Mr. Turner was SEC chief accountant from 1998 to 2001.