“Soft despotism is a term coined by Alexis de Tocqueville describing the state into which a country overrun by "a network of small complicated rules" might degrade. Soft despotism is different from despotism (also called 'hard despotism') in the sense that it is not obvious to the people."

Thursday, February 05, 2009

The Testimony of Harry Markapolis

Government Oversight Chairman


Scan this document and look at some of the emails. To those who trust in government, our rulers and masters, to protect you, take special note.


  1. - The End of the Financial World as We Know It -

    "Consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.

    In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.

    In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.

    Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee.

  2. Starling said…

    It is a shame really, that someone couldn’t or didn’t investigate this guy sooner.

    That said, I really wonder what was the extent of his chicanery and when it began.
    After all, a moneky throwing darts at list of stocks could have made money in the late 1990s. Was he on the take even then? And then there was the bull-market of 2003-07. Did his con-game give better profits than the average returns during those periods?
    I guess I am wondering if he was just an incompetent stock picker or just greedy?
    Probably a combination of both.“

  3. Pretty damning testimony.

    The SEC during te Bush Administration was as inept in its' operations as was FEMAs' message marketing and on the ground responses to the flooding caused by hurricane Katrina.

    Poor prior planning on the ground guarenteed piss poor performance. A lack of coordination and experience seems to have permeated the Bush Administration. Even in Iraq, there were three years of failure to obtain the objectives, before Mr Bush would admit the failures were large and in charge.

    The Federal Socialist cultures that existed across the Government existed well before Mr Bush took office, in 2000, but he and his did not attempt to reform that culture. They reinforced it.

    Rewarding mediocrity.

    Now, under the Obama Administration, tax cheats and worse are being given hugh amounts of authority for both the management and the reform of powerful Federal institutions.

    Folks that are worse than inept, they are criminally negligent in their personal lifes. Seemingly the higher on the Federal foodchain, the greater their misunderstanding of the law or the worse their 'memory' becomes.

    Using Mr Biden's own standard of patriotism the Obama Administration has tapped a variety of sunshine patriots to soldier on, like it was summertime in the American States United.

    Trouble with that, we're in the beginning of a long slog of a winter campaign.

  4. Pay attenshun, chillins; I only want to say this once. This recession is about over.

    Yeah, I know, we had 626,000 jobless claims this morning, and Carl Quintanela (or, however you spell his commie-assed name) is babbling about "off-the-charts," and whatever; but, we're just a couple of car purchases from the end of "the end."

    First off, whatever you say about the stimulus bill (spare me) It's Massive, and it's Coming. It will jolt the economy.

    The Banks are making money hand over fist, and are starting to lend. They need the second leg of the TARP like I need another bad habit. Look, there's a reason why no one can devise a plan to get those "toxic" mortgages off their books. Those ARMs are throwing off "Cash Flow" like crazy.

    If Ten Percent of the ARMS go bad that would only lower the "asset value" of the trenche by about 3%. They're being carried on the books at some ridiculously low value, which makes the balance sheet look crappy; but the "Money" keeps rolling in.

    I don't know if Obama is "lucky, or Good," but by calling the bankers' bluff on the CEO compensation he's going to flush out the truth. Watch, and see, if several of the big banks don't start giving the TARP money back.

    The HAI (home affordability index) is at its all-time high. People are starting to snap up the repos. As they get bought up houses will have to rise to "replacement cost."

    "Productivity" in the 4th quarter was UP 3.2%. When productivity is rising at that rate it's time to quit firing, and start hiring. This will be the last "down" quarter. The recovery starts in July.

  5. but he had been trying to explain the fraud to them since 1999.

    Time to start bashing Obama, not Bush, he's back in Texas cutting brush.

    Rufus, you might just be right. I do know there's no recession in the universities around here. Idaho up, North Idaho up, LCSC up, and the Washington State University figures just came out, up a big 5% in Pullman, and even higher than that at the branch campii. Usually, it's down in the spring semester everywhere.

    Happy days are here again, here.

  6. No, no, no, bob.

    We are still bashing Jimmy Carter.
    The Bush bashing goes on and on and on. There is no escaping the responsibilities of misused authority.

    If rufus is right, it'll be a Bush recovery and Obama will have been lucky. I doubt that rufus is right, though. He discounts the importance of his favorite economic driver, exports, to the recovery. These will not even begin to recover, by July.

    Just read, the other day, of a large mall in Detroit that recently changed hands. $49 and change per square foot.

    That is as far from 'replacement' value as one could get.
    With regard to housing, it just seems to get worse.
    It may be that my perspective is warped by the proximity to the black hole of real eatate values in CA, AZ & NV. But those States are were the US population is migrating to. Or at least they were. CA is no longer a destination for internal US migrants, but is still a shining city on a hill to those overseas and to the south.

    Two of the families we have associated with during the child rearing years are leaving, come the summer. One off to Kona, HI, the other to land owned by their family, some where in the Carolinas.
    This indicates, at least to me, that the flight from over leveraged real estate will continue well past July. There is a large amount of property that is waiting to enter the market.
    People either hanging on, hoping for a recovery before they sell, or those that say to heck with it, and just move to the beach.

    The Hawaiian migrants owning a number of houses, which today they say they'll sell or just 'let go' before they leave. Life being to short to waste, they tell me, waiting for 'better times'.
    They'll turn the page and start a new chapter of the lifes. I'm of a mind that there are a lot of people thinking that same way.

    I hope rufus is right, but the observable data does not seem to correlate to, nor confirm his prognosis.

  7. The answer, again based upon rufus's and Steve Forbes opinion, is to repeal the 'Mark to Market' requirements and allow the mortgage backed securities to be valued on a cash flow basis.

    This would ease the the regulators demand for ever increasing capital reserves from the banks.

    But not amongst the 'reforms' that I've seen promoted by either Team Obama or Team Pelosi. Just more SEC type mismanagement, the Federals working at cross purposes, either by design or default, does not really matter which. It's the performance that matters, more than the motive.

    Banks: Federal government gives mixed message

    Stevenson Jacobs - Feb. 3, 2009 12:00 AM
    Associated Press

    NEW YORK - Banks that are being scolded by the government for not lending are blaming a new obstacle: the government itself.

    Fearing more bank failures, federal regulators are forcing institutions to hold more money in reserve and scrutinizing loans. Bank executives complain that the extra oversight thwarts their ability to quickly pump billions of bailout dollars into the ailing economy.

    Banks say they are caught in a frustrating Catch-22: How can they make more loans when creditworthy borrowers are scarce, their balance sheets are saddled with bad debt and regulators are hounding them to horde cash?

    "We want to lend, but the regulators are flat-out telling us, 'Get your capital up.' Then there's Congress, telling you to lend it all out," said Greg Melvin, a board member at FNB Corp., a Hermitage, Penn.-based bank that got $100 million in bailout money.

    "Two arms of the government are saying exactly the opposite thing. It's ridiculous," added Melvin, who is also chief investment officer at investment firm C.S. McKee.

    Regulators say they are only being careful, and they deny slowing lending.

    "We don't believe that prudence and increased lending are mutually exclusive. They go hand in hand," said Andrew Gray, a spokesman for the Federal Deposit Insurance Corp.

    The tit-for-tat marks the latest problem for the government's financial bailout, known as the Troubled Asset Relief Program.

    The government rolled out the $700 billion bailout late last year, hoping that injecting money into banks would expand lending and ease the credit crisis. But in a survey released Monday, the Federal Reserve said many banks are making it harder to get credit cards, mortgages and other loans.

    Regulators have long required banks to keep a minimum level of capital on their books to stay in business. It was typically a figure equal to 10 percent of assets.

    But as the financial crisis has worsened, many banks say they have been told to keep capital equal to at least 12 percent of assets. At the same time, regulators are combing through banks' loan applications and flagging those considered too risky.

    It's unclear how broadly the stricter rules are being applied. But interviews with bank executives indicate that both healthy and troubled banks are facing more stringent oversight, regardless of whether they have received bailout money.

    The goal is to keep banks from getting into more trouble.

    To comply, some banks say they have little choice but to scale back lending, sometimes even to creditworthy borrowers.

  8. Let me explain one thing. I'm Not saying that we'll "come flying" out of recession. We won't. We won't grow anywhere near as much in the 3rd and 4th quarters as we shrink in the first and second quarters; but, we Will grow some.

    I think Rat hit the cause of the slow recovery on the head. Real Estate will bottom in the first half, but it will take a while to show any appreciable gains. And, exports will grow slowly as well.

    Oh, did I mention that I think we'll be Back in Recession within a year and a half? Put there by high gasoline prices? It'll either be that or a really wild inflationary spiral. But, that's a subject for another day.

  9. So PJ Media is shutting its' links, come March?

    Couldn't develop a video network of timely reporting and did not reach an economically viable readership base with wretchard and whiskey providing content.

  10. I hope you are right Rufus but I've heard rumblings of another shoe still to drop and that is the general indebtedness of the US consumer with credit card debt being the elephant in the room. this has yet to be worked out I understand...

  11. OT and trish in particular may like it but one can try to do a 'Sully'

  12. Oh, did I mention that I think we'll be Back in Recession within a year and a half?

    You should not honor men more than truth.
    - Plato

    Truth is in price.
    - I added that

  13. 100% Carbon Free Electricity by 2018

    No more oil induced recessions.

  14. From the looks of this, we're not even close to the bottom, let alone turning the corner, in July.

    Of particular concern are “Alt-A” mortgages, offered to borrowers sandwiched between subprime and prime. This market was trumpeted as a means of extending home ownership to those, such as the self-employed, with a reasonable credit standing but unsteady income. Its practitioners specialised in loans with scant documentation and exotica such as negative-amortisation mortgages, which allow borrowers to pay less than the accrued interest, with the difference added to the loan balance.

    That Alt-A has troubles comes as no surprise. Last summer, for instance, it helped to bring down IndyMac, a Californian bank. But the speed with which loans have soured in recent months, and the reaction of rating agencies, have been startling. Delinquencies rocketed in the final months of 2008. They even rose sharply for loans made in 2005, before underwriting turned really sloppy (see chart).

    The rating agencies are rushing to catch up with this grim reality. Moody’s, which last summer had issued a sanguine outlook for Alt-A, recently quadrupled its loss projections on bonds backed by such loans. A steady flow of downgrades has turned into a flood in recent weeks, with thousands of Alt-A tranches taking the plunge. The falls have been unusually steep: of the $59 billion of AAA-rated securities that Moody’s cut between January 29th and February 2nd, an astonishing 91% went straight to junk, according to Laurie Goodman of Amherst Securities. In ratings terms, Alt-A is doing worse than subprime.

    Moody’s calls this “unprecedented”. That is putting it mildly. It now expects losses for 2006-07 Alt-A securitisations to top 20%, compared with an historical average of well under 1%. In an ugly echo of the fiasco over collateralised-debt obligations, holders lower down the structure can expect total write-offs, while the vast majority of senior holders will not be spared substantial losses.

    The sums involved are depressingly large. In the worst case, losses on the $600 billion of securitised Alt-A debt outstanding—roughly the same as the stock of subprime securities—could reach $150 billion, reckons David Watts of CreditSights, a research firm. Analysts at Goldman Sachs put possible write-downs on the $1.3 trillion of total Alt-A debt—including both securitised and unsecuritised loans—at $600 billion, almost as much as expected subprime losses. Add in option ARMs, a particularly virulent type of adjustable-rate loan, many of which are essentially the same as Alt-A, and the potential hit climbs towards $1 trillion.

    Part of the problem is that much of the Alt-A lending came at the tail-end of the credit boom in late 2006 and early 2007. By then, subprime was already getting a bad name. So Wall Street hit on a ruse: it took borrowers who in normal times would have been subprime and dressed them up as “mid-prime”. Many of these loans were doomed from the start. According to the Bank for International Settlements, a staggering 40% of American mortgages originated in the first quarter of 2007 were interest-only or negative-amortisation loans.

    Now, if what rufus reports is accurate and the cash flow value of the mortgage backed securities is really solid, then this next step could be avoided, with a change in the regulatory regieme put in place by the Federals

    Banks have already sold a sizeable chunk of their Alt-A holdings to hedge funds and other asset-management firms, often at large discounts. UBS’s exposure has fallen from $26.6 billion to just $2.3 billion, for instance. But other European banks were not so zealous. ING, a Dutch bank, still has €27.7 billion ($35.1 billion) of Alt-A debt. American banks are sitting on perhaps $800 billion of the stuff.

    As the market prices of mortgage securities have fallen, banks have had to mark down their holdings, taking “unrealised” losses that erode their capital position. Multi-notch downgrades could put further downward pressure on prices. They hit capital in another way, too, because junk-rated debt carries a punitive risk weighting; banks must set aside five times as much capital as they have to for top-notch securities. Rating cuts also affect income statements, by pushing banks to acknowledge that losses which they had classified as temporary are now permanent.

  15. The biggest single Alt-A casualties are America’s bungling mortgage agencies, Fannie Mae and Freddie Mac. They waded into the market in 2006-07, snaffling up business in red-hot states such as California and Arizona, comforted by down-payments of 20%. When house prices there fell by more than that, they were left holding the first loss, since borrowers who put in that much equity do not have to take out mortgage insurance.

    Rotten as Alt-A loans are, worse may be to come. As unemployment in America heads towards 8%, even strongly underwritten loans will go bad. Bankers are growing increasingly anxious about the $1.1 trillion of prime mortgage loans and securities, much of which they held on to themselves, assuming it to be bombproof. This sits on their books at “much more optimistic” values than lower-grade mortgages, says one.
    Some 70% of prime securities will eventually have their ratings cut, according to a “downgrade-o-meter” produced by JPMorgan Chase.

    As Guy Cecala of Inside Mortgage Finance, a newsletter, puts it:
    “The mortgage storm’s first wave was subprime. Now we are being buffeted by Alt-A. But a bigger wave is on the horizon, and it cuts across all loan types.”

  16. From Rats citation:

    "Banks have already sold a sizeable chunk of their Alt-A holdings to hedge funds and other asset-management firms, often at large discounts"

    This may help the Banks balance sheet but the new holders are still exposed if the discounts weren't large enough. Are these 'holders' anonymous rich folk who can afford to take the hit or ... pension funds? Not only is Social Security a problem but the diminished value of Pension funds is problematic - especially the 'defined benefit' variety. A tad bit underwater they are.

    Then there is the leasing industry. I had a beer with a chap a month or so ago and he was telling me how his business worked. He was a broker. They marry lessee's with lessors. The only thing they care about is the deal lasting long enough in order for them to keep their fees (approx. 1 year) "Just like the sub-prime brokers" he said.

  17. There is nothing quite like the tide going out exposing the sharp rocks below...

  18. The market is moving up, dRat. The qqqq's formed a "cup & handle" formation and are about to break from a trading range. The market is ignoring the financials and the housing market. And btw, that solar stock we talked about a month two ago, has now almost doubled in price.

  19. There is nothing quite like the tide going out exposing the sharp rocks below...

    You know, you should consider it a fscking miracle that you've gone thru life without having your face busted.

  20. Word is "mark to market" is going to be abolished. Hedge funds are buying financials.

  21. Ever had one of those days?

    "Are you okay to land runway one at Teeterboro?"

    "We're gonna be in the Hudson."

    "Come again?"

    Except that most of us would say something more along the lines of, "Holy Mother of Christ, we're gonna be in the fucking Hudson!" Followed after a stunned silence with a response of, "Oh, man, you're shitting me, right?!"

    Training. It pays.

  22. Those air traffic communications were quite interesting. I liked how the air traffic controllers responded so quickly without needing to ask for clarification -especially the understanding right off that both engines got knocked out by the birds.

  23. One of my (retired) neighbors back in VA had been the tower chief at Reagan and then at Dulles. A lifetime of ATC. Not a day went by that he didn't miss it terribly.

  24. Some lines of work are like that. : )

  25. I've got an uncle (in-law) who has flown water-bombers for many years. He's too old to fly here in NA but he keeps wandering the globe (i.e. Italy) looking for contracts. He hasn't had many the last couple of years. Talk about flying by the seat of your pants...

  26. That might be one of those cases in which, when you're too old to do, you teach. A different kind of satisfaction.

  27. I have no idea what will happen, as usual, and, you're right, people are still bashing Carter. Bash away.

  28. Labor Secretary nomination in trouble over--tax problems. And Justice Ginsberg in the hospital with pancreatic cancer. Dang I was hoping for a few more Republicans in the Senate before a new Supreme Court member, but the court isn't worth a shit anyhow, so what does it matter?

  29. The picture of Ginsberg on Drudge looks a little like Meryl Streep in "Doubt" but with a really happy look on her face, in comparison. Good movie.

  30. 23% Fear Global Warming Will End World - Soon

    Nearly one-out-of-four voters (23%) say it is at least somewhat likely that global warming will destroy human civilization within the next century. Five percent (5%) say it's very likely. A new Rasmussen Reports national telephone survey found that 66% say it's not likely that civilization will be destroyed by the year 2100. That includes 27% who say it is not at all likely.

    "Live as if the day is now", daddy always said.

    "A day late and a dollar short, the story of my life", daddy always said that too

  31. "Smooth as a school marm's leg", was another thing daddy always said.

  32. There is an interesting story:
    How to Save Your Newspaper
    By Walter Isaacson

    Which tells the tale of funding a publishing media company. How the free content INet came to be and who it benefits and who it hampers.

    How media companies looked to the INet, much like they did over the air broadcasting, rather than 'real' paper publishing.

    PJ Media, even on their homepage has the space for ads, but none are present.

    Little wonder they are closing, did not even have enough sense to put their own solicitations in the space. Proving to one and all, the space had no value, not even to the publisher.

    So sad. :)

  33. "Cold as a well diggers' ass"

    Here comes the attempt to shut down talk radio.

    Accountability, Fairness

    1st Amendment issue, heart of the Constitution, the 2nd slipped by with only 1 vote, before the Supreme Court.

    Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.

  34. This comment has been removed by the author.

  35. bobal said...
    Join The National Rifle Association Today

    I did last weekend....

  36. Good group. The last time I joined they promised me "The Shooters Bible" but never sent it. Finally saying they had run out, but it will come. My dues ran out before it came. But I've forgiven them, and the times are serious, so I joined again, just recently.

  37. I think Obama's rating are going to plummet. More Catholics voted for him than not, and the first thing he does is fund abortions worldwide, slapping them in the face. Lots of folk in the red states voted for him, and now the gun legislation, slapping them in the face. Lots of people like talk radio that voted for him, and now there's talk of 1st Amendment restrictions, slapping them in the face. Everybody pays taxes, he's slapping everybody in the face with his appointments. A trillion dollar and more stimulus bill, people are seeing through, the polls are against it. The rose is going to lose its bloom.

  38. This comment has been removed by the author.

  39. Polls won't make much difference, bob.
    They never did effect Mr Bush.

    Obama has the House and the Senate, more solidly than Mr Bush ever did.

    They'll trim a bit here, slim a tad there, and the stimulous will sail on through.

    So will everything else Obamasan REALLY wants. Only question is how many of your fears are justified.
    Not how popular Obama polls.

    He'll be above 27% for quite a while yet to come. Even then, as both Ms Reno and General Casey proved, opinion polls don't matter to the Federal Police or the Army, much.

  40. Sinking polls might cause a few dems around some states to shy away from some of the stuff I mentioned. My new democratic representative, for instance. Others too. Otherwise, I agree.

    Here's a discouraging quote from the aging Ben Franklin--

    Even so wise and moderate a man as Benjamin Franklin, whose symbolic presence at the Convention in Philadelphia had been crucial to its success, understood the problems inherent in the document as framed. He was eighty-one at the time and too feeble to speak often from the floor of the Convention. Franklin delegated James Wilson, a good friend, to read his concluding remarks to his fellow framers, and they make for chilling reading:

    "I agree to this Constitution with all its faults, if they are such: because I think a General Government necessary for us, and there is no Form of Government but what may be a Blessing to the People if well-administered; and I believe farther that this is likely to be well administered for a Course of Years and can only end in Despotism as other Forms have done before it, when the People shall become so corrupted as to need Despotic Government, being incapable of any other."

    To this dire prophecy, he added a conciliatory note:

    "I doubt too whether any Convention we can obtain may be able to make a better Constitution."

    "Promised Lnad" Jay Parini

    So if the best that any Convention can make is doomed, where are we?

    On those happy thoughts, to the dormatory....

  41. Since December 1954, the Playboy social contagion has fostered the demand side for women and children trafficked into sexual slavery. David Ogden cannot bite the pornography hands that have fed him, nor can his handpicked team. Has the Playboy flag really displaced the Stars and Stripes over Washington?

    Obama' Big Porno Deputy Attorney General

    Woman Who Traded Sex With Senators Husband For Money Gets Jail
    (This is the Senator who wants hearings on the Fairness Doctrine, to bring it back)

    Let's face it, we've been living in a sewer, and the sewer rats rule.

  42. Even the Swedes are showing some good sense--

    Sweden Lifts Nuke Plant Ban
    If one of the "leaders" on alternative energy - the size of Sweden, say - is struggling to meet demand through wind and hydro, ... so it opts to lift its ban on nuclear power, that sort of puts Obama and the Left behind the curve, not ahead - dudn't?

    STOCKHOLM (AP) — The Swedish government agreed Thursday to scrap a three-decade ban on building new nuclear reactors, saying it needs to avoid producing more greenhouse gases.

    Sweden is a leader on renewable energy but is struggling to develop alternative source like hydropower and wind to meet its growing energy demands. If parliament approves scrapping the ban, Sweden would join a growing list of countries rethinking nuclear power as a source of energy amid concerns over global warming and the reliability of energy suppliers such as Russia. Britain, France and Poland are planning new reactors and Finland is currently building Europe's first new atomic plant in over a decade.


    as you asked. i'll try to do a hyperlink, too--


  44. No can access.
    What I'd like is for you to post saome of the text from the article.

  45. Doug --2164 gonna be peestoff how long this is --help me get it deleted --can i do it ? i'll check --gotta get away now computer is driving me MAD

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    Mark to Market, or to Myth? FAS 157 Worries
    By Colleen Cunningham — September 25, 2007

    he Bear Stearns hedge fund meltdown put “fair value” on the front pages. Now, Financial Accounting Standard No. 157 is going to put it on your books, and soon.


    Compliance Week columnist Colleen Cunningham is the former president and CEO of Financial Executives International. She was named managing director of the New York tri-state area for Resources Global Professionals in June 2007. In this role, she oversees the operations, financials and recruiting while mentoring teams and offering strategic guidance to the six practices within the region.
    An internationally recognized expert on corporate financial reporting and accounting, Cunningham served as CEO of FEI for nearly four years, during which time she had significant influence in legislative and regulatory matters including Sarbanes-Oxley, pension reform, and financial accounting standards.

    The former chief accountant of AT&T, Cunningham was previously the SVP and CFO, North America, of Havas Advertising, which was, at the time, the fifth largest advertising holding company in the world. In that role, she was responsible for North American financial operations, including tax, controller, and treasury functions, SEC and U.S. GAAP reporting, and worldwide accounting policies. She began her career in public accounting with the firms formerly known as Touche Ross and Coopers & Lybrand.

    Colleen Cunningham can be reached via email.


    Related Resources

    Text of Statement 157 (September 2006)

    Text of Statement 159 (February 2007)

    Text of Statement 144 (September 2000)


    Previous Colleen Cunningham Columns


    Related Coverage

    Sub-prime Accounting Rule Shows Its Strain (Sept. 11, 2007)

    Fair Value’s Role in the Sub-prime Meltdown (Sept. 5, 2007)

    Rulemakers Try To Close Gaps In Fair Value (July 3, 2007)

    Fair Value Measurements Vexing PCAOB (June 19, 2007)

    Fair Value Options (April 24, 2007)

    In case you’ve forgotten, the Financial Accounting Standards Board’s fair value standard will be effective in a couple of months. The standard—known officially as FAS No. 157, Fair Value Measurements—is effective for fiscal years beginning after Nov. 15, 2007, and interim periods within those fiscal years. For calendar year-end companies, that means implementation is required in the first quarter of 2008.

    FAS 157 establishes a framework for how fair value should be measured. Prior to the standard, there were many different definitions and applications of fair value. Those inconsistencies, combined with a lack of guidance, created confusion that added to financial reporting complexity.

    The new standard attempts to address those issues by, among other provisions, delineating between different “types” of values: those with active markets, and those that rely on more “unobservable” inputs. In the former, known as “Level 1” of the fair value hierarchy, a liquid market exists where buyers and sellers can determine a fair value. For example, a financial asset traded on multiple exchanges might be considered a Level 1 market. At the other end of the spectrum, “Level 3,” no ready market exists to value assets or liabilities. A reporting unit or a business could, for example, qualify as Level 3 in the fair value hierarchy.

    The introduction of this Level 3 category into the accounting lexicon has recently led some to cry foul, as it is extraordinarily difficult to ascribe fair value to something nobody has recently tried to sell or buy. It’s even more challenging when the owner of the asset or liability has an inherent conflict in determining the outcome of the valuation. This conflict has led some to joke that such measurements are not “marked to market,” but are instead “marked to make believe” or “marked to myth.”

    FAS 157 stresses that fair value is a market-based measurement, not a measure of the value to the owner of the asset or the obligor of the liability. In other words, the fair value measurement should be determined based on a hypothetical transaction with a market participant, in contrast to what the entity actually plans to do with the asset or liability (which is instead an “entity-specific” assumption). Certainly, these measurements are a good deal more theoretical than real; whether investors agree that the measurements are better remains to be seen.

    The standard introduces other significant changes from current practice as well, including:

    Perspective. The fair value definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an “exit price”), not the price that would be paid to acquire the asset or received to assume the liability (an “entry price”);

    Transaction Costs. If the initial measurement is at fair value, transaction costs must be expensed as incurred, as such costs are not considered an attribute of the asset or liability;

    Disclosure. In addition to the establishment of the fair value hierarchy mentioned above, disclosure of how the assets or liabilities were valued is required. This is intended to illuminate the relative reliability of the values determined;

    Credit Risk. The entity’s own credit risk must be included when measuring the fair value of its liabilities;

    Block Size. The fair value of a block of financial instruments that trade in an active market should be measured as the product of the quoted market price times the quantity held; no adjustment is permitted based on the size of the block relative to the trading volume.

    Determining Fair Value

    Determining the fair value of an asset or liability can be tricky. Let’s take a look at some of the steps involved.

    The first step in the implementation process is to determine the assets and liabilities that are required to be measured at fair value. Basically, FAS 157 will need to be applied in any instance in the U.S. Generally Accepted Accounting Principles where there is a requirement for an asset or liability to be recorded at fair value. The potential list of such circumstances is immense, since the application of the new standard is ubiquitous—FAS 157 refers to no fewer than 28 accounting statements, opinions, and interpretations published since (gulp) 1971 that have been amended by the new standard. And that doesn’t include the 39 other FASB pronouncements that refer to fair value, the dozens of Emerging Issues Task Force documents that address the issue, the myriad Securities and Exchange Commission bulletins, and other industry documents that are affected by FAS 157. A catalog of the affected pronouncements is included in an appendix of FAS 157, and preparers should carefully review that list to determine where they need to focus their implementation efforts.

    In planning for implementation, it is also important to recognize that valuation processes and procedures need to be analyzed under FAS 157, then documented and audited. One of the lessons learned by early adopters has been to start early, and to commit a generous amount of resources, as the process takes a lot longer than one might expect.

    With respect to determining the fair value under FAS 157, one must first identify the valuation premise appropriate for the measurement consistent with its “highest and best use.” That phrase has no relationship to how the entity intends to use the asset; rather, assumptions must be made as to what is the “highest and best use” based on its likely use by other market participants. One critical question for which there is no guidance is whether the market participant is a financial buyer (such as private equity) or a strategic buyer (a competitor). The differences in valuation inherent in that choice can be significant.

    Next, one must identify the principal market—or, if there is no principal market, the most advantageous market—for the asset or liability. A question being asked a lot these days is whether that market is determined at the end of the reporting period, historically, or on a forward-looking basis. With the current dislocations in the credit markets, a number of additional questions are getting a lot of attention as to which date to use for the market information.

    Finally, one must determine the valuation techniques appropriate for the measurement of the asset or liability. This is complex, as one must consider the availability of data that can help develop measurement “inputs,” and where in the fair value hierarchy those inputs fall. (That is, are they observable or unobservable?) In addition, the inputs should represent the assumptions that market participants would use in pricing the asset or liability.

    One must also ensure that appropriate disclosure is made regarding the assumptions used, the measurement techniques, and the level in the hierarchy of the related inputs. The most challenging of these is the “roll forward” of current-year changes in the fair value assets and liabilities determined to be Level 3 in the hierarchy. For most companies, the information systems that can provide the data elements to facilitate this process don’t exist.

    Leases and Contracts

    One major implementation issue that I keep hearing about from companies relates to leases. The original FASB exposure draft for fair value measurements excluded leasing transactions from its scope. But FASB included them in the final standard, noting that some respondents believed the fair value measurement objective for leasing transactions is generally consistent with the principles in the standard. It is not clear how much thought the respondents gave to making those comments, but it’s likely they didn’t anticipate the major changes in practice that will result from applying FAS 157 to leases.


    One critical question for which there is no guidance is whether the market participant is a financial buyer (such as private equity) or a strategic buyer (a competitor).


    Much of the problem stems from how FAS 157 changes the determination of lease residual values. Changes here, in turn, can affect everything from lease classification (for both lessees and lessors) to the treatment of lease revenues and gains or losses on disposal. Many lessors determine residual values based on a probabilistic weighting of markets into which the leased asset will be sold (wholesale, retail, release by customer). FAS 157 requires selection of a single primary market, which can result in overstatement or understatement of the recognized lease residual when compared to its economic value (the value on which pricing is based).

    For example, let’s assume the primary market is determined to be retail, which offers the highest selling price and presumably is the most advantageous. In our scenario, too much lease revenue will be accrued over the life of the lease. That might be OK, we would assume, because we can recognize an impairment charge to the extent that the lease residual is not recoverable.


    We will have a loss on disposal—perhaps a very significant one—but we won’t be able to recognize it under FAS 144, Accounting for the Impairment or Disposal for Long-lived Assets, because the fair value under FAS 144 is determined under FAS 157 as well. So we have a guaranteed loss on disposal that we cannot recognize, but we know it’s unavoidable. The best we can do is disclose these facts to investors and hope they understand.

    Another implementation issue relates to whether executory contracts should be included in determining the FAS 157 fair value measurement. The latest FASB thinking on executory contracts is that they are their own unit of account under GAAP and cannot be combined with other assets. So, let’s say we have a power plant that sells all of its output under long-term contracts, and that those contracts are below market. If the plant’s undiscounted cash flows—which are determined on an entity-specific as opposed to market participant basis—are insufficient to recover the asset, how should we determine the fair value of the asset?

    There are at least three options: (1) exclude all cash flows from the long-term contract; (2) exclude only the degree to which the contract is in or out of the money; or (3) include the whole fair value of the contract.

    I have heard accounting firms argue for each of these three views, and the issue is not yet settled.

    But perhaps the most vexing issue is one FASB knew about and decided not to address: how to account for assets and liabilities measured under FAS 157 on “Day 2.”

    Take the example of an acquired trade name that will be abandoned by the acquirer. It is measured at fair value to a market participant that will presumably continue to invest in it. Should it be amortized over the useful life of the market participant? Should it be written off immediately, as it will produce no cash flows to the reporting entity? Should it be impaired to the extent that the value to the market participant has declined, leading to step impairment charges? All three approaches have support among practitioners.

    The examples above are just a few of the challenges that have followed in the wake of FAS 157. As the implementation of the new standard reaches its final stages, more are likely to surface in areas that companies have yet to delve into. Surprisingly, there is very little in the way of guidance from the accounting firms, and new issues don’t seem to have ready answers.

    Which leads to the inevitable question: Are we really ready for FAS 157?


    Compliance Week provides general

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