Towers Perrin: $700 Billion Bailout Plan is "No Excuse" to Forgo Fair Value Accounting

STAMFORD, CT, October 8, 2008 – Now that the government has pledged support for a $700 billion economic bailout plan, look for the Securities and Exchange Commission (SEC) and accounting authorities to help out, according to global professional services firm Towers Perrin.  The most talked-about relief in regulatory circles is a temporary — or even permanent — suspension of fair value accounting for derivatives and other hard-to-value assets (HTVAs), the firm said.

"After all, it was the skyrocketing volatility and plummeting market prices of collateralized debt obligations (CDOs) and credit default swaps (CDSs) — not actual defaults — that caused collateral calls at AIG and Lehman Brothers, and thus arguably precipitated today's liquidity crunch," said Tricia Guinn, managing director of Towers Perrin's Risk and Financial Services business.  "Many observers are thus asking the SEC and accounting authorities to roll the clock back, to immunize HTVA issuers from the vagaries of day-to-day market movements."

Among the company's observations:

Opacity is not a viable long-term solution to a market that is crying out for transparency.

"A central clearinghouse is one proposed step toward transparency, and is probably a good one," said Patrick Finegan, Towers Perrin principal and senior consultant within the company's Enterprise Risk Management practice.  "But ultimately, the strength and resilience of the derivatives market will depend on the credibility of the financial statements of those who issue and hold such instruments, and that will depend on the quality and reasonableness of their valuations."

Rather than rolling the clock back on HTVAs, the SEC and accounting authorities should roll the clock forward, setting forth standards of independence, competence and methodology for ensuring that fair value accounting is objective, state-of-the-art and transparent.

"That would do much, in our opinion, to restore confidence by investors, rating agencies and customers in the credibility of the financial sector's financial statements," Mr. Finegan said.

Valuation methodology should vary, depending on the transparency, completeness and liquidity of the market.

"There are times when market prices are not an appropriate financial measure of the value of assets, for example, when securities are so thinly traded and bid-ask spreads so wide that prices markedly depart from the real discounted cash flow expectations of each security," said Stephen Lowe, Towers Perrin principal and managing director of the company’s global Property/Casualty practice. "This is particularly true when the assets are used to back long-term liabilities, such as insurance policy benefits and pension plan obligations, and are therefore not needed to meet immediate liquidity requirements of the business."

"During such times, 'fair' value is not determinable from observed market prices.  Rather, it should be approximated by a risk-adjusted analysis of fundamental cash flow expectations," added Mr. Lowe.  "These valuations should still be generally consistent with how the market prices risk."

Finally, Mr. Finegan said that it is imperative that the International Swaps and Derivatives Association (ISDA) reexamine the lock-step relationship between accounting value and collateral that pervades the contract language of all credit default swaps. 

About Towers Perrin

Towers Perrin is a global professional services firm that helps organizations improve their performance through effective people, risk and financial management.  The firm provides innovative solutions in the areas of human capital strategy, program design and management, and in the areas of risk and capital management, insurance and reinsurance intermediary services, and actuarial consulting.  Towers Perrin has offices and alliance partners in the United States, Canada, Europe, Asia, Latin America, South Africa, Australia and New Zealand.  More information about Towers Perrin is available at www.towersperrin.com.