WASHINGTON (Reuters) - U.S. securities regulators provided initial guidance on fair value accounting and reminded financial services firms that they don’t need to use fire sale prices when evaluating their hard to price assets, according to a document first obtained by Reuters on Tuesday.
The U.S. stock market added to its gains on the news, on hopes that regulators’ new interpretation could slow or reverse the heavy flow of mortgage-related losses on banks’ balance sheets.
The Securities and Exchange Commission issued a press release about its guidance on Tuesday shortly after the markets closed. U.S. accounting rule maker, the Financial Accounting Standards Board, will propose additional guidance later this week, the SEC’s release said.
U.S. accounting rule makers assume that fair value inputs are based on an orderly transaction between willing market participants. The SEC release indicated that the agency does not believe distressed, or forced liquidation sales are orderly transactions.
According to the document, the SEC reaffirmed that management’s internal assumptions can be used to measure fair value when relevant market evidence does not exist.
Under U.S. accounting rules, assets can be valued based on a simple price quote in an active market. But the hardest to value assets are often based entirely on management’s best estimation derived from mathematical models.
However, as credit markets seized up this year, many banks were forced to rely on models to value complex mortgage securities that used to trade in more active markets. Critics have complained that accountants forced banks to base their values on fire sale prices in illiquid markets instead of the so-called level 3 or unobservable inputs such as the mathematical models to evaluate their securities.
The SEC’s guidance says that sometimes the level 3 inputs may be more appropriate than the so-called level 2 or observable inputs.
“In essence, the SEC wants to stop the avalanche of declining prices,” said Tom Sowanick, chief investment officer at Clearbrook Financial. Sowanick said that the new guidance should allow banks to rely more on their own assumptions when they determine fair value rather than the distressed sale prices occurring in the markets.
Reporting by John Poirier, Emily Chasan, Rachelle Younglai with additional reporting by Jennifer Ablan; editing by Carol Bishopric