A part of this week’s fuel for speculative erosion in the stock values of Fannie Mae and Freddie Mac was regulatory comments indicating the two should report on a fair value basis. In the current free-fall environment for valuing securities backed by mortgages, this would trigger the need for FNM & FRE to raise substantial new capital, in order to meet their regulatory minimums.

The fair value principle’s dependence on observable markets being rational on a spot basis ignores that they are not. The standard can shoehorn balance sheets and earnings into irrational displays of value because of it.

FAS 159 tells us fair value is:

“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (par. 6.a)

And the ubiquitously quoted Keynes tells us this about markets:

“The Market can remain irrational longer than you can remain solvent.”

For those who have presided over transactions in the markets on behalf of your enterprise, you know that FAS 159 can be true and that Keynes is true. This leaves us with the knowledge that earnings and balance sheets reported under FAS 159 will be overvalued and undervalued for very long periods of time. It’s difficult to understand how that serves or protects investors, or how it improves current historical cost reporting, where unrealized fair value movements are captured separately and impairments written down when realized.

The pollyanna view is that fair value reporting will provide transparency to real value on balance sheets and in earnings. But with spot price behavior, fair value reporting instead clouds a meaningful value presentation for investors.

The debt markets have been unable to reliably value its mortgage backed instruments for a year now. This absence of confidence in the instrument, and competency for valuing the instrument, does not give credibility to FAS 159’s reliance on observable markets for determining fair value on a consistent basis.