【正文】 n the list are ―Level 3 inputs‖ which are simply ―unobservable,‖ ., there really are no active markets. Under Level 3, inputs are to be ―developed based on the best information available in the circumstances.‖ Often that will mean that, in the absence of an active market, resort will be had to models that seek to figure out what the price to be received in a hypothetical sale of the asset would be. When a draft of FAS 157 was circulated to the financial munity for public ment, not everyone was enthusiastic about its threelevel approach, and thoughtful mentators were understandably concerned about the reliability of hypothetical values that would result from the use of Level 3 inputs. Still, the standard seemed to be the best available resolution to a knotty problem. Some large financial institutions even adopted FAS 157 earlier than required. As they implemented its approach, overall things seemed to go okay. Among those areas where FAS 157 seemed to be working satisfactorily was financial 3 instruments related to subprime loans. MARKET DISLOCATIONS That changed this past summer. We’re all too familiar with what happened. Two Bear Stearns funds ran into problems, and the result was increasing financial munity uncertainty about the value of mortgagebacked financial instruments, particularly collateralized debt obligations or ―CDOs.‖ As investors tried to delve into the details of the value of CDO assets and the reliability of their cash flows, the extraordinary plexity of the instruments provided a significant impediment to insight into the underlying financial data. Financial markets can deal with bad news, but an information vacuum is another thing altogether. The problem with CDOs was not disappointing value. The problem was that the value of the underlying assets could not be figured out. As a result, the markets seized. In other words, everyone got so nervous that active trading of many instruments all but stopped. Largely unnoticed behind the scenes was the fact that, with the disappearance of active markets, much CDO valuation was no longer eligible for ―Level 1‖ treatment under FAS 157. For that matter, often there was not even sufficient analogous market activity so that CDOs could be valued under Level 2. So financial officers and accountants quickly found themselves needing to cope with Level 3. That meant they were faced with the need to resort to financial models that would somehow recreate what the price received in a hypothetical sale would be. But they quickly encountered a problem. Because CDOs to that point had been valued based on Level 1, established models for valuing the instruments at Level 3 were not in place. Just as all this was happening, moreover, another well intended aspect of our financial reporting system kicked in: the desire to report fastbreaking financial developments to investors quickly. For those with financial reporting responsibility, therefore, the circumstances were exceedingly uncharitable. To their credit, they wanted to get updated value information on their subprime instruments to financial markets fast. But historical approaches to valuation were suddenly unavailable. What to do? Come up with the best possible models under Level 3 as the circumstances would allow. But that was no easy feat. Models valuing subprime investments might conceivably want to take into account such imponderables as the future of housing prices, the future of interest rates, and how homeowners could be expected to react to such things. One way or another, well meaning preparers found a way to e up with their best estimates and report them to investors. Not all investors seemed to appreciate, though, the extent to which the reported declines in value, presented numerically and thereby suggesting a level of precision that numerical presentation often implies, were necessarily based upon financial models that relied upon predictions about an inherently unknowable future. It is hardly surprising, therefore, that in some instances asset values had to be revised either because models were being adjusted or because predictions were being updated as things seemed to get worse. To some, particularly to those who never liked fair value accounting to begin with, this was all evidence that 4 fair value accounting is a folly. According to one managing director at a risk research firm, ―All this volatility we now have in reporting and disclosure, it’s just absolute madness.‖ The frustration is understandable. But defenders of fair value accounting would point out that keeping financial assets on the books at levels well above that for which they could be sold is not exactly a model of transparency in financial reporting. The point is that it is a function of financial reporting to tell people what is going on. And while the news has not been particularly pleasant for anyone, one benefit to fair value accounting – and FAS 157 in particular – is that it has given outside investors realtime insight into market gyrations of the sort that, under old accounting regimes, only insiders could see. True, trying to deal with those gyrations can be difficult and the consequences are not always desirable. But that is just another way of saying that ignorance is bliss. BUT WHAT ABOUT LITIGATION ? Whatever one thinks of fair value accounting, though, one feature of the subprime aftermath has the potential to be pletely counterproductive. It is the extent to which our system of litigation and regulatory oversight results in unjustified assertions of ―fraud‖ against those who were doing their best under circumstances that were exceedingly difficult. In this regard, the aftermath of the subprime mess may be a harbinger of things to e. For the very aspects of fair value accounting that make it su