[OPE] "Fair value"

The debate on fair value continues...

Disclose the fair value of complex securities
By Robert Kaplan, Robert Merton and Scott Richard

August 17 2009

Banks and other financial institutions are lobbying against fair-value
accounting for their asset holdings. They claim many of their assets are not
impaired, that they intend to hold them to maturity anyway and that recent
transaction prices reflect distressed sales into an illiquid market, not
what the assets are actually worth. Legislatures and regulators support
these arguments, preferring to conceal depressed asset prices rather than
deal with the consequences of insolvent banks.

This is not the way forward. While regulators and legislators are keen to
find simple solutions to complex problems, allowing financial institutions
to ignore market transactions is a bad idea.

A bank typically argues that a mortgage loan for which it continues to
receive regular monthly payments is not impaired and does not need to be
written down. A potential purchaser of the loan, however, is unlikely to
value it at its origination value. The purchaser calculates a loan-to-value
ratio using the current, much lower value of the house. After calculating
the likelihood of default, the potential buyer works out a price balancing
the risk of default and amount that might be lost - a price well below the
carrying value on the bank's books.

The bank is likely to ignore this offered price, or trades of similar
assets, with the claim that unusual market conditions, not a decline in the
value of the assets, causes a lack of buyers at the origination price. Its
real motive, however, is to avoid recognising a loss. Yet, by keeping assets
at their origination value, the bank creates the curious possibility that
its traders could buy an identical loan more cheaply and so carry two
identical securities in the same not-for-sale account at vastly different
prices. (...) If companies choose not to disclose their best estimates of
the fair values of their assets, market participants will make their own
judgments about future cash flows and subtract a risk premium for
non-disclosure. Good accounting should reduce such dead-weight
losses.

This already happens in another financial sector. Mutual funds in the US now
use models, rather than the last traded price, to provide estimates of the
fair values of their assets that trade in overseas markets. The models
forecast the prices at which these overseas assets would have traded at the
close of the US market, based on the closing prices of similar assets in the
US market. In this way, the funds ensure that their shareholders do not
trade at biased net asset values calculated from stale prices. (...)

For fair-value estimates made by internal bank analysts to be credible, they
need to be independently validated by external auditors. Many certified
auditors, however, have little training or experience in the models used to
calculate fair-value estimates. (...)

Legislators and regulators fear that marking banks' assets down to
fair-value estimates will trigger automatic actions as capital ratios
deteriorate. But using accounting rules to mislead regulators with
inaccurate information is a poor policy. If capital calculations are based
on inaccurate values of assets, the ratios are already lower than they
appear. Banks should provide regulators with the best information about
their assets and liabilities and, separately, allow them the flexibility and
discretion to adjust capital adequacy ratios based on the economic
situation. Regulators can lower capital ratios during downturns and raise
them during good economic times. (...)

http://www.ft.com/cms/s/f206cf68-8b59-11de-9f50-00144feabdc0,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2Ff206cf68-8b59-11de-9f50-00144feabdc0.html&_i_referer=http%3A%2F%2Fwww.ft.com%2Fhome%2Feurope

I've quoted FASB on OPE-L before on valuation problems:

"In summary, verifiability [in financial accounting] means no more than that
several measurers are likely to obtain the same measure. It is primarily a
means of attempting to cope with measurement problems stemming from the
uncertainty that surrounds accounting measures and is more successful in
coping with some measurement problems than others. Verification of
accounting information does not guarantee that the information has a high
degree of representational faithfulness, and a measure with a high degree of
verifiability is not necessarily relevant to the decision for which it is
intended to be useful - FASB Statement of Financial Accounting Concepts No.
2 Qualitative Characteristics of Accounting Information May 1980

The idea is that "fair value" is the average current price at which an asset
is traded, but the whole problem is that the asset price, and thus its
yield, could fluctuate in value in the future. In this case, the bank - with
government support - itself is a "price setter", not the current market for
a type of asset. Well, anyway, there is more to prices than meets the eye!
Obviously if the government guarantees the bank loans, the bank will
continue to be a price setter, and this is actually quite profitable.

J.

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Received on Tue Aug 18 13:13:18 2009