Hard to Value Assets Create Stir for Investors

by: Susan Mangiero, CFA

As this blogger has long maintained, what you see is not necessarily what you get, and what you don't see could come back to bite you. It is therefore troublesome to think that billions of dollars of assets are likely to be classified as Level 3 or the international equivalent of FAS 157 "hard to value" items.

According to "Financial groups' problem assets hit $610bn" (December 10, 2008), a significant trend is already underway for banks to move securities to third tier status. Financial Times reporters Aline van Duyn and Francesco Guerrera cite a Standard & Poor's study that shows an increase in illiquid assets by more than 15 percent from Q2-2008. Difficulty in finding buyers for mortgage-backed securities and collateralized debt obligations accounts in part for the increase. Somewhat alarmingly, the article adds that "level-three assets are many times bigger than the market cap of the banks."

In "Running the Fund: Alternative Realities" (November 2008), PlanSponsor reporter Judy Ward quotes me extensively on the topic of valuation of "hard to value" assets from the investment fiduciary perspective. As regular readers will recall, the U.S. Department of Labor has made no secret that it would like to see pension decision-makers do a good job of vetting valuation numbers that are provided by its asset managers.

Litigation, sub-par asset allocation, anemic risk management, overpayment of fees and eventual losses due to hidden economic pot-holes are just a few of the possible nasties when valuation process is ignored. If it is true that banks themselves are struggling as to how to properly classify a holding(s), how will plan sponsors need to respond? As I said to Ward, The number is important, but it is more important to know why that valuation number is what it is, and if the factors that contributed to that valuation number are likely to change. People take a sense of false security from that one number."

If regulatory filing statistics portend more recategorizations to "hard to value" status, there will be an awful lot of nervous pension decision-makers, deciding what to do next.

Editor's Note: Click to read a "Summary of Statement No. 157," provided by the Financial Accounting Standards Board. Wall Street Journal reporter Mark Gongloff provides a nice overview of the FAS 157 hierarchy, defining Level 3 assets as those for which inputs are not directly observable. See "A FAS 157 Primer" (November 15, 2007.)