On Valuation, Frayed Nerves and Liquidity

Needless to say, we are in chaotic times. Balance sheet values are being questioned in portfolios across all industries and geographies. The banking sector, if not being brought to its knees, has been substantially weakened due to massive write-downs. Some have called for suspension of mark-to-market accounting practices, implying that it will somehow slow the downward spiral of asset values and market prices. Others feel strongly that this would be a big mistake, and that carrying values need to fall to their market clearing level, at which point liquidity will once again enter the market.

My issue is that I'm not sure either of these camps are really answering the fundamental question: what is a balance sheet supposed to tell me about a business? Today's value? Value as a going concern? And what if the value today impacts the ability to operate as a going concern?

Accounting practice has gotten it largely right from my standpoint as it relates to balance sheet classification. Short-term assets are those that are likely to convert to cash within a prescribed period of time. These assets have generally been carried at market value, subject to volatility and vagaries of market prices. Long-term assets are not expected to convert to cash within the prescribed period, and are therefore subject to "lower of cost or market" [LOCOM] treatment, with an adjustment for "permanent impairment." The concept here is that the asset should be carried conservatively, and that LOCOM does a good job of enforcing that intention. The problems, as we have seen over the past six months, are two-fold:

1. What if short-term assets don't have readily observable market prices?
2. What if long-term assets don't have readily observable market prices?

If short-term, supposedly near-cash assets don't have market prices because liquidity is poor and price discovery is almost non-existent, they need to be marked down to whatever level clears the market - period. And no funny business with trying to reclassify them as long-term assets, because that's cheating. One could supposedly make an argument for reclassification if they had both sufficient funding and the intention of holding onto the securities for the long term, but it would be a very, very difficult analysis to test the veracity of these claims. Absent such a bold move, the assets have to be marked down. Way down, to market clearing levels in private transactions. No questions asked.

I think the question as it relates to long-term assets is harder. However I think the definitive test for whether or not the asset needs to be marked down is a function of one thing: liquidity. If a firm has the financial wherewithall to finance its long-term book for an indefinite period of time, and if it is difficult to ascertain whether permanent impairment has, in fact, occurred, then I think there is a strong argument for carrying the assets at cost. But, and it is a big BUT, only if the two conditions I've stipulated hold. If not, then they are, in fact, short-term assets by virtue of their inability to be financed over a long time period. But I'd also make the point that footnote disclosure - very clear and transparent disclosure - should be provided to offer investors insight into the potential divergence between carrying value and market value. But for the company that doesn't need to sell the assets to continue as a going concern, and if they can argue that permanent impairment hasn't occurred, then the fluctuations in market value are simply moot.

The issue with today's financial meltdown is clearly one of liquidity and leverage. If the banks and investment banks thought the paper they held was good and felt the value was there, then ok. Except for one key point. By being leveraged to the eyeballs and practicing exceedingly poor gap management (the spread between the duration of assets and liabilities, where most money is made investing in long-term assets and funding them on a short-term basis), they've put themselves in the position of having to mark-to-market their troubled portfolios pursuant to the guidelines above. Because the magnitude of these portfolios are such that they can't assure the markets that they can be carried indefinitely. They can't. And it has put banks globally into a painful Catch-22. Sell the assets, lock-in their losses, substantially shrink their businesses and raise billions in new capital to reload. Or try and hold on to their assets, and play a game of chicken with governments and the financial markets. Neither picture is particularly pretty, but this is where we are.

So the answer of which accounting regime is appropriate isn't really the question. It is which fits the dynamic nature of the financial institutions business, where the management of assets and liabilities are inextricably mixed. And at a time when distressed, illiquid assets are being met by hostile capital markets, pretty much everything should be marked-to-market if logical and rational accounting principles hold. It is a sad state of affairs but here is where we are.