SFAS 157: Market Prices Too Low? Just Ignore Them!

by: Barry Ritholtz

Here's a honey of an idea that almost slipped by unnoticed last week. Thankfully, the NYT's sharp eyed business columnist, Floyd Norris, caught it.

A SEC opinion letter advising companies how to deal with their Level 3 assets made a rather curious suggestion. They advised that if the prices of mark-to-model crappy paper are underwater, well then, declare it the result of forced liquidation -- and then you can simply ignore them.

It truly boggles the mind.

Would someone please explain to me how providing an official mechanism for allowing companies to ignore market values of the bad investments they made helps investors? Instead of working towards transparency, the SEC is providing a mechanism to allow banks to hide losses from their shareholders. This is nothing short of an invitation to commit fraud.

Here's the offending passage:

“Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.” (emphasis added)

Norris suggests this is an invitation for banks having two sets of books. One for Bank disclosures for shareholders: Ignore these paper losses, the prices are only due to a forced liquidation -- and another for Margin calls: Hey! You are underwater by XX% in this; send in more money! Apparently, the SEC believes prices are irrelevant, except when it comes to margin calls.

Stop and think about this for a moment: Every margin call is essentially a forced sale. Consider the alphabet soup of highly leveraged derivatives out there, where many of the most recent trades have occurred because some hedgie has blown up. What might the unintended consequences of this rule actually be?

Monday is the last day of the quarter. There is often window dressing to the upside the last few days before a Q's end to make the fund's performance look better. Imagine if there was an incentive to make a huge category of derivatives' last trade appear to be the result of a margin call? We would have this enormous window dressing down -- so as to not have to come up with a legitimate value for tier 3 junk.

This is a directive to banks to make the situation much, much worse. They can clean up their own books by forcing liquidations elsewhere. Un-fricking-believable.

Holy shnikes, have any of these people at the SEC every worked on a trading desk?

Source:

If Market Prices Are Too Low, Ignore Them
Floyd Norris
NYT, High and Low Finance
March 28, 2008, 6:21 pm