Deficiencies in Fair Value and Mark-to-Market Accounting

by: David Enke

As recently reported on CFO.com and elsewhere over the last few months, the subprime crisis exposed some fatal flaws in the market. The first was the assumption that securities could always be sold and converted to cash. Obviously, this was not the case, making the prices of derivatives based on these assets also difficult to value. This, of course, further exposed the second major flaw - that of companies overlooking and not properly understanding their exposure to downside risk.

Of course, if Allstate, State Farm, or other property and casualty insurance companies can manage their risk, why can't the banks? In general, counterparty risk for financial assets is much different than the risk normally taken and managed by the large liability insurance companies.

With securities, risk takers cannot estimate the value of their liabilities with the same ease. With market prices, it is difficult, but not impossible. When the market refuses to give you a bid, it then becomes nearly impossible. For a natural disaster or other liability event, traditional insurance companies can within a short period of time get an estimate of the damage, their exposure, and the cost of any liabilities. For a non-traded asset, or at least one that is not offering a bid given that a credit event has occurred, not only do you fail to determine the size of the loss, but you also do not know the solvency of the counterparty. If you took out insurance with a monoline, or took some type of credit hedge position, then great, but chances are all you did in this environment was just double your counterparty risk.

To make matters worse, any negative event will affect your ability to raise capital, unlike the property insurance companies. When a damaging storm hits, then yes, the insurance companies will take a big hit and end up spending some of their float and capital base, but they can recover it back over the next year as they increase rates to cover past losses and new risk.

Credit risk has just the opposite effect. Increased risk lowers your credit rating, making raising new funds just that much more expensive. To add insult to injury, fair-value accounting will require you to take a write-down, even when you are not currently experiencing the impact of a change in credit risk given that you can still hold the asset while you wait for conditions to hopefully improve. These accounting rules cause the market to continue to experience these forced write-downs, even for securities that have not been sold, or may be sold later for less of a loss, or even a gain.

But this does not really matter since for this quarter the company is in the tank, or at least we think they are since no real price is available to mark against. To add to the uncertainty, it is difficult to tell how many of these write-downs will be unwound in later quarters, or how much market capitalization has been lost and not put to productive use as companies write-down losses that in some cases are temporary and pulled out of thin air.