Deficiencies in Fair Value and Mark-to-Market Accounting

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.

Comments

[PT53]

Pulled out of thin air? I am sure that lots of this is going on. So, maybe you could cite an example or two, OK? Or did you not know that the rating agencies are revising DOWNWARD their assumptions on valuation based on GREATER losses than previously anticipated and the fact that mortgage fraud (buyer fraud, appraiser fraud, broker fraud) were becoming much more evident?

Sorry, but you can't use our free market economy on both sides of the argument, if the market says something has no value then that something is worthless and accounting principles must reflect that. And, I for one seriously doubt that mark downs taken today will suddenly reappear as profit in 6 months, which is what investors must be believing in order to be buying into financials at this point.

[David Enke]

PT53, thanks for reading, and your comments. Some companies, like Encana recently, are forced to take write-downs on hedging losses that may be temporary, and may not ever be realized if the hedge is held until maturity. Nonetheless, they have a loss this quarter, and must report it, even without selling. Other companies, in particular the financials, have it even tougher given that they cannot even price their security gains or losses.

It is kind of like selling your house. If your next door neighbor sells for a 50% discount, just because he is in need of cash, then all of the sudden any short-term appraisal of your property that uses recent selling prices could temporarily affect the appraisal value of your home, until of course the market corrects. Fortunately, if you are not selling soon, you may not care. But some companies don't have that flexibility. Others are selling debt at distressed levels (puking them up as they say in Wall Street elegance), and all of the sudden you have issues, even though you did not plan to sell anytime soon.

While you are right that companies may not be literarily pulling prices "out of thin air", when others sell at distressed levels, and then you get marked against it, it begins to feel that way, and makes it difficult for you to justify or describe a price that you don't understand, and that seems variable. No matter how you come up with a price for shareholders - using some type of valuation, mark-to-model, or using the last bid - it begins to look somewhat arbitrary. I am sure the Bear Stearns shareholders felt that way when offered $2 initially, yet had no way to know if that was even a fair value.

I would agree that many of the financials will probably not get to claim gains on the write-downs at a later time, but some, like Merrill for instance, might, given how they seem to have thrown in the kitchen sink during the recent transfer of power. The key is we just don't know in many cases, but still have to use something, even if it appears to be out of thin air. A little hyperbole? Maybe. But I think it illustrates how many of these companies feel. Thanks again for reading.