Fair Value accounting should be changed immediately. It does not work when there are no market prices. If we had Fair Value accounting, as interpreted today, in the early 1990’s the United States financial system would have crashed. Accounting should not drive economic activity, it should reflect it.
–John Allison, President & CEO of BB&T, in his letter to Congress: Key Points on “Rescue” Plan From A Healthy Bank’s Perspective
The current guidance for fair value accounting is seriously flawed. There is supposed to be a clear distinction between value in the normal course of business and value in liquidation. Setting the value of an asset at what some other company can get for it in an emergency sale is just wrong.
That said, any valuation on a credit default swap is no more solid than cotton candy. Interest rate swaps, no problem at all. Currency swaps/carry trade? Not as clean, but no big problem. Credit default swaps? Forget it. Take a SWAG to as many decimal places as you like, but you’re only refining your ignorance. Two different valuation models, legal disagreements over what constitutes a “credit event,” squishy estimates of the likelihood of one of these “credit events” — sorry, but the Magic 8-Ball is cheaper and works about as well. More later, I hope. (Reply hazy, try again.)
“Accounting should not drive economic activity, it should reflect it”…this sounds good, but is it really true? I guess you could say “The altimeter should not drive the flight of the airplane, it should reflect it”…but if the altimeter isn’t accurate, then (in non-visual conditions, at least) something very bad is likely to happen.
As a letter in today’s WSJ points out, banks have been financing long-term assets with short-term funds. If you have a CDO with a maturity 10 years out, and you need the money **now** because your financing dries up, then the current market price of that CDO is very relevant indeed.
The problem is that you can’t get financing because poorly conceived accounting rules arbitrarily devalue your assets. Mark to market doesn’t work for illiquid assets.
If Bank “A” just sold a particular tranche of a particular CDO for 40% on the dollar, and Bank “B” holds the same security, then the best available information as to the *immediate* value of that security to Bank “B” is 40%. It is true that this may be pessimistic due to illiquidity..but it is also true that a hold-to-maturity valuation must be based on a DCF using assumptions about the default probabilities of the mortgages in the pool over the entire future life of the security, and these assumptions are pretty subjective. And it’s also true that if Bank “B” has financed its operations largely with short-term money, it may find that it has to sell the security in question *now* and the fire-sale price is in fact the relevant one.
-Fire-sale transactions give information about fire-sale prices, but why should such prices be used for accounting purposes? It’s as if mortgage lenders refused to lend more on a house than the amount of money you could get for the house if you had to sell it overnight. Any calculation of value will be arbitrary to some extent, in the absence of a liquid market. Why use the worst-case liquidation value as a standard in cases where asset owners almost never sell their assets at such low prices?
-The practice of linking, for regulatory purposes, firm-capital requirements to the liquidation values of illiquid securities portfolios creates a risk situation similar to that created by “portfolio insurance.” Problems at one or a few firms that result in fire-sale asset liquidations create a cascade in which other firms’ capital is suddenly devalued. The firms scramble for capital, not for operational but solely for regulatory compliance reasons, leading to further liquidations, lower asset values, huge demand for additional capital, and ultimately bailouts, inefficient mergers, etc.
I agree with the thought that ‘mark to market’ is not working in today’s environment. However, I would be opposed to carrying assets that are seriously diminished at full value… particularly in today’s moral climate where anything goes.
Remember, the reason for valuing certain assets at market value was the practice of some companies deceiving the marketplace by inflating their value (and income) by carrying assets (usually created by accountants) at a ridiculous value.
That leaves the Federal Government… who, one could argue, started the whole thing anyway. We elected the bums, we get to pay the piper.
In the end, there is no substitute for ethics in finance/accounting. Relying on hard rules (as opposed to standards) always creates situations where the rules break down and potentially takes the system down with it. And on top of that, unethical people can still game the rules, they just need to be smarter. Accounting always involves judgements and tradeoffs – it is an attempt to roll up all the complexities of a firm into a single set of numbers. If the key people in a firm are corrupt, no rules will prevent the results from being a sham – the best you can hope for is that the auditors notice something suspicious.
You see the same thing with ethics in government. Ethical people simply need guidelines as to what is expected of them. No amount of “ethics” rules can keep an unethical person from being corrupt – “no, no – that wasn’t a bribe, subsection C paragraph 6 clearly implies that …”