Wednesday, October 01, 2008
The SEC is on the mark
The SEC listens to TigerHawk (and many other more influential people)!
Two weeks ago we looked at whether post-Enron accounting "reforms" had contributed to the current financial crisis by forcing financial institutions to value securities according to their market value in a distress sale rather than by estimating their future cash flows. Well, the SEC has heard our distress:
The Securities and Exchange Commission and the Financial Accounting Standards Board have just made an announcement that, dry as it sounds, may mean a great deal: "When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable."
Our wise and experienced readers should weigh in. My reaction, though, is that financial transparency is impaired, rather than served, by requiring that companies always measure the "fair value" of securities according to the price they would receive if they had to sell right now, today, to the highest bidder. Some days there are no bidders, but that does not make the asset worthless.
5 Comments:
By 
Charlottesvillain, at
Wed Oct 01, 10:19:00 AM:
I think this will help with regulatory capital, but I don't think it will help interbank lending. It is likely to further muddy the water. You are right that it is hard to place a "market value" on illiquid assets, particularly in times of crisis. The problem is that the value for many of the assets at hand does in fact approach zero. (See ABS CDO market). Management at these institutions needs to find a way to establish credibility in their estimates, or people will think they are over valuing worthless assets. More transparancy is needed here, not less.
By RiverRat, at
Wed Oct 01, 01:01:00 PM:
The value does not approach zero. Your talking about land and the replacement cost of the improvements, ultimately. If these loans which were subsequently securitized with implicit government gaurantees had been subject rational LTV ratios and had not been fueled by a monetary policy restricting the free market cost of capital we wouldn't be here.
This is simply Washington making the taxpayer the lender of last resort for political gain. A pox on both parties with emphasis on demogoguecrats.
A lesser pox on investment bankers who erroneously took Washington policymakers seriously.
I spent 35 in financial services. The last 15 as CFO of a large investment management firm.
What's really funny in all if this is that in 1986 I sold all of financial services sector assets and bought Treasury securities. I largely did the same in the spring of 2007.
I could not give you a reason other than my "gut" telling me these companies were overvalued. Maybe it's better being an observer of many years than an analyst.
By 
, at
Wed Oct 01, 05:36:00 PM:
The value of these assets CAN approach zero, since many of the assets held are claims on securitized pools, and claims in lower tranches (e.g., the residual tranche) can easily be worth zero.
I don't believe that fair value or mark-to-market accounting requires you to mark the assets to fire-sale prices, only that you determine the value of the asset that a reasonable buyer would pay (in a non fire-sale situation). The problem with moving away from fair-value accounting is you open the box to all sorts of valuation methods that may or may not reflect the true value of the underlying cash flows. Often, non fair-value methods are a way for a company to cover-up crappy assets.
By Escort81, at
Wed Oct 01, 06:43:00 PM:
Anon 5:36 (and 'Villain) is correct to distinguish between a (presumably) collaterized conventional first mortgage loan, which will always have some positive value provided that the land and the house have some post-foreclosure value, which is quite likely, and some other type of instrument that is derived from the mortgage or pools of mortgages. Think of a plain vanilla call option on a stock that you might buy, because you think the underlying stock will rise in price, but you want more leverage to that forecasted rise -- you buy a slightly out-of-the money call, but the stock stays flat and the call expires worthless. Not a perfect analogy, but an example of how any kind of dervived security can go to zero.
The question about M2M becomes almost philosophical, one that I am sure the AICPA and FASB members must be somewhat bemused that the general public is now ruminating over. What are the benefits and detriments of carrying assets or instruments at book value or FMV? Should there be a bias toward undervaluing or overvaluing items on the balance sheet? In which direction is there a higher probability of misstatement? What's the point of financial statements anyway?
As to the SEC's language, what constitutes an "active market?" If trading volume is reduced by 80% from the previous quarter's average daily volume, but there are still dozens of trades per day in the particular instrument, and bid/ask spreads (an indicator of liquidity) are not awful, is that "active?" Or can the institution holding the instrument say, nah, we liked the value earlier in the year, we don't think this is active enough. Maybe this is not a great example, but there does need to be some firmer guidance here.
If the point of all this is to try to create barriers to a cascading series of capital calls as the balance sheet of a financial institution apparently weakens, then maybe a mulligan or safe harbor provision like this makes sense -- "when you are holding a lot of crap, we'll let you wait until the price of crap recovers before you have to make an accounting entry." Of course, not holding crap in the first place would be helpful.
By MEANA55, at
Thu Oct 02, 12:00:00 PM:
The unintentional consequence of M2M is more opacity. There is no point to trying to determine a true value for any "toxic" asset if the only value that anyone will sign-off on is the the most recent sale regardless of circumstances. Under M2M, asking about the real value of an asset is a trick question, so don't risk legal action when the only "correct" answer is "don't know—better put zero."
Once upon a time early in my career, the ethics officer and Chief Counsel for the organization that employed me explained that his job entailed much more than simply keeping the organization within well established ethical boundaries. In his curmudgeonly phrasing (still seared in my brain nearly twenty years later), "any non-illiterate jackass can do that." His estimation of his charge was to make things happen around the fuzzy edges.
Post-Enron and under SOX, American business has been operating under the tyranny of non-illiterate jackasses.
