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Wednesday, 1 October 2008


Commentators are somewhat confused about "Fair Value" accounting. Some think it only means marking-to-market (MtM). The general definition is the price that is most likely to be agreed between a willing seller and a willing buyer in an open liquid market between unrelated parties. In disorderly, abnormal, turbulent or illiquid markets i.e. a severely one-way bet buyer's or a seller's market, then holders of the assets may deem them not for sale ("for holding to maturity", or not available currently for imminent sale etc.) and create a longer term valuation (fair value). The global accounting body behind IAS, now IFRS, the AIBD (The International Accounting Standards Board founded on April Fool's Day, 2001) has issued standards in recent years that provide flexibility in fair value, but Dr Tweedie, its President, insists vehemently in the absolute necessity to MtM wherever possible. Banks have used a fusion of MtM and long run, even cyclical, fair value estimates, sometimes including aspects of VaR, historical and NPV and other cross-correlations, and then called the writedown "an adjustement for market turbulence." The AIBD fear that this complexity gives too much scope for gaming. Now, the SEC has stepped in with concessions to securities traders and investment funds, prime brokers and hedge funds.
Yesterday, the SEC reprieved them from marking hard-to-value assets down to fire sale prices, following SEC Chairman Christopher Cox and a bipartisan group of more than 60 U.S. legislators who urged the SEC to suspend the fair value accounting rule immediately - and stock markets rose on the news. Valuation problems lie at the heart of the credit crunch crisis, and that this move may slow or reverse announcements of mortgage-related losses on banks' balance sheets. Basically, the SEC states that firms need not use fire-sale prices when evaluating illiquid assets, that "distressed or forced liquidation sales are not orderly transactions." The U.S. accounting standards body, the FASB said it would change the agenda for its Wednesday meeting to focus on fair value accounting and issue further guidance same day! Yesterday was the last day of Q3 for most U.S. companies, allowing them to incorporate the changes in their quarterly statements. Management's internal model assumptions can be used to measure fair value when relevant or reliable market prices do not exist. The American Bankers Association had been among several bodies pressing the SEC to clarify the rules for months.
The fact is, however, that complex mortgage securities until a year ago traded in one-way markets, and liquid secondary cash markets never took off despite the $trillions involved! The difficulty or reluctance to flip (sell-on) ABS, RMBS etc. and simply to use them as high grade collateral spurred on a massive credit derivatives OTC market that created 10-20 layers of insurance and hedging cover of the underlying, much of which is short term and will unravel during this month. Critics have complained that accountants forced banks to base their values on fire-sale prices in illiquid markets instead of the so-called level 3 input (for illiquid assets and unobservable factors, using various internal risk pricing estimation models). But until Basel II is fully implemented such black box models cannot be strictly supervised.
This move will bring relief to Hedge Funds after a bad year and rumours of investors withdrawing funds, though at the same time may frustrate vulture hedge funds looking to buy at fire-sale prices. There are warnings afoot about this. Reuters reports Chris Whalen, co-founder of Institutional Risk Analytics, saying "Fair value accounting is a utopian dream that ran into the reality of business and litigation," and "Equating an opinion with a market price is crazy," and "It doesn't matter who gives the opinion -- the auditor is still going to say to the client, 'Why don't you write it down?'"
Note: accounting rules define a "Level 1" asset as MtM based on a simple price quote in an active market. "Level 2" assets are "mark-to-model" s estimated based on observable market prices plus other data inputs. A "Level 3" asset is so illiquid its value is based only on management's best estimate derived from complex internal models.

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