Banks Demand Fantasy Fair Value

Investors locked horns with the banking industry on Wednesday on whether U.S. regulators should suspend or change accounting rules used to value assets such as mortgage-backed securities.

Fair value accounting, which requires assets to be valued at market prices, has been blamed for billions of dollars in writedowns by some U.S. banks and policymakers. But investors and accountants say the approach gives investors a clearer window into banks' balance sheets.

The U.S. Securities and Exchange Commission was charged by Congress to produce a study by early 2009 analyzing the effects of fair value accounting rules on financial firms' balance sheets and examining alternative accounting standards. The SEC held a public meeting on Wednesday to gather information on the accounting rules, also known as mark to market or FAS 157.

Charles Maimbourg, senior vice president of KeyCorp bank, told the SEC that what management intends to do with an asset should help determine the fair value of the asset.

"You have to include management intent. They have opinions, they are in the best position to do that," Maimbourg said.

Under the fair value rules, assets can be valued based on a simple price quote in an active market. But hard to value assets rely on management's best estimate derived from computer models.

Given that there is no market for certain securities such as those linked to mortgages, banks say they have been forced to value assets at fire sale prices they could fetch in the current market. That is misleading, they contend, because the banks do not plan to sell the assets immediately and their value could rise in the future.

"There are loans that banks hold and intend to hold," said Maimbourg. "The fact that the market will only pay us 20 cents ... (is not) a reason to mark it down to 20 cents on the dollar."

Patrick Finnegan, a director at CFA Institute, disagreed and said allowing management intent to influence the value of an asset was an "insidious" idea.

Reuters

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This is quite astonishing. The idea is that by sleight of hand companies can massage their balance sheets to make themselves look better. Indeed, I heard one senior commentator on Bloomberg some days ago openly say that as far as he was concerned banks should value these "assets" at whatever level is necessary to make their balance sheets look good! A blatant public plea to companies to swindle their investors.

And as for the pathetic quote above, that just because an asset is now worth 20% of its "value" as it might be worth more in the future companies should be allowed to reprice it, they should call it "unfair value accounting" or "fantasy book value". That is the whole point of fair value accounting - by booking it to 20% now, if the value should rise to say 50% then that's a profit compared to the present valuation. By creating a fantasy valuation companies are not only misrepresenting their liabilities to shareholders they are also going to be presenting losses for years to come as they chip away at these "liability assets".

As an example, if I have an account with a broker I need to place a deposit for every trade. The beauty of leveraging is that I can place a fraction of the real value of the trade. This increases profits in percentage terms. However, if suddenly the market for an instrument evaporates and the price drops to zero, my broker is going to phone me and ask me to either put up the money for the whole trade or close that trade. If I say to him that surely this is just temporary and that once markets stabilize the value will look less distressed, the broker is going to turn round and say to me,"Sure, you may be right, but that's your risk! At the moment it is worthless - put up the money on the assumption it remains worthless."

Surely if a market in a particular instrument just disappears, that is telling us something important. The problem with leveraged trades is that one can lose more money than one has put in. If I buy a stock at $100 but only need to deposit 10% of the price, my liability is just $10. If the price rises to $110 I have made $10 profit. Notice that the asset price has risen 10% but my profit is 100% - that's the nature of leveraged positions. However, if the price drops to $50 I am $50 down with only $10 deposit. I have to find the money to cover that extra $40 loss. As far as my leveraged trade is concerned my asset, the stock, is actually a liability, and will remain so until the price goes back to $100. Perhaps these bank "assets" are worth negative amounts of money. Perhaps these assets should be moved to the liabilities column. Then we can see their fair value.