Financial Times – 6/3/2008 –Asia Ed1 -Page 18An investor might be tempted to think these days that many of the largest banks in the world have suddenly and inexplicably swung into loss after years of reporting record profits. Chief executives have been sacked, hedge funds liquidated and once actively traded markets for low-risk assets are now virtually shut.
A large portion of the crisis of confidence now affecting global markets comes from non-cash losses reported as a result of the adoption of “fair value” accounting rules in the US. Fair value accounting was adopted in the US after years of debate and, in theory, provides more transparency than measurements based on historical cost.
Unfortunately, the subprime mortgage debacle in the US exposes the practical limitations of fair value measures.
Under current accounting rules, the fair value of an asset is the amount at which it could be bought or sold in a current transaction between willing parties. A quoted market price in an active market is the best evidence of fair value and should be used as the basis for the measurement. If a quoted market price is not available, “preparers should make an estimate of fair value using the best information available”. Most of the losses reported by global banks are based on such estimates.
Consider the financial statements of bond insurer MBIA. MBIA reported a Dollars 3.5bn loss in the fourth quarter of 2007 due to fair value adjustments to its illiquid credit derivatives portfolio, but the actual cash impairment was just Dollars 200m. More, MBIA states that these estimated paper losses may be reversed in future periods. MBIA could conceivably be forced to write off most of its book equity under fair value accounting, yet still meet its statutory capital requirements on a cash basis. How does such a presentation help investors?
Unfortunately, in many circumstances, quoted market prices are unavailable for most assets, even assets that are listed on exchanges. Professor Joseph Mason of Drexel University in Philadelphia told this writer last week: “Only a very small portion of the market has deep prices. Academics who sit in their offices think that markets are deep. Get outside of the couple of hundred most active stocks on the NYSE and the fallacy becomes apparent.”
Fair value accounting is a utopian concept that traces its intellectual roots back to the same origins as efficient market theory, the wellspring for most of the discredited quantitative models employed by the global banks to create the subprime mess. Unfortunately, the proponents of fair value accounting ignored the invocations of classical theorists who stated that liquid markets are a necessary condition for using market prices, either as a surrogate for measuring risk or for valuation.
Fair value accounting is a good idea in theory, but like most good ideas it is difficult to implement. Sylvain Raines, a lecturer at Baruch College in New York, told a meeting of the Professional Risk Managers International Association last September: “The Chicago School of Economics has been telling us for a century that price and value are identical, i.e. that they are the same number . . . If we do not recognise the fundamental difference that exists between price and value, then we are doomed.”
Given that most securities and loans do not have liquid, actively traded markets, it seems fair to ask: why did the US adopt the fair value accounting standard in the first instance?
While it may be reasonable to apply fair-value rules to actively traded securities, for the vast majority of assets that are illiquid, historical cost remains the only reasonable and consistent way to report the value of financial assets.
Christopher Whalen is the co-founder of Institutional Risk Analytics
Tags: fair value, Fair value accounting, financial times, investor, market price, profits
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