Mark-to-market accounting I

SFAS 157, issued by the FASB in 2006, became effective for financial assets and liabilities issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. It defined fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition applies to assets that are held for trading – not to assets held for investment or to maturity.
From this definition of fair value follows a three-level hierarchy of valuation based upon the type of inputs available:
• Level One inputs include directly observable market data, such as quoted prices in an active and unimpaired market;
• Level Two is applied when a market is impaired (such as the market for bonds at mid maturity), and value is derived indirectly from the prices of Level 1 assets;
• Level Three is applied when the market is inactive (such as the market for mortgage-backed securities in recent months) and value can be derived from management projections and modeling.
For a more complete account, see “Mark-to-Market Accounting in the Absence of Marks,” The Hedge Fund Law Report, Vol. 2, No. 1 (January 8, 2009).
Many institutions have complained that this system, combined with the incentives of auditors, is far too niggardly in allowing managements to move down the hierarchy from one to two, and from two to three.

They found academic support too, for instance from James Angel, Associate Professor of Finance, McDonough School of Business, Georgetown University.

I spoke to Mr. Angel not long ago, and he asked me to consider a hypothetical asset that a bank or hedge fund has purchased for a dollar.

“The management believes in its heart of hearts that its present value is $0.75. But nobody is buying that sort of asset right now, except for a bottom-fisher who offers them a nickel. Under mark-to-market strictly applied, it is worth a nickel.”

But, Angel continued, the fact that management chooses to hold on to it is evidence that it is in fact worth more than a nickel. “Its value is somewhere between 5 and 75 cents. I believe in a mark-to-management approach that would explicitly take account of management’s own view of asset value.”

More tomorrow.