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Marking to moral hazard

This entry was posted by Sam Jones on Monday, March 31st, 2008 at 9:50 and is filed under Capital markets. Tagged with sec, SFAS 157. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

1. Mar 31   16:18 Posted by Paul Murphy [report]

   This debate rumbles on….

   Barry Ritholtz at the Big Picture - Market prices too low? Just ignore them.

   http://bigpicture.typepad.com/comments/2008/03/sfas-157-market.html

2. Mar 31   15:48 Posted by VP [report]

   Does remind me of that old shares adage: “It’s not a loss until you realise it”.

   Then again - I do sympathise slightly with the banks, when it’s a balance sheet valuation issue. If they were to become forced sellers, then it’s totally different.

3. Mar 31   12:57 Posted by Paul Amery [report]

   Over and over again since the start of the credit crunch I have heard comments like “the ABX indices don’t reflect reality”, “you won’t incur losses on an AAA MBS if you hold to maturity”, “mark-to-market doesn’t make sense in these exceptional times”. This only goes to show how early we are in the bear market. The price of any financial instrument is what someone is prepared to pay for it - full stop. It is unsurprising that the SEC is compounding its earlier errors by proposing to let banks off the hook, but this will merely prolong the downturn as all the banks will know their counterparties are lying on real losses (since they all are), and the lending seize-up will continue.

4. Mar 31   11:14 Posted by Sam Jones [report]

   Carlo, ADM - I agree that the issue isn’t as totally clear cut as my above post might indicate. The AICPA white paper sets out a lot of the nuance and is worth reading. The point though, I think, is in the manner in which the SEC is highlighting the issue now and in such a direct way, to CFOs. It’s an invitation to use the distress sale caveat more than has hitherto been applied. In light of Carlyle, Peloton securities sales, it’s particularly telling. That’s my take anyway - perhaps I’m reading too much into it! Interesting debate though.

5. Mar 31   10:49 Posted by pegnu [report]

   Monkey - of course the other problem is that trust in financial institutions is so low that you’d rather avoid going through a hedge fund!

6. Mar 31   10:46 Posted by Carlomagno [report]

   Or to put it another way, the SEC doesn’t get to decide what constitutes “forced” or “distressed” transaction, the auditors do. And - as per the papers I referenced - they have apparently already decided to take a restrictive approach, probably because they don’t want to get sued into oblivion.

7. Mar 31   10:45 Posted by ADM [report]

   Agree with Carlomagno. This comment about “forced liquidation or distress sale” is just giving a definition of what doesn’t count as an “orderly transaction” in the sense used in the second paragraph of the FASB describing SFAS 157 (link in Sam’s original post). That paragraph defines the exchange price notion underpinning fair value as “the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability”. The next paragraph makes the point that “fair value is a market-based measurement, not an entity-specific measurement” - if institutions had to include prices from distressed sales, they would be making measurements specific to the entities making the distressed sales. However, all that being said, it does mean that accountants and auditors should be demanding a high standard of proof that a transaction to be excluded from anyone’s model was indeed distressed.

8. Mar 31   10:39 Posted by Monkey [report]

   Pegnu - I think you would have to do it via a hedge fund. There are a few out there specialising in Lev Loans - some are even listed. You could play the index but the real value is in the cash loans rather than the derivatives. The legal docs and complexity around booking this type of corporate debt makes it difficult for retail investors to step in without prior experience. Which is part of the problem.

9. Mar 31   10:24 Posted by pegnu [report]

   i wonder if there is any way of investing in this under-priced debt as a retail investor

10. Mar 31   10:20 Posted by Carlomagno [report]

    Sam, I think you might be making just little too much out of this. For a comprehensive discussion of the issue see the paper issued by the AICPA’s CAQ last October:

    http://tinyurl.com/23udkt

    While this clearly cautions against abusive appeals to “forced” or “distressed” transactions, it does not rule out the possibility that such may exist. See in particular the section on Illiquid Markets Vs. Forced Sales starting at the end of page 3. At first sight, the quotation from the SEC you hihlight does not seem to trangress the CAQ’s paper.

    For similar discussion in the context of international accounting standards, see:

    http://tinyurl.com/2rqoqm

    I hope those links work out OK.

11. Mar 31   10:17 Posted by VP [report]

    Don’t disagree Monkey; the prob. is in allowing the banks/their compliant auditors to decide where fair value is.

    Only reasonable way to determine fair value is in a market - and back round the problem goes.

12. Mar 31   9:59 Posted by Monkey [report]

    Unprecendented times may call for unprecedented measures. I know that most Aplhavillers would prefer drastic write downs now to avoid long drawn out pain but these write downs are, as I have been saying, creating a negative feedback in the credit market that is producing some absurdly low valuations. When you see big, cash generative companies with modest leverage yielding 18% p.a. on their debt even though most market commentators agree defaults are unlikely does it really make sense to take a mark to market loss which, on the balance of probabilities, will not be realised and which will probably result in the forced unwind of more of the debt. Divisive subject I know.