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Generational Dynamics Web Log for 14-Oct-07
How do you compute the "fair value" of a security?

Web Log - October, 2007

How do you compute the "fair value" of a security?

FASB Statement 157 doesn't help much because it ignores history.

For ten years, we've been increasingly in a world where investors have poured their money into securities that have no obvious value.

And, as each day goes by in the current liquidity crisis, it's more and more apparent that financial firms are scrambling to hide losses through deceptive or fraudulent practices. These losses come from having sold investments in CDOs and other structured credit securities at wildly optimistic prices that can no longer be sustained in the marketplace. In some cases, such as at Bear Stearns, the securities turn out to be almost totally worthless.

The practices include: refusing to reveal prices of assets to investors; hiding at-risk securities in separate "black-box" corporations known as SIVs (structured investment vehicles); deceptive or fraudulent sweetheart deals with other financial firms to establish artificial "market values" for assets.

The Financial Accounting Standards Board (FASB) has tried to help out by issuing a new accounting rule, Statement 157, to take effect on November 15, on how to determine the "fair value" of the securities that now turn out to be overvalued.

Unfortunately, I don't see that Statement 157 provides any help at all, for two reasons.

But first, let's summarize Statement 157. The actual statement can be found on the the FASB web site (or full text PDF file.)

The gold standard for the fair value of a security is its price on an open market: "The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is 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."

However, this method for determining fair value is useless if there's no open market for securities being valuated. (And many of the deceptive and fraudulent practices being used by financial firms today are tricks to avoid an open market valuation.)

The FASB statement provides three different types of valuation. Here's a summary of the three methods, as provided by the Wall Street Journal, in decreasing order of "precision":

Level 1 - "Marking to Market."
Valuations are based on "quoted prices in active markets for identical assets or liabilities." Prices appear on computer screens.
Assets in this category: Publicly traded stocks, listed futures and options, government and agency bonds, and mutual funds.

Level 2 - "Marking to Matrix."
Valuations are based on "observable market data" for similar or comparable assets, such as dealer-pricing services based on surveys or other market bids and offers. Fewer screen prices.
Assets in this category: Emerging-market government bonds, some infrequently traded corporate and municipal bonds, structured notes, some mortgage and asset-backed securities, and some derivativatives that don't trade publicly.

Level 3 - "Marking to Model." [[Called "Marking to Myth" by Warren Buffett.]]
Valuations are based on management's best judgment, and involve management's "own assumptions about the assumptions market participants would use in pricing the asset." The process can employ pricing models based on estimates of future cash flows or other formulas.
Assets in this category: Some real-estate and private-equity investments, certain loan commitments, some long-term options, and less easily tradable asset-backed bonds.

As I said, there are two problems with this new accounting rule.

The first problem is that it doesn't change anything; it simply encodes the practices that have caused the current problems. Except to handle some technical issues, there really isn't much point of issuing Statement 157.

The second problem is that it exalts market-based valuation methods, without recognizing the possibility of an asset bubble.

In particular, it doesn't even recognize bubble-independent historical earnings-based valuation methods.

Now, regular readers of this web site will immediately recognize that this is the sort of thing that I've been railing about here for years. In my article, "How to compute the 'real value' of the stock market," the current value of the stock market is computed by three different methods: historical earnings, historical growth rates, and historical book values. All three of these methods come to roughly the same result -- the real value of the stock market today is around Dow 5000, meaning that the stock market today is overpriced by a factor of 250%.

I'm not saying that FASB should prescribe historical methods as the preferred valuation method. What I'm saying is that FASB should give SOME RECOGNITION to historical methods. For example, a rule might specify the following: If market methods and historical methods differ by, say, more than 25%, then you must provide a justification for why the market price isn't a bubble price. (If the market price is lower, as would happen during a period of deflation, you'd have to justify the lower price in the same way.)

I like to joke that most people today seem to believe that the world was created ten or twenty years ago, and nothing that happened before that has any relevance to today.

That's the reason why Generational Dynamics has worked over and over through the centuries. People think that "old data" and "old events" are too old to matter. So when the same thing happens again, people panic and turn a crisis into a disaster. I doubt that a new FASB rule requiring some recognition of history would make any real difference, but it certainly couldn't hurt. (14-Oct-07) Permanent Link
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Generational Dynamics Web Log for 14-Oct-07 How do you compute the "fair value" of a security?

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Generational Dynamics Web Log for 14-Oct-07
How do you compute the "fair value" of a security?