How to value toxic assets (part 3)

Continuing on from my previous thoughts (1, 2, 3, 4) …

In the world of accounting, the relevant phrase here is “fair value.”  In the United States (which presently uses a different set of accounting requirements to the rest of the world, although that is changing), assets are classified as being in one of three levels (I’m largely reproducing the Wikipedia article here):

Level one assets are those traded in liquid markets with quoted prices.  Fair value (in a mark-to-market sense) is taken to be the current price.

Level two and level three assets are not traded in liquid markets with quoted prices, so their fair values need to be estimated via a statistical model.

Level two assets are those whose fair value is able to be estimated by looking at publicly-available market information.  As a contrived example, maybe there is currently no market for a particular AA-rated tranche of CDOs, but there are recent prices for the corresponding AAA-rated and A-rated tranches, so the AA-rated stuff should be valued somewhere in between those two.

Level three assets are those whose fair value can only be estimated by appealing to information that is not publicly observable.

These are listed in the U.S. Financial Accounting Standards Board (FASB) Statement 157.  In October of last year, the FASB issued some clarification/guidance on valuing derivatives like CDOs when the market for them had dried up.

Brad DeLong, in early December last year, was given a list of reasons from Steve Ross why we might not want to always mark-to-market (i.e. assume that the fair value is the currently available market price):

• If you believe in organizational capital–in goodwill–in the value of the enterprise’s skills, knowledge, and relationships as a source of future cash flows–than marking it to market as if that organizational capital had no value is the wrong thing to do.
  • Especially as times in which asset values are disturbed and impaired are likely to be times when the value of that organizational capital is highest.
• If you believe in mean reversion in risk-adjusted asset values, mark-to-market accounting is the wrong thing to do.
• If you believe that transaction prices differ from risk-adjusted asset values–perhaps because transaction prices are of particular assets that are or are feared to be adversely selected and hence are not representative of the asset class–than mark-to-market accounting is the wrong thing to do.
• If you believe that changes in risk-adjusted asset values are unpredictable, but also believe:
  • in time-varying required expected returns do to changing risk premia;
  • that an entity’s own cost of capital does not necessarily move one-for-one with the market’s time-varying risk premia;
  • then mark-to-market accounting is the wrong thing to do.

Other posts in this series:  1, 2, [3], 4, 5, 6.