Fair value: confidence trick

The first time mark to market was put into the spotlight was when Enron
collapsed; a key tool deployed for this confidence trick was ‘marking to market’
the value of future revenues from gas supply contacts.

Mark to market has been accused of under-valuing securities once the markets
turned, thus exacerbating the severity of the downturn, although accountants
have correctly pointed out that this yardstick quickly and efficiently exposed
the reality of past imprudence and the subject was effectively closed in

Clarifications have been put in place both by the SEC (in respect of US GAAP)
and IFRS to slightly water down the rules and allow some securities to be held
to maturity.

But the issue has not gone away. The latest surprise was the decline in
Barclays’ share price. Management was mystified ­ after all, this started only
one day after auditors had reported healthy profits. But the market did not
believe the valuations and an important reason for this was how many assets had
been valued ‘held to maturity’.

Markets did not believe the valuations of Freddie and Fannie, or Lehman
Brothers either, and until markets can believe valuations there will be no end
to the current malaise.

International Valuation Standards

As long ago as 30 July 2003, the International Valuation Standards Committee
wrote to the Bank of International Settlements to say that valuations used to
assess capital adequacy were ‘fundamentally flawed and bound to be misleading’.

As far as the record shows, they were ignored. Yet what appears to have just
happened was that valuations of assets and liabilities of financial service
companies all around the world, proved to have been just that, fundamentally
flawed and misleading.

According to international valuation standards, a valuation is an estimate of
how much money you are likely to get for an asset (or to pay to be released from
a liability) on the day that you decide (or are forced) to sell.

Mark to market and fair value accounting only give an idea of how much you
might have received yesterday. The difference is the fundamental clash that
international valuation standards have with fair value as it is defined under US

Mark to market served as a valuable tool in highlighting the depth and the
extent of the financial catastrophe.

But the defenders of this yardstick have overlooked that it is fundamentally
destabilising. It overvalues when markets are in what IVS calls disequilibrium
(on the high side), fuelling the disequilibrium by allowing more credit. And it
undervalues when the price is less than value, as is (perhaps) happening now,
cutting off credit.

Take, for example, the housing market. Houses were valued mark to market and
based on those valuations loans were written. From those, mortgaged-backed
securities were created and then bets were taken on those bets.

Sense of balance

It is clear now, that the market was in what IVS calls disequilibrium, and
that the true value of housing was much less than what the market said it was at
the time. If the ‘value’ component of the loan-to-value ratios of the mortgages
and the securities that relied on them, had been assessed using IVS, by 2005 the
value would have been 70% of the price. That might well have stopped the bubble
in its tracks.

Now housing is in ‘disequilibrium’ on the low side, yet holders of securities
are obliged to mark to market, even if they have no intention or obligation to
sell now. Now, the big buyers of wholesale credit, pension funds and insurance
companies, are not buying for fear that the bonds they buy will be marked to

And they are not selling because they know that held to maturity, many bonds
will come good.

Gordon Brown can bully banks to lend until he is blue in the face, but short
of starting a government bank with relaxed policies, little can be done until
loans can be sold on into the wholesale market. There was a system, which worked
well for many years, but now it’s broken. More regulation won’t fix it, what is
needed is better regulation.

Even after trillions of dollars have been put at risk in bailouts the
wholesale debt market is still inextricably stalled. There is no certainty that
more money will re-start it until markets start to believe the valuations. In a
recent blog post, Professor Roubini (who predicted much of the current financial
turmoil) suggests the UK is taking a dangerous gamble. The alternative is to let
some banks fail, as he once recommended, effectively preventing the bad apples
from infecting the half-bad ones. Deciding which is which, of course, requires a
more sophisticated yardstick than mark to market.

IVS explicitly distinguishes between market value and other than market
value, used when markets (on the day) are not a reliable benchmark. In such
circumstances, adequate market-derived data (from the past) must be used to
assess value and if markets are not working (on the day), this must be clearly

Estimating other than market value is harder and more expensive than the
simple expedient of marking to the market. And how other than market value might
be consolidated into financial reporting is problematic, it might require that
assets are valued one way for tax, another for the P&L and a third for the
balance sheet.

But perhaps the complexity of the man-made construct that is the financial
system, requires a system of valuation that can reliably deal with such

IVS were created after the Asian crisis for just this eventuality. They are
approved by practically every valuation institute in the world and as a United
Nations NGO they are truly ‘international’. IVS are ‘real-world’ tested and good
to go. Perhaps their time has come.

Andrew Butter is an independent analyst providing
valuation services in the Middle East

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