Mark to Fantasy, new Level 3 "Fair Value"

Discussion in 'Wall St. News' started by anvil993, Oct 17, 2007.

  1. Recently the Financial Standards Board, the private group charged with coming up with rules under which publicly traded companies must report their financial results, issued Statement 157 entitled "Fair Value Measurements." (1) Up until this time companies could generally use either "mark to market" or "market to model" to report assets and liabilities. The latter method is subjective by its nature and prone to abuse. A staff accountant armed with a spreadsheet in the back room can play with assumptions and inputs to gin up the bottom line in a way that allows management to qualify for the maximum bonus.

    However, in our sophisticated and enlightened business world these two methods were not enough to permit companies to report on their true results. So the accountants obliged by creating a new reporting methodology called Level 3. At the heart of this new "standard" is:

    "Unobservable inputs are inputs that reflect the reporting entity’s own assumptions

    about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances." (Page 21)

    When managers are trying to figure out how deeply to dig to come up with information to verify their unobservable inputs they can use this guidance:

    "Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions." (Page 24,emphasis added)

    This last loophole will come in handy when a trial lawyer asks the CFO why he carried Microsoft stock on the balance sheet at three times market value.

    It is no surprise that Level 3 was quickly called Mark to Fantasy.

    I think it is fair to say that a company will try very hard to classify assets in Level 1 (mark to market) or Level 2 (mark to model). Anything that goes into Level 3 has to be is in a pretty bad state. For example, few CEOs would be willing to take their bonuses in Level 3 assets.

    The accountants introduced Level 3 (Mark to Fantasy) at a good time. Martin Hutchinson just published a column (2) that describes the deteriorating quality of earnings and features shenanigans at Goldman Sachs as follows:

    "Goldman Sachs, for example, reported this week that the "Level 3" assets in its books, those for which liquidity is lowest and valuation most difficult, had jumped by a third in the quarter to $72.05 billion. These "Level 3" assets presumably don’t include Goldman’s multi-billion dollar holding of the Industrial and Commercial Bank of China, quoted daily on a stock exchange, however over-inflated its share price and illiquid its trading market. Instead, they appear to represent mostly derivatives and securitization assets linked distantly to mortgage loans and leveraged buyout deals, whose valuation is carried out by the operating unit itself, based on the price at which it would have to sell the asset to preserve its bonus pool from unexpected losses.

    "Set against Goldman’s capital of $36 billion, that $72 billion is a frightening figure. At some point, probably in a downturn, the real value of those "Level 3" assets will have to be recognized. No doubt the resulting losses will be written off against capital but even Goldman’s brilliant and gloriously paid accountants will find it difficult to write off $72 billion of losses against $36 billion of capital."

    So Level 3 assets are twice the size of Goldman’s capital. If the accountants hadn’t invented this timely gift Goldman Sachs would have a negative capital account. I don’t think Goldman Sachs could survive that write down. Goldman has contractual dealing with businesses around the world. All of those contracts probably have provisions that require the parties to stay financially healthy. Negative capital would trigger massive defaults. Many of the businesses, governments and foundations that Goldman does business with have charters that require their business partners to live up to exacting financial standards. If Goldman Sachs had negative capital could it underwrite bonds for California or act as a trustee for anyone?

    It appears that the only thing that is keeping Goldman Sachs alive, and enabling its executives to get their bonuses, is an accounting gimmick. If this is correct, the American economy is in very desperate shape. No wonder Hank Paulson looks stressed out.
    Hank Fellerman

    1. Statement of Financial Accounting Standards No. 157, September 2006.
    2. Martin Hutchinson, "Increasingly Elusive Earnings," October 15, 2007