Supporters of fair value, or mark to market, accounting have some prestigious allies on their side: Nobel Prize winners Myron Scholes and Robert Merton.
Merton wrote a column for the Financial Times this week arguing that banks opposed to mark to market accounting just want to conceal depressed prices. Yesterday, Scholes joined him in urging banks to mark more securities to market and to put those that can’t easily be market on public exchanges to discover the value.
Scholes and Merton shared the Nobel in 1997 for helping invent a model for pricing options.
“I’d like to see us encourage many more securities held on the books of the banks be migrated to exchanges if possible,” Scholes told Boomberg Radio. Doing so would “allow for market discovery and market pricing as much as possible.”
“While regulators and legislators are keen to find simple solutions to complex problems, allowing financial institutions to ignore market transactions is a bad idea,” Merton wrote, in the article co-authored with Robert Kaplan, a professor at the Harvard Business School, and Scott Richard, a professor at the University of Pennsylvania’s Wharton School.
A bank typically argues that a mortgage loan for which it continues to receive regular monthly payments is not impaired and does not need to be written down. A potential purchaser of the loan, however, is unlikely to value it at its origination value. The purchaser calculates a loan-to-value ratio using the current, much lower value of the house. After calculating the likelihood of default, the potential buyer works out a price balancing the risk of default and amount that might be lost – a price well below the carrying value on the bank’s books.
The bank is likely to ignore this offered price, or trades of similar assets, with the claim that unusual market conditions, not a decline in the value of the assets, causes a lack of buyers at the origination price. Its real motive, however, is to avoid recognising a loss. Yet, by keeping assets at their origination value, the bank is also entertaining the curious possibility that its trading desk could acquire an identical loan at a lower price and then carry two identical securities at vastly different prices.
Financial assets, even complex pools of assets, trade continuously in markets. Markets function best when companies disclose valid information about the values of their assets and future cash flows. If companies choose not to disclose their best estimates of the fair values of their assets, market participants will make their own judgments about future cash flows and subtract a risk premium for non-disclosure. Good accounting should reduce such dead-weight losses.
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