Here is a simple illustration to understand the thrust of this article: Last year, Ah Chong bought an apartment for RM900,000 in downtown Kuala Lumpur. His real estate agent says it is worth RM800,000 today. Banks are not lending, so no one is offering to buy Ah Chong’s apartment. A drunk that Ah Chong met at the bar said he would pay Ah Chong RM50,000 for the apartment. The mark to model amount is RM800,000, while RM50,000 is mark to market. How much is Ah Chong’s apartment worth? If he used it as collateral for a loan, how much would you lend him?

Many of us would take the real estate agent’s valuation with a pinch of salt and try to substitute it with our own perception of its value, depending on whether we are the buyer or the seller. But most of us would definitely reject the valuation of the drunk as being totally crazy! Therein lies the dilemma for the banking world as it attempts to tackle the financial crisis and set things right.

After much wrangling and grilling by the US Congress, the Financial Accounting Standards Board (FASB) —an independent US organisation that sets the rules for accounting practices — voted on April 2 to change a key rule that could help restart credit markets, which have mostly ceased to function since the onset of the financial crisis. The rule is commonly referred to as “mark to market”, and forms the accepted basis on which most assets are valued. The change from the mark-to-market accounting rule to one that will give more leeway to banks in determining how to value some of their most troubled assets will definitely improve credit flow.

Mark to market is an accounting principle under internationally recognised generally accepted accounting principles (GAAP) that says an asset should be measured by the price it would fetch if sold at the prevailing market price. It is considered a component of so-called “fair value” accounting, which maintains that the marketplace should measure the worth of an asset, not the entity holding the asset.

Although the concept of marking asset values to market prices is generally considered one of the more positive aspects of a financially sound country, the financial crisis has shown that the rule can trigger some harmful effects. As companies in weak financial positions are forced to raise capital, they engage in distress sales that drive asset prices down.

Unfortunately for their financially healthier peers, these asset declines are then reflected in their books as well under the mark-to-market principle, regardless of whether or not they themselves intend to sell. Since banks are required to prove that they have a substantial portion of their total assets in liquid form — that is, readily convertible to cash — this can make banks turn technically insolvent through no fault of theirs. Lending grinds to a halt as a result as these healthier institutions have to raise cash, yet dare not lend any out.

However, asset managers have a real problem valuing illiquid assets in their portfolios even though many of these assets are perfectly sound and the asset manager has no intention of selling them. Mark to market prices should not be used in isolation in my view, but rather should be compared to model prices to test their validity. Models should be improved to take into account the greater amount of market data available.

The rule change by FASB means that banks and other financial institutions can now use a great deal more judgment and foresight in expressing the value of previously distressed assets. Securities backed by real collateral, like mortgage-backed securities, can be held on balance sheets closer to what the company expects to earn on them in the long run. This should help to unclog credit markets by improving capital ratios of firms that adopt the new rules. More capital means more credit flow by enhancing both investor confidence in the firms and freeing the firms to write more loans.

Proponents of the mark-to-market rule would point to the fact that Warren Buffett decried the traders of Wall Street for “marking to myth” their assets as they sold untold trillions of those to the ill-informed. But it must be noted that the traders were using or abusing models to price these assets where miraculously, the models always seemed to offer high valuations. This has given the process of mark to model a bad reputation. What Buffett was really criticising was the bubble in valuations caused by the systematic underpricing of risk. This was exactly what happened during the dotcom bubble where analysts extrapolated forecast profits into multi-billions for companies that had not even made a single dollar of revenue, and then sold overpriced junk stock to unwary investors.

As illustrated by our example at the beginning of this article, just because there are no buyers for your asset does not mean that the asset is worthless if (and this is a big if) you are not a forced seller. The core issue is whether you need to sell your asset to raise cash. If you are not in a rush, over time the market price will recover. Many fixed income assets are bought and held to term (with no leverage). Provided the issuer does not default on interest or capital, the asset has the value of its cash flows and principle. So if you have such assets and a long-term investment horizon and no liquidity issues, how should you value these assets?

What happens if you are put in a perverse position where you have to mark the value of your assets down to a level where your terms of reference force you to sell them? Mark to market is good for transparency, but where there is no liquidity, does this approach still work?

In the housing market, the forced sellers are the people who have defaulted on their mortgages, are divorcing or have inherited a property and want to get cash quickly. These are the asset sales that, at the margin, define the market price. Until this overhang of supply works its way through the system, there will be no motivation for buyers to pay more. I am not arguing that one should ignore the market but rather that blind faith in it does not make sense and that the law of unintended consequences can play havoc as a result. Rules that enforce one approach can have perverse results.

Even when Buffett buys an asset, he uses his own model for determining whether the asset is good value or not. Sometimes, he will pay more than others for a given asset. He works out the price he will pay and then he sticks to it. This is a good example of making the market come to the model price. Buffett’s model is based on a fundamental approach to valuations that stays consistent irrespective of the market pricing and he maintains the discipline of sticking to his model for valuation even if he has to wait several years to buy.

It must be remembered that a valuation is not the same as a transaction and in times of stress, a dogmatic application of rules can cause more harm than good. There is no harm in challenging “market” prices if they seem skewed, and the best way to do that is to have alternative opinions in the form of independent model prices. New methods and new data are available to help improve models and these should be used. In the end, all prices start off from a model.

Jason Leong is executive director at Paddy Schubert Consultants Sdn Bhd



This article appeared in The Edge Malaysia, Issue 753, May 4-10, 2009