Some Mark-to-Market Concerns about Liquidity

This article is in response to Neil O'Hara's "The Unfair Attack on Fair-Value Accounting."

In early April of 2009, FAS 157, the mark-to-market accounting statement, was amended amid great controversy. Depending on the categorization of an asset (as belonging to one of three “levels”), FAS 157 had required firms to value financial assets on a mark-to-market basis. Level three assets such as mortgage-backed securities and collateralized debt obligations were subject to this requirement, even though, unlike traded securities, they did not benefit from liquid markets. The new rule gives firms greater discretion as to how level three assets are valued, and allows them to take into consideration the illiquid market for these securities.

While adherents of fair-market valuation as it existed before the change may have been right to point to its transparency, critics have been equally justified in asking under what circumstances a fair-market value actually exists. Suppose I own a table and I see an identical table at a yard sale for $10. Does that mean my table is worth $10? A strict reading of the previous mark-to-market valuation would have implied that the table would be valued at $10, even though the yard sale is not a particularly liquid market. Banks feared this type of valuation, which contributed to the FAS 157 revision.

The table below reveals the significant amount of level three assets held by banks and corporations. Note the number of cases in which the ratio of level three assets to equity exceeds 100%. Then consider how much equity would have vanished with a 50% reduction in the value of those assets, as in a distressed valuation under the previous version of FAS 157.

Ultimately, the goal of disclosure of financial assets is to improve security price efficiency. Yet the suspension of short selling last fall took place very quickly, with minimal discussion, because the immediate imperative of preserving the financial sector from total collapse trumped efficiency as a priority. A similar logic—the immediate imperative of preserving the banking system—applied when FAS 157 was amended, though the fair-value controversy far exceeded the controversy attending the suspension of short selling.

The situation is difficult but familiar. Past investment schemes—portfolio insurance, for instance—have tended to fail when confronted with a liquidity crisis in the market because the underlying assumption of such schemes is perpetual market liquidity (in other words, there are no yard sales for securities). Our unwillingness to face the effects of illiquidity, then, has undone us before.

The change to FAS 157, while a positive advancement, constitutes only emergency treatment of the illiquidity problem, not preventative care. Regulatory bodies should not consider this mission accomplished. They must continue to investigate the problem, and to make substantive changes to account for illiquidity.

Level Three Assets Reported by Banks and Corporations

Company	Level Three Assets	Ratio of Level Three Assets to Total Financial Assets	Ratio of Level Three Assets to Equity
IndyMac Bancorp	$11.00B	91.55%	1147.13%
Morgan Stanley	$78.38B	18.98%	226.10%
Lehman Brothers Holdings	$41.34B	16.62%	214.41%
Merrill Lynch	$61.03B	14.57%	205.15%
American Capital	$9.01B	100.00%	178.05%
Allied Capital Corporation	$4.21B	100.00%	174.38%
Citigroup, Inc.	$157.64B	20.94%	159.82%
Goldman Sachs GP	$67.87B	9.62%	159.69%
UBS AG-REG	$73.70B	7.10%	158.80%
Hartford Financial Services	$19.94B	7.60%	158.77%
Principal Financial	$8.30B	7.20%	147.89%
Prudential Financial	$27.31B	7.44%	146.06%
Allstate	$20.35B	17.61%	120.16%
Metlife, Inc.	$25.97B	7.10%	108.06%
JPMorgan Chase	$144.66B	17.79%	105.06%
American International Group	$60.77B	9.36%	85.37%
Wells Fargo & Company	$34.77B	25.81%	75.05%
Wachovia Corporation	$25.20B	15.07%	62.71%
State Street Corporation	$7.91B	8.77%	60.55%
Genworth Financial	$6.28B	9.87%	59.80%
Lincoln National Corporation	$5.12B	3.84%	53.87%
Bank of America	$59.93B	10.92%	43.78%
WaMu, Inc.	$9.89B	27.73%	43.58%
Capital One Financial	$4.62B	15.56%	18.03%
General Electric	$15.29B	29.22%	13.61%
Verizon Communications	$4.76B	69.77%	9.34%

Source: Bloomberg, December 5, 2008.

–The authors are affiliated with the Robins School of Business at the University of Richmond, where Tom Arnold is an associate professor of finance and the F. Carlyle Tiller Chair in Business, John H. Earl Jr. is an associate professor of finance, and Michael Weiss is a student. They thank Rodney Sullivan for his helpful comments.

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