Fair value accounting

Earlier this week, the US Securities and Exchange Commission (SEC) released a 259 page study on mark to market accounting as required by the TARP related legislation. The study contains a lot of useful data about the extent of mark to market accounting in the US financial sector as well as the extent to which fair value accounting uses opaque valuation methods (Level 3, often called “mark to myth”).

The key takeaway is that for all the “modernization” of the financial sector that we read about, mark to market accounting covers less than half of all assets of the large financial firms. The percentage of assets where fair value changes impact reported profits is even lower at 25%. It is only the (erstwhile?) broker dealers who have practically all their balance sheet in fair value or in short term assets whose historical cost is practically the same as fair value. The insurance companies have a large percentage of fair value assets, but insurance is an industry where the valuation of liabilities matters more than the valuation of assets. For banks, less than a third of assets is at fair value.

The percentage of fair value assets which is in Level 3 is not too bad at around 10%. What I found more troubling is that around three-quarters of fair value assets are Level 2, leaving only about 15% for Level 1. This is a measure of how little of the financial sector assets are traded in exchanges or other liquid markets as opposed to opaque OTC markets. This is another respect in which the “modernization” of the financial sector has been much more limited than I would like.

The characterization of financial institutions as storehouses of illiquid and opaque assets is as true today as it was decades ago.

Posted at 2:44 pm IST on Fri, 2 Jan 2009         permanent link

Categories: accounting, risk management

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