If Market Prices Are Too Low, Ignore Them
The issue is the application of SFAS 157, which governs the way companies compute fair value of assets, assuming they have to do so anyway. (Banks and brokers have to do that a lot, but I won’t go into the details of when they can avoid it.) The rule took effect on Jan. 1, although some companies adopted it last year.
The rule sets out three categories of assets, with different ways to value them. Category 1 includes assets with easily observable market values. I.B.M. stock closed today at $114.57, and it is not easy to justify a different value if your quarter ended today. Category 2 is a little fuzzier, where there are observable markets that provide a good guide to prices of your asset, even though there is no direct market. And then there is Category 3, which is essentially mark to model.
In companies that adopted Statement 157 early, we have seen a lot of assets end up in Category 3. That may be proper, since there are plenty of complex financial instruments for which there is not much of a market these days. But it also provides companies with a way to fudge figures.
The S.E.C. letter asks companies for some disclosures on how they came up with those values, and on why a lot of assets may have moved into Category 3. Such disclosures can only help investors.
But one part of the letter stood out to me, providing an excuse for companies to ignore a market value if they don’t like it (italics added):
“Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.”
That sounds to me like an invitation to fudge. Some people on Wall Street think that nearly every sale today is a forced sale. There are entire categories of collateralized debt obligations where most, if not all, of the trades, occur because a holder has received, or expects, a margin call.
What the S.E.C. should require is a disclosure when a company concludes that a market price should be ignored because it came from a “forced liquidation or distress sale.” Then there should be a disclosure of how much lower that distress price was from the value the company is using in its own valuation.
Alternatively, there could be a simple rule, at least for banks. If you will ignore this price as irrelevant when you decide whether to send out margin calls to those to whom you have lent money, then you can ignore that market price when you make your own reports. But if you won’t lend based on a valuation that ignores actual market prices, then you should not use that valuation for your own accounts.
Addendum, Tuesday April 1:
The posting should have noted that the phrases the S.E.C. used are taken from the original rule. This is not a new loophole, merely an invitation to use an existing one without being forced to actually disclose its use. It is a fair bet that the rule writers did not contemplate a market where people could claim virtually every sale was a forced sale, but they did leave the opening.