Thursday, March 20, 2008

“You can’t treat a virus with antibiotics.”

Last Tuesday night I received an e mail from Edith Orenstein, writer for the Financial Executive Internationals Financial Reporting Blog. Edith noticed my blog posting from earlier that day titled “FAS 157: Timing is Everything” and asked if I could comment on the differing opinions from, among others, the CFA Institute on the subject of mark-to-market accounting. In the e mail from Edith were several links on the emerging debate re mark-to-market accounting including one that contained the following recent quotes from Paul Volker:

“I have problems with fair value accounting…”

“…it is evident it doesn’t solve all problems, in fact, it may create a few…especially among financial engineers.” Specifically, he noted, “There is a real question how to blend insights of mark-to-market accounting where there is no market…. and it may lead to exaggerated movements in the markets.”

“There are beautiful theoretical models in economics which impress accountants, [since the Economists] get Nobel prizes, but applied to the real world that don’t work well, [that] is the real challenge.”

Since I am time constrained due to my travels to conduct my final two early 2008 events, I crafted an initial reply to Edith this morning that I wish to share with you here:

Hi Edith,

Before replying to your questions, I want make sure that the core of argument is understood as it hits right at the heart of what constitutes "fair value" and what I consider to be the questionable acceptance that the current price (exit price) for long duration assets such as fixed income instruments (including mortgages) and equities constitutes "fair value".

To begin, nothing captures the essence of my argument better than your quote of Paul Volker:

"There are beautiful theoretical models in economics which impress accountants, [since the Economists] get Nobel prizes, but applied to the real world that don't work well, [that] is the real challenge."

Assets rise and fall in value for many reasons, some of which are tied to the theoretical models Mr. Volker refers to such as the inputs that go into the discounted cash flow model. Such valuation levels reached via these methods are anchored in the rational investor theory as postulated in the "Modern Portfolio Theory" (MPT) and the "Efficient Market Hypothesis" (EMH).

However, recent research in the field of Behavioral Finance has shown what common sense has known all along - investors are not rational at all times and, therefore, are just as easily motivated by non-theoretical factors that are more self interested such as loss aversion and regret.

It is easy to understand why FASB and the CFA Institute are willing to accept the long established dogma of MPT and EMH. Mr. Volker has referenced one reason why. And, in the case of FASB, the threat of litigation as noted by Michael Young of WIlkie, Farr, & Gallagher is, no doubt, a contributing factor. Nevertheless, the fundamental principle underlying price as "fair value" for long duration assets, particularly in a time of deleveraging and capital base impairment (which begets further price pressure on the current price of an asset), is both out of date and at odds with reality (how the markets really work), common sense, and current theory.

I hope this helps clarify my position.

Investment Strategy Implications

“You can’t treat a virus with antibiotics” is an apt description of the current credit crisis. The Fed is clearly attempting to stay out of the theoretical fray of mark-to-market accounting and “fair value” and has referred that role to the FASB with its dogmatic belief in MPT and EMH.

The Fed’s solution to the credit crisis is to produce a tidal wave of liquidity designed primarily to unfreeze the core of the financial system in the hope that it will produce a return to confidence in counterparties and risk assessments and, thereby, prevent future runs on the bank such as that experienced with Northern Rock in Brittan and Bear Stearns in the US. In the process, the Fed hopes its efforts will prevent a spillover of the credit crisis into the real economy. Additionally, the Fed hopes that same liquidity will support the real economy by reducing the interest burden on consumers and business.

Lots of hoping and maybe it will all work. However, two elements at the core of the problem have not been resolved and will not be so simply through more money. One is the aforementioned fantasy of equating the current price of an asset with “fair value”. The other pertains to the consequences of the delevering of the US economy. (This second aspect will be addressed in a future report or blog posting.)

Whenever the economy has gotten into trouble in the past, liquidity acted like caffeine and helped stimulate the body economic. This time, however, liquidity seems to be less like caffeine and more like morphine.

The patient is ill with a virus. That virus is the unwinding of the credit bubble. The false belief that price equals “fair value” (and the “Fair Value Hierarchy”) combined with other factors such as accountants fear of litigation (to be addressed tomorrow) has turned this illness, this financial flu into pneumonia. And neither morphine nor antibiotics will produce the cure. Nor will hoping.

…to be continued.

No comments: