November 23, 2008
Fair Market Value (FMV) accounting is dangerous and flawed, and is based on the wrong premise. The wrong premise is that the market value is the most accurate reflection of an asset.
The goal of the FMV accounting is to provide transparency and useful information to investors. So far, the FMV accounting has provided no further transparency and usefulness. But, it has caused tremendous capital implosions at financial institutions instead. As an investor, I strongly believe that it is far better to force financial institutions to supply detailed, supplemental schedules with assumptions and methods of pricing securities with proper explanations of various pricing conventions.
Reliance of the market price is to assume that market prices are always fair and they can never be manipulated. This reliance is ill-advised. We know that market prices can be volatile and can be manipulated if illiquid. Reliance on the market prices also means reliance of the effectiveness of trading regulations. We have seen that trading regulations have changed over the years, and the changes have had major impact on price levels.
The foundation of the pricing of a fixed income security is the discounted cash flow. The foundation needs to be precise, mathematical, and not based on the whims of irrationally depressed or optimistic investors.
Returning back to the discounted cash flows with an appropriate level of discount rates will help an institution manage the assets and liabilities effectively. Because, it will help to avoid the situations that the liquidation prices of one institution will negatively impact the value of other healthy institutions. Thus, institutions can plan for long-term investments, matching assets against liabilities appropriately. As a result,
The economy will benefit as capital is deployed correctly.
Forcing the FMV rule on financial institutions is the equivalent of requiring these institutions to manage with a goal to liquidate their assets instantly. It is not consistent with the long-term goals of many businesses as ongoing enterprises. Thus, it is inherently flawed and ineffective, although it seems to make investors to have a wrong sense of security.
However, it is important to recognize market value as an important variable to determine the liquidity position of an enterprise. Thus, it is also necessary to determine the market value of an asset as a liquidity value. And the discounted cash flow value would hence be reconciled over time with the liquidity value, e.g. amortization or accretion of the differences over the average life of the asset.
To summarize, the current FMV accounting rule does little to add useful information for security analysis. Instead, it has helped to wipe out the capital of many financial institutions. As a result, the economy is starving for money, as many financial institutions worry constantly about the net worth. In the end, the FMV rule hurts the consumers and the economy. Its goal of providing better transparency is noble, but it needs to be modified to help financial institutions to manage their assets and liabilities effectively. And finally, the rule must not stray away from the fundamental of bond pricing which is Discounted Cash Flows.
Thank you for allowing me to present my views on this important issue.
Dan Nguyen, CFA, MBA.