Facts are the enemy of the truth

The quote above from Cervantes is eerily accurate when it comes to this op-ed piece from FT. Merton a Noble prize winning economist, a director at LTCM writes

Banks and other financial institutions are lobbying against fair-value accountingfor their asset holdings. They claim many of their assets are not impaired, that they intend to hold them to maturity anyway and that recent transaction prices reflect distressed sales into an illiquid market, not what the assets are actually worth.

….

A bank typically argues that a mortgage loan for which it continues to receive regular monthly payments is not impaired and does not need to be written down. A potential purchaser of the loan, however, is unlikely to value it at its origination value. The purchaser calculates a loan-to-value ratio using the current, much lower value of the house. After calculating the likelihood of default, the potential buyer works out a price balancing the risk of default and amount that might be lost – a price well below the carrying value on the bank’s books.

But this is true for any business. There are two types of assets in any business, current assests and Fixed assets. Fixed assets are used for generating income while current assets are what the business buys and sells in it’s day-to-day operations. Obviously in the case of FIs the line blurs between Fixed Assets and Trading Inventory but as long as the management and auditors are scruplous about keeping the two sets separate and report it in their accounts clearly ther should not be any issues. This is simply Acounting 101.

The fetish for mark-to-market accounting is simply idiotic. Most of the people pushing it seem to be economists who do not seem to understand that simply reflecting asset values on a particular day when books are closed is not necessarily a more truthful account of the affairs of a business. Let’s assume I have a business making widgets and I have a widget maker which I bought for $100. Obviously if I tried to go out and sell the widget maker I wouldn’t get $100 dollars for it. I might only get $50 for it, that doesn’t mean that I write down the value in my books to $50. What I have is a Depreciation schedule which says how many years I expect to use the Asset there are usually standard rules on marking down the value, sometimes dictated by Revenue Authorities, sometimes by industry practice. Which is why companies reports EBIDTA, so the investors get a sense of operating capability of the company.

Accounts are drawn up on a Ongoing Business basis and not on the basis that everything would be liquidated on that day. Values like that may be factually accurate but they are not anywhere close being true. An auditors job is to ensure that accounts are true and fair and not just factually correct.  As the authors note

Obtaining fair-value estimates for complex pools of asset-backed securities, of course, is not trivial.

No number of external experts can validate complex assest values. The right thing to do is to not let banks speculate and if they are speculating to clearly lay it out in the accounts, that this is speculation income, just like it is done in the case of businesses which have windfalls from Forex or Assest sales. It should not be reported as part of operating income of a bank. It’s as simple as that.

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