Thursday, May 8, 2008

US Financials and Fair Value Accounting

A few days ago, AIG reported first-quarter losses of $7.8 billion resulting from the sharp drop in the value of its mortgage securities and credit derivatives. If you were paying attention, you knew that something was in the offing. For some time now, the company’s CEO had been railing against the idea fair value accounting. As reported by Financial Times in March 14:

American International Group is urging regulators to change controversial accounting rules on asset valuation … Under AIG’s proposal, which has been presented to regulators and policymakers, companies and their auditors would estimate the maximum losses they were likely to incur and only recognise these in their profits … Martin Sullivan, AIG’s chief executive, told FT that “mark-to-market” rules forces companies to recognise losses even when they had no intention of selling assets at current prices.

First, note the word "controversial." That is FT's characterization. The paper's editors know where their sympathies must lie.

Why is fair value accounting controversial? It is a generally accepted accounting practice that purports to record and report securities at their fair market value. What could be foul about that?

In the fair value accounting, you have to mark the prices to market, i.e., take note of the changed price of a security and recognize the difference as either profit and loss, depending on your purchase price. Suppose you buy a security for $100. If the next day the price increases to $110, you'd have to report $10 profit; if the price drops to $90, $10 loss. That is how AIG was forced to report approximately $8 billion in losses. Hence, the unhappiness of the company’s CEO with the fair value accounting. His selfless proposal: to disregard the prices in the market and let the CEOs tell us what they think a security should be worth.

It is tempting to dismiss this as the nonsensical utterance of an embarrassed executive. But the idea is being seconded by others and might gain traction. If so, it would lead to less transparency and more misinformation.

There is more.

The concept of fair value accounting is improbably philosophical. It logically arises from the social nature of value and price and the transformation of one to another. It touches upon the question of the turnover of capital and the frequency and the speed of the circulation of its various components (within the same sphere of production) that gives rise, by turn, to money markets and capital markets.

The pressure to do away with it is the antithesis of the inner coherence of the financial system that has been maintained, however tenuously, since the collapse of the Bretton Woods regime of fixed exchange rates. It is made of the same cloth that makes Libor value questionable and pushes the authority of the Federal Reserve to its edge. It is, in short, the rise of yet another contradiction that is the hallmark of when things begin to fall apart and the center cannot hold.

These are the subject of Vols. 4 and 5 of Speculative Capital.