Fair value’s

Fair value requirements are aggravating the credit crisis, as institutions are continually forced to write-down holdings, according to more than half of respondents to a new poll of chartered financial analysts (CFAs) — yet the same poll finds overwhelming support for fair value reporting.

Fair value requirements, which are already in place in the U.S. and expanding to other jurisdictions, ensure the reported value of securities on a balance sheet is as close to the present market value as possible.

While this measure makes sense as a way of increasing transparency, it has also led to massive write-downs on structured investment products, like collateralized debt-obligations. Since many of these types of investments are illiquid, there is some confusion in how they should be valued.

The CFA Institute, which conducted the survey of more than 2,000 CFAs worldwide, found that 79% believe fair value requirements will “improve transparency and contribute to investor understanding of the risk profiles” of financial institutions. Further, 74% of respondents believed the measure would improve market integrity.

Yet a majority of respondents (55%) believed that fair value requirements were aggravating the global credit crisis. Georgene Palacky, director of financial reporting, says this is not a contradiction among respondents, but rather a widely held belief that the pain being felt by financial institutions is necessary for the long-term stability of capital markets.

“When you look at the comments we received, many CFAs said fair value is aggravating [the credit crisis], but they view this as short-term pain…for long-term gain. They are still saying ‘don’t do away with fair value’,” she says.

Indeed, many of the comments express this exact sentiment.

“While fair value has increased the market risk in credits coming out of a credit bubble and hurt financial firms, the problem is not in fair value assessment, but is ultimately one of poor risk management to begin with,” one CFA wrote in the comments. “The pain of fair value assessment today may help prevent future crisis and give more incentive to better manage risk.”

The CFA Institute felt compelled to conduct this survey because there have been growing rumblings about “smoothing” out or rolling back fair value requirements to give financial institutions some breathing room and allow their structured investments to mature.

The CFA Institute and many respondents to the survey reject this argument.

“A rollback or intervention of any kind, while out of line in our perspective, would also be an infringement on the independence of the standard-setting process. This would undermine the system that has been designed to protect the process from politics and self-interest,” says Kurt Schacht, managing director of the CFA Institute Centre. “To change course at this stage and continue to suggest solutions that will ultimately only serve to smooth bumps in the road or attempt to mask the reality of current market conditions would be very unfortunate and not a responsible way to manage real risks.”

Palacky says an analysis of financial reports from 2000 to 2006 conducted by the CFA Institute has shown very few institutions purchased the now illiquid securities with the intention of holding them to maturity.

“A very small percentage of the total invested assets are in fact being categorized as ‘being held to maturity’ by financial services firms,” she says. “From our research we were able to discern roughly about 11% of assets on average — if you take the median, that percentage is 0% — was designated to be held to maturity. About 78% of those assets were available for sale, and the rest was designated for trading.”

The problem many institutions now face is that they must accurately value their illiquid assets since there is no market reference point to calculate their value.

The absence of an active, liquid market forces analysts to use mark-to-comparable valuations — similar to the real estate market — or level three valuation.

Under level three calculations, values are determined by company management using historical data and projections. It’s not a perfect system to be sure, but Palacky says at least when companies go through the process, they are providing investors with disclosure and transparency that can be used to make informed decisions.

“Our view is that you don’t stop with just giving us a number; we want to know the range of possibility for valuing something where you have a less liquid marketplace,” she says. “This is where disclosures from companies are essential to provide the necessary backdrop for that value.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(04/21/08)

Mark Noble