Accounting & Tax

Bearing It All

The perils of derivatives and fair-value accounting.
Economist StaffJuly 20, 2007

To many investors, hedge funds are impenetrable “black boxes”, moving in mysterious ways and holding indecipherable positions. This week, however, investors in two troubled Bear Stearns hedge funds were given a peek under the lid. What they were shown was black indeed.

Both funds had invested heavily in securities backed by subprime mortgages. Suffering steep losses in May and June, one was saved only by a $1.6 billion loan from its parent company last month. A Bear Stearns team has been “working diligently” ever since to tot up the losses. On July 17th it admitted that there “is effectively no value left” in one of the funds, and “very little value left” in the other.

Such brutal clarity is, however, a rarity in the world of complex derivatives. Investors may now know what the two Bear Stearns funds are worth. But accountants are still unsure how to put a value on the instruments that got them into trouble.

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Traditionally, a company’s accounts would record the value of an asset at its historic cost (ie, the price the company paid for it). Under so-called “fair value” accounting, however, book-keepers can now record the value of an asset at its market price (ie, the price the company could get for it). But many complex derivatives, such as mortgage-backed securities, do not trade smoothly and frequently in arm’s length markets. This makes it impossible for book-keepers to “mark” them to market. Instead they resort to “mark-to-model” accounting, entering values based on the output of a computer.

Unfortunately, the market does not always resemble the model. When the Bear funds ran into trouble, their bankers tried to sell their collateral, which was mostly in the form of mortgage-backed derivatives. As well as raising cash, such a sale would have had the side-effect of setting a true market price for these hard-to-value instruments. But the bankers worried that if the derivatives were sold into a falling market, the low price would set an ugly precedent for their own portfolios. The disclosure of fire-sale prices could force them to slash carrying values on their own books. This in turn would spur more selling, driving prices further down in a vicious cycle. In the end, the bankers decided that they would rather hold the toxic investment.

Situations like this, says Ray Beier at PricewaterhouseCoopers, reach “the heart of the fundamental challenge in fair-value accounting”. Models are supposed to show the price an asset would fetch in a sale. But in an illiquid market, a big sale can itself drive down prices. This can sometimes create a sizeable difference between “mark-to-model” valuations and true market prices.

That is not the only problem with fair-value accounting. According to Richard Herring, a finance professor at the Wharton School, “models are easy to manipulate”. RiskData, a consultancy, studied more than 1,000 hedge funds and concluded that nearly a third of funds trading illiquid securities were smoothing the results of their models, so as to iron out too much volatility in their books.

Unfortunately, the alternatives to fair-value accounting can be worse. Historic cost may be harder to manipulate than the results of a model. But as Bob Herz, chairman of America’s Financial Accounting Standards Board, points out, it too is “replete with all sorts of guesses”, such as depreciation rates. And for derivatives, historic cost accounting is patently wrong. The historic cost of employee stock options, for instance, is zero.

Fair value is perhaps most worrying for auditors, who are often blamed for faulty accounts. Faced with murky models, the best they can do is examine assumptions and ensure disclosure. Mark Olson, chairman of the Public Company Accounting Oversight Board, a regulator, expressed his unease last month. “Valuation requires training,” he said, “and many auditors may not have extensive training.” Investors, in other words, are on their own.

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