On "Market Value" Valuation

The Wall Street Journal published an article last Wednesday involving the use of so-called 'market value' methods for asset valuation. In it, the authors wrote,

"Credit Suisse Group yesterday said it expects to take a $2.85 billion write-down of financial instruments affected by the credit crunch, which will result in a $1 billion drop in quarterly profit, just a week after telling investors it had largely escaped the worst of the financial crisis.

The quick about-faces highlight the problem that companies, even those that are supposed to be financial experts, are having with a seemingly straightforward question: How much is something worth?

The difficulty lies in part in the increasing use of so-called market values to determine prices for items that companies aren't necessarily selling. This has become especially tough since the debt crisis has caused large parts of markets to seize up, meaning there often aren't any prices to use as reference points.

Supporters of the market-value approach say it will help prevent the kind of long-term economic malaise that gripped Japan in the 1990s, when that country's banks sat on problem loans. But companies fear it is distorting returns and speeding the financial crisis, even as investors wonder if companies may be overestimating potential losses to establish cookie-jar reserves.

The debate over how best to figure values is more than just academic. Major financial firms have recognized more than $150 billion in losses, based mostly on the use of market values. At the same time, the Securities and Exchange Commission and federal prosecutors are investigating whether some firms may have applied different market values to the same securities, depending on whether they were held by the firm or its clients."

It's an old debate. On one hand, as the foregoing passage notes, market value provides a real sense of the current value at which one could buy, or sell, an asset. That should, theoretically, be good for investors or those who wish to understand the balance sheet of a firm. Ostensibly, using market values provides investors, counterparties, and other interested observers with a clearer picture of the current value of an enterprise.

However, the market value method is not without its detractors. Consider these passages from later in the Journal article,

"Even when used properly, market values can prove problematic, because in trying to reflect investors' perceptions, they can ignore the underlying economic reality, says Damon Silvers, associate general counsel for the AFL-CIO, which has long been critical of the increasing use of market values in accounting. "You have a portfolio of real-estate loans, and those loans are performing, but now you're making it look like you're losing money, when in fact you're not," he says.

Plus, the approach "treats all the assets of an ongoing enterprise as though they are constantly for sale, and that does not convey very good information about the profit of the business, because they're not actually for sale," Mr. Silvers adds.

The debate about the appropriateness of the market-value approach aside, using market values holds another challenge for investors. It requires them to think differently about debt instruments and loans, viewing them like stocks whose value can swing from day to day or quarter to quarter."

These are very valid points.

Why should a firm be forced to keep its balance sheet on a 'breakup' valuation basis? If the firm doesn't plan to sell itself or liquidate, why must every scrap of every asset be current-valued?

What about industry sectors in which substantial investment is required in assets whose value will grow with time, such as cable, mining, or technology? Or commercial banks which legitimately desire to be portfolio lenders to the housing sector, and, thus, are not affected by performing loans whose values are temporarily depressed due to market or credit conditions?

It's one thing to force market valuations on assets which are purposefully traded frequently, such as bond or equity funds. But forcing firms which own significant amounts of assets that are not intended to be liquid seems silly, especially if the 'market' for those assets temporarily dissolves, creating an apparent value of zero.

FASB spent years mulling over inflation accounting in the 1970s and '80s. Would it be asking too much to ask them to consider this issue now?