Tuesday, May 25, 2010

Extend and Pretend Reaches A New Level

Posted on FT Alphaville:

The accounting standard known as FAS 157 gained not-a-small amount of notoriety last year.

In March of 2009, the US Financial Accounting Standards Board (FASB) changed the rule, which governed how companies should mark their assets to market and was established in September 2006.

It was a controversial move to say the least, and many commentators still think the easing was one of the things that helped propel banks to some hefty profits that year. Others argue that mark-to-market helped exacerbate the financial crisis and FASB’s decision was a prudent one.

One of the features of FAS 157 was its codification of categories for asset valuation: Level 1, Level 2 and Level 3. You can read a full description here, but suffice to say, Level 1 asset values were those based on readily observable market prices. Level 2 asset values were based on quoted prices in inactive markets, or based on models but the inputs to those models are observable. Level 3, meanwhile, was the least marked-to-market of the categories, with asset values based on models and unobservable inputs.

Last year, the Board changed FAS 157’s name to Topic 820 as part of its overhaul of fair value rules. It still seems to be tinkering with some of them, but the basic text of 820 is up and running.

Posted on Deux Ex Macchiato:

Why should you care, dear reader? Well, there are two things in 820 that struck me as apposite; one good, one bad...

The good one first.

Financial statement users indicated that information about the effect(s) of reasonably possible alternative inputs [to level 3 valuation models] would be relevant in their analysis of the reporting entity’s performance.

So, with a reasonable amount of luck, 820 will require firms not just to state the value of their level 3 assets, but also to assess uncertainty in that value. This would be a major step forward in accounting disclosures for financial instruments, and I commend the standard setters for it.

Now the bad part. They have made this a lot less useful than it would otherwise be by extending (or at least clarifying the extent of) level 2.

I used to think that level 2 assets were things valued using a model, but where all the model inputs were current market observables. In other words, a swap valued using a discounted cashflow model calibrated to the quoted libor rates is level 2, but a quanto option valued using historic correlation isn’t, as correlation is not a current market observable (but rather an historic property). In fact anything valued using a model where one input is an historic property – historic vol, historic prepayment rates, etc. – should be level 3.

Unfortunately the text of 820 now includes the clarification that anything based on a market input is in level 2. And since historical volatility is based on a price history, an option priced using historic rather than implied is in level 2. This is not good. There is a crucial difference between a current price used as an input (or equivalently a convention for quoting prices, like implied vol) and anything else. Level 2 should be kept for purely price based model inputs. That, of course, would also make the level 3 uncertainty disclosures much more useful.

Comment from Naked Capitalism:

Eeek. Having crawled in the bowels of some financial firms, I’ve been skeptical of whether an investor can make head or tails of the performance of a financial institution of any complexity. This move should give the skeptics even more cause for pause.

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