The following excerpt from an August 19, 2009 story by By Jeff Kearns apparently written for
Bloomberg reveals the thinking of award winning economists.
"Myron Scholes and
Robert Merton shared the 1997 Nobel price for economics, and they are now united in calling for banks to give more accurate valuations on their illiquid assets.
Financial institutions should use mark-to-market accounting or list the hard-to-value securities on public exchanges whenever possible, Scholes said in a Bloomberg Radio interview yesterday. Scholes, winner of the Nobel with Merton for helping invent a model for pricing options, said investors need better data on prices to accurately value the debt and equity securities of banks.
“I’d like to see us encourage many more securities held on the books of the banks be migrated to exchanges if possible,” he said. Doing so would “allow for market discovery and market pricing as much as possible,” Scholes added.
Banks that oppose new accounting standards on asset values want to conceal depressed prices, Merton wrote in the Financial Times yesterday. He composed the column with Robert Kaplan, a professor at the Harvard Business School along with Merton, and Scott Richard, a professor at the University of Pennsylvania’s Wharton School.
“This is not the way forward,” they wrote. “While regulators and legislators are keen to find simple solutions to complex problems, allowing financial institutions to ignore market transactions is a bad idea.”"
The problem, of course, is they are only partially correct. Consider:
1. Using mark-to-market accounting sounds like a commercial for the use of a valuation model such as the Black-Scholes model co-developed by one of the economists. Could a valuation model be applied to a commercial loan? Of course! What is the probability the result would be correct, comparable or meaningful given the range of judgments that are required by any model? I suspect the answer is less than 50%. Do you suppose any of these economists have ever tried to value a community bank commercial loan portfolio?
2. The amount of documentation required to list any security on an exchange is staggering. How much documentation would be required to list a $1 million commercial loan to a privately held, non-rated corporate entity? Frankly, listing hard to value securities on public exchanges sounds like a fairy tale. (It also assumes those securities are for sale, which is usually not the case.)
3. Proponents of mark-to-market accounting apparently believe that every bank asset is being held for sale. In fact, most bank assets are not for sale. Their value arises from the payment of interest and principal over time. Mark-to-market accounting is liquidation value - not the value to a going concern.
4. If today's problem assets had been valued at "market" two years ago, most of them would have values at or near "par."
5. If you purchase a U.S. Treasury Note today and interest rates go up, the market value of the Note goes down. You would have suffered an economic loss because you would have earned a higher return if you had been able to buy that security today. However, we also know it is impossible to accurately time the market, so you would have suffered an economic loss if you had held cash instead of purchasing securities when you did. In addition, there is no assurance you would have purchased the securities at the optimum time. Fortunately, you don't need or want the cash represented by my investment in this Note so you wait another year and watch the value go back to par when it matures. Substitute "bank" for you and "commercial loan" for the U.S. Treasury Note and we have described the typical scenario for a community bank loan portfolio. Observations:
- A community bank loan portfolio is difficult, if not impossible, to accurately value because most privately owned commercial entities are not rated by credit agencies and industries, management, corporate culture and local economies vary widely.
- If a bank and its borrower can weather economic storms, the likelihood of repayment is usually very high.
- When a loan is deemed to be uncollectible in full or in part, current accounting and regulatory rules effectively require the loan to be valued at recovery value - cash that is likely to be received from payments and/or sale of the collateral. (This information is provided in the financial statements.)
Mark-to-market accounting works well for securities that are traded regularly on an active exchange.