Summary
In the present context, Mr. John McCain rightly says that "Fair value rules may be exacerbating the credit crunch", since the market reacts and stabilizes on sentiments. While strictly applying the valuation rule of mark to market accounting, the assets held by the investment companies will be vaued at current market rates which has already fallen considerably. For those assets, which are valued at mark-to-model accounting would still find a dilemma in its valuation, and if the assets are valued at distress sale price, it would take several companies towards failure, as the investors will line-up for the redemption of their investment at throw-away prices, which will automatically reduce the possibility of survival of several investment banks. Those "sound" assets that had suffered undue valuation may be allowed to be suspended, so that there is always a possibility of better recoveries, but liquidity is the factor to be considered in such a situation.
Analysis
Since the market reacts and stabilizes on sentiments, strictly applying the fair value rules of mark to market accounting and distress value accounting will definitely have an adverse effect, since the asset held by the banks will show much less recoverable value than the one shown by their balance sheets earlier, and such information will convey a message to the investor who will line up for the redemption of their investments. Under such circumstances, the central bank must prevent such runs on banks and financial institutions, by reassuring depositors that their bank deposits are safe and also provide liquidity to financial institutions against good collateral.
The downturn in cyclical securities will force the banks to provide for the erosion of value which may bring down their current profits, but such provisions can be written back, once the asset gains its value. Such provision in the Balance Sheet of the bank will take care of the erosion of value of investment, and will show the correct operating results which is reliable. While making decisions of investment, the investors will also consider these facts. The most crucial and difficult point lies in the valuation of derivatives for which the market rate is not available, and at present such securities are valued at mark-to-model prices. Such valuation has several short comings as the whole system of valuation depends on a mathematical model based on several variables and factors. The mark-to-model valuation of derivatives may send a pleasing message to the investors with regard the profitability of the company, but while facing crisis, like the one faced now, the value of such investments come down like a bunch of cards. "Fire sale of assets" is also quite unjustified, since the assets are sold at throw-away prices. Proper provision at an early stage of investment in the Balance sheet may be one solution to such situation.
