More Attacks on Fair Value

Implications: Why does the SEC not enforce the rule against "naked short selling?"

Analysis:  “John McCain, a man not known for his interest in balance sheets” is correct, there is a credit crunch but it is hardly all due to the use of fair value.  Undoubtedly, the accounting  profession does deserve some blame for not requiring banks to consolidate their qualified special-purpose and structured investment entities.  The mortgage meltdown too long went unnoticed because the mortgage receivable was not on the bank’s books nor was the securitized mortgage obligation.  So in a sense, this debt was not on anyone’s books.  However even Federal Reserve Chairman Bernanke “raised the possibility the practice (mark-to-market) was helping to destabilize markets.” [The Wall Street Journal, “In crisis, Fingers Point at Mark-to-Market Rule,” September 19, 2008, p. C4]    
 
Mark-to-market accounting does force entities to value their tier 3 assets using a model.  The uses of models on the other hand are criticized because management may make assumptions that are overly optimistic given the pessimistic markets.  However, it’s the role of the auditor to test the reasonableness of management’s assumptions.  Still, reasonableness like beauty is in the “eye of the beholder.”  
 
American International Group (AIG) argued that while, “It booked $25 billion in losses based on market prices for its derivatives holdings, the insurer expected its ultimate losses to be in the narrower range of $5 billion to $8 billion” [op cite].  While arguments such as this are fairly persuasive, one must realize that measures of financial position and performance are not absolutes.  They only have significance in comparison with others of the company’s peers.  As long as all companies are using fair value meaningful comparisons can be made.  

Unfortunately, under the current mark-to-market rules not all financial assets are measured at fair value.  For example, a bank could be showing its mortgage receivables at amortized cost or at fair value.  When management says it intends to hold the mortgage receivables to maturity it can elect to ignore fair value. This exception in the rules is inexcusable but bear in mind it came about because of the widespread pressure the banking industry put on the Financial Accounting Standards Board.  

Certainly a downturn in cyclical securities could force banks to recognize losses at the same time and thus weaken capital.  Is this accounting’s fault?  Perhaps, banks should consider more diversification in their investment portfolios. 
 
Fair value or mark-to-market accounting is the only method with which comparison’s with other entities can be made.  Showing financial assets or for that matter even non-financial assets at their original cost is uninformative.  For example under current standards, many companies carry goodwill amounting to over half of their assets at its original cost.  The asset impairment test which compares the undiscounted estimated future net cash flows against the carrying value of the goodwill is nonsensical. 

The credit crisis has many causes including for example, lax regulation, expansion of the global economy and the invention of financial instruments never before imagined.  Certainly, the lack of regulation of hedge funds has had much to do with the market turmoil.  On Friday, September 19, 2008, the SEC announced a temporary emergency prohibition against the naked short selling of 799 financial stocks.  “At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuations,” [“SEC Call Halt to Shorting of Financials,” www.cfo.com/article/cfm/12280740?f=alerts].  Short selling has been around since the markets began and many would argue provide the market with liquidity.  The problem however is with ‘naked short selling.”  (It is the practice of selling a stock short without borrowing the shares or at least making arrangements to borrow the shares if necessary). 

Naked short selling has always been illegal but the SEC in recent years has chosen not to enforce it.  The problem with the SEC’s ruling is there are no penalties for violating their ban.  The only way the SEC will know if the rule is violated is through an SEC audit and the odds of that occurring are far less than an IRS audit.  The new ruling also doesn’t cover day traders who never have a position open for three days and therefore do not need to borrow any shares.  Finally, the new rule seemingly only applies to new short sales and there is no closeout requirement for failed trades.

I am not an opponent of short selling because I do believe that they play an important role in preserving market liquidity.  But naked short selling gives too much of an advantage to the seller thus disadvantaging the buyer.  Why the SEC fails to see this, is beyond my understanding.