Litigation Risk: Impacts of Mark to Market

In an environment rife with concern over litigation, does mark-to-market accounting work? This question matters greatly to the “credit crisis,” as financial pictures based on mark-to-market standards drive much of the turmoil (as well as M&A and equity investments) currently underway. Further, complex mark-to-market accounting has oft-hidden impacts. This has led many to focus on how financial service companies may overvalue securities and loans on their books. Less-studied, however, is whether fear of litigation may have led some to undervalue assets as well.

As background, the objective of mark-to-market is depicting “fair value” of a company’s securities, updated to a moment in time. For complex securities, it replaced earlier standards that had been based on historical book value (itself often based on the initial acquisition cost). Since its adoption by the SEC (incorporating FAS 157), “mark to market” has been used by companies to determine fair value and then disclose both the fair value and the methods used for the fair value determination to the public.

This is no easy task. Mark-to-market accounting attempts to capture the fair value measurement of assets and liabilities through a standard framework based on three different levels, or “fair value hierarchy”. The most difficult securities to measure are termed “Level 3,” where there may not be an active market, requiring valuation based on inherently-subjective internal models and management judgment. Accounting treatment of valuations must be sensitive not only to “inherent” asset attributes, but also to the identity and number of buyers and sellers, as well as to the sale process.

In short, the calculation is complex and plagued by 3 problems: opacity, pro-cyclicality, and subjectivity. All of these were raised as issues at an October 29 SEC roundtable on Mark-to-Market. The opacity means that the valuation of some of these securities is extremely difficult to understand or verify. The SEC is concerned about this and has shown a deep interest, in ways broad and targeted. On a broad level, the SEC is now conducting a series of roundtable discussions and a related study on Mark-to-Market (mandated under the recent EESA bailout legislation). Its interest began much earlier – for example, in March of 2008, the Division of Corporate Finance issued a letter highlighting certain disclosure areas around FAS 157 in preparing the Management Discussion & Analysis of upcoming 10-Qs.

The SEC has also addressed the issue in more targeted ways. It has issued a series of Staff Review letters, released to companies ranging from Ford Motor, to Assurant, to XL Capital. In each of these letters, the SEC commented on the sheer difficulty in understanding how securities were valued. As an outside observer, it's difficult to know if values are overstated, understated or accurate. The companies each responded with proposed disclosures they would use in the future. Ford Motor Credit even included a policy paper they’d utilized to determine fair value of their interest rate swaps.

However, if the SEC feels the need for the explanations, it stands to reason that the investor community does as well. The opacity of valuation leaves a big question mark hanging over it, giving rise to speculation that these values may have been artificially manipulated (either up or down). Effectively, it has these companies saying to the market "trust us, they're valued correctly"...all of which worked fine until the market's trust evaporated.

Companies try to give a sense of methodology, but as is seen in the sampling of filings in our sidebar panel (from Genworth Financial, AIG, and others), this was never easy. Companies continue to fine tune their messages around FAS 157 valuation, so that players like AIG now acknowledge in their disclosures the degree to which subjective judgment is utilized in assessing fair value. On the same day it received its next round of government bailout (see our related story “Significant Events Briefing”), AIG made the following statement in their November 10, 2008 10-Q “The valuation of the super senior credit derivatives continues to be challenging”, and went on to point out market illiquidity, the absence of price transparency and disparity in methodology among various parties.

A note about pro-cyclicality: Mark to market by its very nature moves with the business cycle. When the markets go up, so do asset carrying values on balance sheet. As we’ve all seen in recent months, asset values travel in the other direction as well, when markets head south. Pro-cyclicality doesn’t only plague "classic financial institutions" -- it affects other industries as well. One that has been quite vocal around this is the private equity industry (several players of which are actually public companies). Several have been public in their complaints around FAS 157. In an offering document from its recently-pulled attempt to go public, KKR complained of the negative impacts of pro-cyclicality. Similarly, Steven Schwarzman, co-founder of Blackstone, discussed how fair value accounting was “amplifying potential losses” by requiring larger than necessary write-downs.

Subjectivity is the third of the plagues and it is where the fear of litigation, raised above, comes to play. Those with the stomach for risk and the balance sheet to support it may opt to understate asset values to avoid future litigations. Understatement of value could have the perverse impact of undercutting capitalization of these institutions, at least in the short term. Undercapitalization (perceived or actual) is serious – it led to the bank-run type activity that characterized the banking world in Sept and Oct. of 2008.