As the market has continued to decline to new lows in February of 2009, the toxic assets of financial institutions continue to be the focal point for our policy makers and financial analysts. The bad bank – good bank dispersal seems to be on the move through the harness of stress tests by the Fed officials and new secretary of the treasury, Tim Guietner. There are about 18 banks which will be exposed to the this process in the first stage towards cleansing toxic assets held by the banks. Although very little has been reported about the process, one could assume that a type of “if what scenarios” to measure the worst case-scenario impact on their financial standing may be applied. As the stress test may take 6 to 8 weeks to finalize, the market has to deal with uncertainty. Since uncertainty and lack of conviction will lead to more instability, we could see further deterioration in the economy and the stock markets.
Financial companies comprise approximately 10% of the S&P 500 index, which is a broader market performance measure. However, it holds a critical role in igniting the capital markets healthy performance. To sustain a dynamic growth, developed countries need to provide an efficient flow of credit from savers to borrowers. Accordingly, credit is the life blood of the economy and has to be available to corporations and economic agents. Therefore, if banks and other financial institutions do not prosper, they cannot facilitate credit and leverage. Earnings and profits help banks to capitalize on their assets and provide capitals for new projects, expansions and social and private commercial developments which in turn creates more jobs and prosperity for communities and individuals. Consequently, this is a major step toward long lasting prosperity to nourish the financial health of banks and the financial sector. Market participants have realized the current pathetic and dismal state of major financial institutions, and thus, have very little desire to buy this market. Appropriately, institutional investors and traders do not anticipate any major stock market rebound despite its oversold conditions.
There are three major methods to value the balance sheet assets for financial companies; historical cost basis, mark-to-market and market-to-model. Each of these three methods provide some advantages, but none is free from limitations and pitfalls. After a brief overlook of each of these three methods in the following sections, I propose a method as an alterative for balance sheet asset valuation. If we agree on a practical but comprehensive approach to measure and clean toxic assets held by banks and other financial institutions, the market and later the economy should ultimately pare off losses and begin their recoveries.
Historical cost basis method considers the acquisition cost for an asset less its depreciation value. As an example, if an equipment was acquired for a $1000 two years ago, today’s value could be estimated as the purchase price less depreciation for the two years period. However, depending on which deprecation method (straight line, declining balance, and Modified Accelerated Cost Recovery System, MACRS) a company may utilize, one would obtain different values. This is a popular and relatively straightforward practice, since it values assets at the production cost or purchase price, less depreciation. Long-term and fixed assets like land and buildings are valued at net historical costs, and current assets at cost or net realizable value, whichever is the lower. The main limitation of this method is its lack of dynamic adjustment with market conditions. Financial institutions utilizing this method are unable to capitalize from their assets value. In other words, the historical cost method could create an enormous cost of opportunities in a booming economy.
The second method is mark-to-market, which values balance sheet assets based on their fair market value. This method has the ability to absorb market conditions and adjust accordingly. Consequently, as asset prices rise, banks are able to capitalize on them and in turn increase their lending activities. However, when asset prices fall, as in the current situation, it could literally destroy the holding companies equity values. In discovering market price, several methods could be utilized to equate historical values and comparative methods. Both assets and liabilities could be discounted based on current ongoing market prices. Conversely, if there is no market for it, asset prices could literally fall to zero. This method has been used in the futures markets by traders for many years successfully. In futures and commodity markets, there must be a buyer for every seller, and in many cases the clearing house is the other end of the transaction. During price limit moves due to significant external factors, the clearing house provides liquidity to ensure the existence of the market, thus creating the market. Henceforth, the mark-to-market method is a valid and realistic approach as long as there is a market. Internal Revenue Code Section 475 which covers the mark to market accounting method rule for taxation, states that qualified securities dealers and commodities clearing houses when elect mark-to-market treatment should recognize gain or loss based on selling price for the properties at going market rate or fair value at the end of the reporting year.
Another method for balance sheet asset valuation is mark-to-model, where companies may develop financial models with internal assumptions. This method is far less reliable than the others since it may be unclear how realistic the assumptions of the model variables are assigned. Moreover, a company could deceive the investors by hiding its model due to “highly proprietary nature” justification and thus, have less transparency. Enron is a good example for deceiving the investing community by valuing its balance sheet assets based on mark-to-model. Regardless of how complex a model might be, if there is no real counterpart to purchase the assets, the model is doomed to fail.
Considering the limitations that each of the above-mentioned pricing approaches impose, to solve the toxic assets issue, I propose a Modified Mark-to-Market (MMM) approach where assets would be valued based on mark-to-market. However, the Federal Reserve would have to create an exchange type of clearing mechanism for financial assets. Undertaking this would create a floor for asset prices and bestow a healthy dose of confidence in the market place in times of economic contraction. Since this method is dynamic in nature, it ultimately captures high valuations during economic boom, and will contribute more growth opportunities to the economy. Furthermore, the ability and skills of financial institutions should enable them to implement proper risk management strategies against any systematic risk. This allows them to preserve the value of their financial assets despite any market sell off and correction. Since the Fed will always be there to be the buyer and provide liquidity, financial markets should experience relatively increased stability during turbulent times.
To diminish any uncertainty about the future of financial institutions like Citibank and Bank of America, there should be a clear decision about adherence to a proper method for balance sheet asset valuation. Modified mark-to-market (MMM), a dynamic and realistic asset valuation model could be utilized with the backing of the Federal Reserve as the buyer and assessor of last resort in times of selling pressure. When there is a clear and concise established method for balance sheet asset valuation, we could see a meaningful turn around in our stock market and the economy.
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