Is Fair Value Fair?

John Dizard continues the battering of mark to market in the FT:

Many now believe that like the fictional nuclear Doomsday machine, the unbending application of mark to market rules is not, in the end, a sane way to manage the world.

Here’s the problem: the mark-to-market rules assumed there would always be someone willing to buy or sell an asset at a price that bore some relation to the economic value it represented.

Well, no. Or at least, not really. The accounting principal after all is only known colloquially as 'mark to market'. The formal name is 'fair value', and fair value can be applied to assets with no market, as in FAS 157's level 3. Marking to a proxy has a long and honourable history which goes back much further than the current crisis. Anyone who has ever had a very large position or a highly structured position has probably marked to a proxy somehow or other (remember normal market size trades are a proxy for larger positions, and not necessarily a good one at that).

What would happen if we did not do that, that is if we went back to accrual? Then investors in banks would have no clue about the value of the assets on bank's balance sheets, and they would instead have to trust to something even more subjective - loan loss provisions.

Now of course fair values can change without there being a material change in the likelihood of an asset failing to pay: changes in liquidity premiums, in the cost of financing the position, and in the volatility of the position can all do that. But those changes are important information for the users of financial statements.

Dizard continues:

Right now, though, the problem is that the capital bases of the major banks and dealers are being reduced by losses on the mark-to-market value of securities faster than they can raise new money. That means that because nobody wants to buy a lot of the structured credit products, credit made available by the entire system could contract. That would lead to more losses, and a further contraction of credit.

We call that a depression. Yes, eventually you get to a level of prices where transactions will “clear”, because some people will have enough gold or soyabeans or yuan to buy the distressed assets.

And we need to know where that level is. If we intervene before it is reached, there will be an enormous loss of confidence. Rather than being in the situation of knowing the worst is over, we will instead wonder whether it is, leading to, yes, further falls in asset prices.

A rather odd bit comes later:

Furthermore, as one board member of a very large dealer told me: “Aside from the shrinking capital (from mark to market losses), you are getting more and more assets being put in the illiquid “bucket” [by the accountants]. Those illiquid assets require a bigger capital charge, so you are getting a double whammy.”

What? What capital requirement, exactly, causes this double whammy? I'd love to know. It's nothing in Basel 2, that is for sure, but the SEC website isn't that easy to search. The closest I can find is:

The requirements of paragraph (a)(7), as revised, are intended to help ensure that a broker-dealer maintains prudent amounts of liquid assets against various risks that it assumes and that it maintain a robust internal risk management system.

But I can't track down the full text of the illusive 15c3(1)(a)(7) or any of its relatives.

Dizard gets very interesting next:

Also, it has been suggested by some dealers, whose capital bases are getting too stretched to adequately maintain market liquidity, that they be given access to the Federal Reserve’s discount window and the generous Term Auction Facility. That would provide enough extra liquidity to keep more securities from being dumped into the capital-eating illiquid valuation “buckets”. This idea is likely to be taken seriously by the authorities.

Yep. The banks have become addicted pretty quickly to the crack cocaine of the TAF, aka 'post what you like and we will give you money'. The broker/dealers want some of that happy powder. Ignoring for a second the question of why being able to repo something with the FED makes it liquid, this might even be the right short term policy response. Keep fair values for the assets, but provide funding for them. The difficulty will be weaning the banks and the dealers off this cheap liquidity.