Asset price ‘security alerts’ mask real risks; Defining value is hamstrung by assumptions and expectations

Last updated: November 22, 2013 9:44 am

Asset price ‘security alerts’ mask real risks

By Tracy Alloway in New York

Defining value is hamstrung by assumptions and expectations

Any reader who has flown commercially in the US during the past dozen years will no doubt have a passing awareness of the Homeland Security Advisory System. The now defunct terrorism threat scale was rolled out to indicate the threat level faced by the nation, from green – for a “low” risk of an attack – to red for “severe”. I was this week reminded of the now-moribund warning system thanks to a flight to Florida and a new research report by Fitch Ratings that draws an unusual parallel between the nation’s old colour-coded scale and US accounting rules. There is something undoubtedly alluring about a process that classifies a complicated concept – be it the threat of a terrorist attack or the value of a security – into an easily digestible label. But there are unquestionable trade-offs in doing so. For much of its lifespan, the Homeland Security system was stuck at “yellow” or “orange” – indicating a significant or high risk of terrorist attacks. So omnipresent were the yellow and orange indicators that many critics of the system pointed out that the colours should simply become the baseline for the entire scale. When the warning system was eventually phased out in 2011, public officials noted that it had provided “little practical information”. About five years ago, a new “mark to market” regime came into effect to govern how US banks value the assets on their balance sheets at market prices, known as “fair value”. The rule – FAS 157 – created three categories financial institutions could use to classify the securities on their balance sheets.At the “top” of the fair value hierarchy are “Level 1” assets, which can be valued fairly easily. There are prices to be observed, like stock prices on an exchange.

Next come “Level 2” assets whose values may be based on models or on quoted prices in relatively inactive markets – such as derivatives or some loans.

Then there are “Level 3” assets which cannot be valued using observable prices or even models. Instead they are priced using a hefty dose of subjective assumptions.

The Fitch report finds that since the new rules took effect, the “Level 2” category has accounted for about 85 per cent of all fair value assets.

While much of that will no doubt be due to the breakdown of securities on banks’ balance sheets, there is something to be said about the usefulness (or lack thereof) of an indicator that appears stuck at one point in an already simplified scale.

“A classification system that offers little differentiation provides only limited informational value,” write Fitch analysts. “Level 2 encompasses a range of situations, from assets that may be actively traded but fail to qualify for Level 1 categorisation, to assets that are difficult to value.”

And just as the Homeland Security system suffered from debates over its subjectivity, so too do US accounting rules and the perceived values of various securities.

A simple categorisation of ‘fair value’ may mask many assumptions and relegate progressively important information from scrutiny

US banks generally categorise US Treasuries as Level 1 – yet many mutual funds opt to classify them as Level 2, according to Fitch. Last week, the Commodity Futures Trading Commission upset many traders when it announced it would require cash to backstop Treasuriesused as collateral for derivatives trades.

If the markets cannot agree on the value of one of the most liquid and relatively safe assets in the world – an $11tn market – then it is tempting to believe that even the most basic assumptions are open to interpretation.

In other words, while finance may appear to be a well-defined and ordered arrangement of numbers and accounts, the reality is far more nuanced. Financial institutions are as much an amalgam of broad assumptions about values and forecasts as they are a collection of well-defined assets and liabilities.

It may seem like an obvious point but it is, I think, an increasingly important one.

This is a world where expectations – of the continuation of the Federal Reserve’s bond-buying programme, of the scope of the economic recovery, or the path of future interest rates – have come to wield a heavy influence on market prices.

All this means that the importance of recognising those expectations, and the scope and extent of their influence, has increased.

Just as a warning system that is forever stuck on high alert may blind the public to shifts in security, a simple categorisation of “fair value” may mask many assumptions and relegate progressively important information from scrutiny.