The Risk of Abandoning Mark-To-Market Accounting

Blackstone Joins the “Pro-Abolishment” Camp
Posted by Leo M. Tilman, November 13th, 2008, 11:31am

Last Thursday, Blackstone Group – the world’s largest private equity firm – reported a loss of over $500 million or 44 cents per share. In a now-familiar pattern, this loss posed a stark contract writing good essays to its profit of 21 cents a year earlier and was significantly underestimated by

equity analysts’ forecasts.

Interestingly, in the prelude to the earnings announcement Blackstone’s CEO, Stephen Schwarzman, proposed his own remedies for the ongoing financial crisis. One of his points included a recommendation to abolish mark-to-market (or “fair value”) accounting.

For a publicly traded private equity firm, this proposal is noteworthy, primarily because private equity firms that used to carry their investments at cost until their sales, now must mark them to market. They are now using the ongoing financial crisis as an argument to go back to the old way.

But will the argument wash? When we talk about the bailout and the program to buy troubled assets, the intent is to stem write downs by financial institutions. It is argued that  forced liquidations and illiquidity during the deleveraging stage of a financial crisis bring prices of securities below their “intrinsic” or “fair” values. Bailouts are designed to stabilize prices. Additionally, various amendments to fair value accounting are proposed to allow financial institutions carry illiquid securities at prices that reflect their intrinsic values rather than firesale levels.

In the case of Blackstone, however, this argument does not apply. One of Blackstone’s larger investments – discussed in The Wall Street Journal – is, for instance, Freescale Semiconductor, whose value Blackstone will need to write down not because of the market disruptions but because of the company’s shrinking revenues, job cuts, and write-downs during an economic downturn. Why shouldn’t a public company report a lower value on such an investment? The issue has nothing to do with the distressed mortgage loans and securities which are at the epicenter of the financial crisis and the bailout and must be judged on its own merits.

Financial Darwinism argues vehemently against abandoning mark-to-market accounting. As a matter of fact, it shows that static business models – that begat vicious circles of leverage and risk taking that preceded the current financial crisis, and other related problems – all stem from the fact that accounting earnings obscure economic reality and do not convey the true risks inherent in financial instruments and institutions. There is no doubt that new systemic regulation will have to address the dangers of marking to firesale prices. However, abolishing mark-to-market value accounting and obscuring the reality altogether is the worst solution by far.

No less an authority than the CFA Institute agrees.  In a recent statement they said:
“[The] CFA Institute believes that fair value accounting, coupled with accompanying disclosure, aids transparency and allows investment professionals to assess the financial health of a company. It can also discourage company management from taking imprudent risks. This financial crisis is about the mis-pricing of risk and ill-considered risk management. We do fully acknowledge that fair value should be based on more factors than an isolated fire sale price. However, masking financial performance through the suspension of fair-value accounting will not address these fundamental points and will continue to impact on investor confidence.”

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Financial Darwinism explores the origins, drivers, and implications of the ongoing tectonic financial shift. It then equips executives and investors with actionable approaches to creating lasting economic value amidst complexity and uncertainty.

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