Pesky question of how banks value securities takes center stage

Once again, the question of how banks value their exposures has taken center stage.  This time, the valuation issue came up due to a lawsuit against four Credit Suisse traders who are accused of manipulating the valuation of structured finance securities.

Regular readers know that one of the primary reasons your humble blogger has been advocating ultra transparency is that it ends this activity.

When market participants can see a bank's current asset, liability and off-balance sheet exposure details, they can independently value these exposures.  After all, setting prices is what markets are good at.

Ultra transparency also allows market participants to call attention to any exposure where there is a considerable discrepancy between their independent value and the bank's value.

The Wall Street Journal ran an article that highlights how without ultra transparency market participants do not know if a bank is solvent (the market value of its assets exceeds the book value of its liabilities).

Allegations that several former Credit Suisse Group AG employees misstated bond values revive a thorny question for investors: whether to trust the valuations companies assign their riskiest, most-illiquid assets....

The case spotlights the valuation questions that have dogged banks and securities firms since the start of the financial crisis. 

The puzzle of whether financial institutions properly acknowledged losses on their investments wasn't made any simpler when accounting-rule makers, pressured by Congress, in 2009 gave banks and other companies more leeway in valuing less-liquid assets. 

Without ultra transparency, there is no way for market participants to know whether banks have recognized all of their losses or whether there are massive amounts of losses still hiding on and off balance sheet.

This is the reason that market participants do not trust banks.

The Credit Suisse case comes as a new set of accounting rules that took effect at the start of 2012 will force companies to disclose more about the methods and assumptions they use in valuing exotic securities. 

The new disclosures wouldn't have prevented the sort of improprieties that allegedly occurred at Credit Suisse, experts say. But they may act as a check on companies, by giving investors a chance to see what assumptions are made in valuation models. 

"The fact that they have to report this will make management think," said Ravi Jagannathan, a finance professor at Northwestern University.

Compare and contrast the new rules with ultra transparency.  Ultra transparency will prevent this sort of impropriety as market participants will be quick to notice.

The new rules are a one-off solution.  It requires market participants to review the assumptions for all the bank's valuation models and figure out which ones might be driving a mis-statement in the valuation of securities.  Then, market participants are left without knowing the size of the exposure of the bank.  Exactly how is this going to lead to market discipline?

The new rules, enacted last May by U.S. and international accounting-rule makers, deal with how companies value their assets at "fair value," which is the market value or the closest approximation of it. The rules will require companies to make some new disclosures about the ways they determine fair value for their "Level 3" securities—the ones companies value using their own estimates and models. 

For instance, for securities backed by home mortgages, companies will have to disclose what assumptions they are using for mortgage prepayment rates, the probability of default and the severity of losses. 

Companies also will have to describe how sensitive their valuations are to any changes in the estimates and models they use. And for any items that companies must disclose the fair value but aren't required to carry at fair value on the balance sheet—such as bank loans—the companies must specify whether the items fall into Level 3 or would be classified as Levels 1 or 2, which are more-liquid assets that companies value using market prices or other "observable" information. 

The new disclosures will start showing up in companies' first-quarter reports.