Accounting Gone Wild
By: Dr. Charles Lieberman
Date: 3/9/2009
A Wall Street analyst suggested that GE Capital should mark down its real estate assets by 25%, implying a $9 billion loss. Such mark-to-market accounting of long-term assets is crazy. Assets held for the long-term should not be revalued each quarter at current market prices, especially when markets are illiquid and dysfunctional. The accounting system is getting in the way of sensible business practices and creating reported losses that do not accord with a companys financial health.
Imagine a building with paying tenants, so the building covers its operating and financing costs. The net rents appear as corporate income. However, they could be dwarfed in the short-term by fluctuations in the value of the building. In a recession, tenants may fail or depart, which cuts into net income, which provides investors with useful information about the building's performance. Recognizing a decline in the building's value would introduce a highly procyclical distortion into earnings. A held to maturity portfolio should not be valued as if every asset is valued at its selling price every day. That would wreck havoc with the ability of any institution to hold any long-lived assets. Moreover, valuing real estate in today's illiquid markets suggests an artificially low price. With financing scarce or nonexistent, there are only distressed sellers. Anyone with staying power is totally unwilling to sell now. So how can current valuations be taken as true indications of value? Fed Chairman Bernanke has acknowledged these problems with mark-to-market accounting, but acknowledges he lacks a satisfactory alternative. Some assets should simply be carried at cost. Or, revalue 10% of all such assets every 10 years, but surely not daily.
Illiquidity also leads to dramatic inferences in other areas, such as the infamous credit default swaps market. It was widely noted late last week that the credit default swaps of Berkshire Hathaway and GE Capital are trading at junk bond levels, lower than such financial stalwarts as Russia. GE's AAA rating might be lowered to AA, but it is certainly not a junk credit. A limited amount of buying by hedge funds and other aggressive players can swamp the CDS market, where few investors are willing to take on the risk of writing insurance on the viability of any company. In truth, bond buyers make this bet daily, although buying a bond is far less aggressive than selling a CDS (much like buying a stock is similar but far less aggressive than buying a call). Yet credit rating agencies and others downgrade borrowers on the basis of the implied higher level of risk. In time, a radical re-evaluation of our accounting system is needed to improve clarity without getting in the way of sensible investment decisions of companies. Download this article in PDF Format
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