Valuation of assets by mark-to-market is not always appropriate, especially for long-term investments; an additional way to value assets is needed. A leading academic – one of the world’s top commentators on the financial crisis – talks to Treasury Today about a possible solution.
If you need the money and have to sell your house tomorrow, the price you’ll get for it will be different to the price you would get if there was no rush and you could hold on for the next ten years. So how much is the house worth now? This conundrum acknowledges that at any one time the same asset can have different – but equally legitimate – values. Why then do regulators insist that long-term investors respond to daily movements in market price by imposing the mark-to-market valuation approach best suited to the short-term markets?
This question has been asked since the start of the global financial crisis by Avinash Persaud, Emeritus Professor at Gresham College and member of the World Economic Forum’s Global Agenda Council on the International Monetary System. He believes that the limitations of mark-to-market asset valuation could create further systemic failure and that this model should be supplemented with a more appropriate measure for longer-term investments.
One price for all
The accountant’s life is made easier if there is only one price for an asset, but the “inconvenient truth” is that there isn’t one price for any product, says Persaud. The house sale example at the top of this article demonstrates this. Mark-to-market is the price for the asset if it has to be sold tomorrow. But what is the price for the long-term asset? For the corporate pension fund investing for the next 20 years, if there is a decline in the price of an asset bought today to the extent that value has fallen below a policy threshold, it may be forced to respond by selling assets or shifting its portfolio allocation. By effectively forcing long-term investors to behave as if they are short-term, the liquidity premium for locking up cash long-term cannot be earned, reducing the attraction of long-term assets, even if they make best investment sense for the long-term saver.
There is also a macro-economic problem, notes Persaud. When there is a shock to the system and the banks with their short-term funding are forced to sell assets to raise cash, the system is safer if long-term investors are able to look at these assets and see the long-term value. “But if we force long-term investors to behave like banks, when the banks are selling their assets, the long-term investors will have to sell too because their assets’ price is declining. If there are only sellers and no buyers, the system crashes”.
The market needs investors who are able to value an asset differently so that when one is forced to sell, others can buy. The different requirements of short and long-term funding give a genuine capacity to price an asset differently, based on its maturity. But how in practice can this price be achieved?
There are two possibilities, both of which may need some refinement, says Persaud. The first is the discounted cash flow approach. By estimating the future cash flow of an investment and discounting it (typically by using the long-run cost of capital) it is possible to work out present value. Arbitrarily, any investment with a maturity of less than a year could be valued using mark-to-market. But anything longer could be priced using a weighting based on the proportion of time that is greater than a year of, for example, a ten year instrument could be priced using a 90% weight for a price derived from a discounted cash flow analysis and 10% for a price if the asset had to be sold tomorrow. The degree of sensitivity to the mark-to-market price of the asset is directly related to the maturity of the funding for the asset and not the mood of the market today. He calls this mark-to-funding. “A portfolio of equities intended to provide a pension in ten years’ time should be valued on the basis of the pension it can purchase in ten years’ time, not on the basis of yesterdays’ price movements”.
In practice it would be difficult to do this for each and every asset as funding tends to be arranged for several assets, but it could be done by matching funds with a pool of assets, says Persaud. The main effect is that long-term investments will no longer be affected by day-to-day market movements, thus encouraging long-term bargain hunters rather than short-term panic sellers.
Regulate with conviction
The accounting requirements put in place by the regulators typically insist that investors use mark-to-market to value their assets. The conversation that will enable the use of a sensible measure for long-term investments held by savings institutions is one that is currently only being held “in the corridors rather than in the main room”, notes Persaud. It will require “bravery” to bring it into the mainstream. Unfortunately, he adds, “we don’t yet have confident regulators that are prepared to take a balanced view”. This is partly because the thinking about regulation is too often framed by banks with short-term funding and not the rest of the sector and in part, because regulators feel they listened too much to lobbyists before the financial crisis and now are not prepared to listen any more. “Basel II was shaped in the image of what banks wanted. It had to be revised. We need regulators that are able to think for themselves, not blindly accept or reject ideas.”
Another problem noted by Persaud is that regulation can become so detailed that it takes on an almost impenetrable legalistic tone. The obsessive focus on correct legal definition and the drive of the self-interested lobbyists tends to push out of the debate those who understand the commercial and economic issues. The end result may tick all the boxes for the lawyers and the lobbyists but ultimately fails to meet the needs of the consumer or the financial system. “There is no one who speaks for the macro-economy and systemic stability,” states Persaud.
The main organised voice in this environment is the banking industry. The central banks should be getting more involved in discussion on the long-term economic environment but are for some reason reluctant to do so, he feels. The International Accounting Standards Board may seem like the ideal force for change, but Persaud sees it as being “entrenched with the notion of there being one price”. He also perceives the voice of industry bodies such as the ACT as being “muted” on this topic. It is, he states, “time that these players raised the volume because these issues are very pertinent to them”.
As for the current crop of regulators, they seem to see themselves as administrators, believing that all under their jurisdiction should follow ‘best practice’, notes Persaud. Whilst homogeneity makes perfect sense when regulating railways or the gas industry, in finance the need is for diversity where for every seller there is a buyer and vice versa. “If all are required to do the same thing, when one wants to sell, all want to sell and If there are times when there are no buyers, the system is fragile, not resilient.”
Start a conversation
Mark-to-market was introduced partly as a means of tackling fraud. When the markets were based on historic prices fund managers could post prices even for assets that had lost most of their value; mark-to-market would make that impossible. For short-term funded investments it is still essential but the unintended consequence of market instability when there is no long-term measure is a heavy price to pay.
For a mark-to funding model, the challenge will always be how to define the liquidity of an asset: a ten-year US treasury bond is a ten-year instrument but it is highly liquid. These issues can be worked out. Indeed, they have to be anyway under the new rules on bank liquidity, says Persaud. But in the interests of financial stability, the main thing right now is that the debate on pricing gets underway in earnest. And what better place than amongst the treasury community?