Strange Bedfellows: Fair Value and the Bailout Plan

The presence of the government in the market could be just another piece of information to assess.

Further, having been provided with added disclosures under 157, investors might not enjoy having it taken away from them. “How would they react to having less information than they’ve had?” he asked. “How does less transparency help?”

Nathan also opposes those who argue for suspending fair value. “I think that’s a cop out,” he says. “I don’t think people are really looking into the spirit of FAS 157, and they are blaming 157. No one said it’s easy.”

Nathan is not a fan of the proposed bailout, objecting in particular to a provision which requires the Secretary of the Treasury to hold reverse auctions to buy distressed securities. “It might be easy to do a reverse auction, and it might be faster and it might be a transparent mechanism, but that doesn’t mean it’s the right solution,” he says.

The reverse auctions proposed under the bailout plan would provide an “observable price,” he acknowledges. But that won’t change the fact that the securities need to be valued as Level 3, in which the bailout’s price would still be just one of many valuation factors to be considered. “In a reverse auction, you are artificially creating a market as opposed to letting free forces create that market,” says Nathan.

For his part, Larsen feels that a government bailout could be an efficient way to activate the credit markets. To be sure, the criteria for judging the potential for success of any bailout proposal will be in the details. Overall, however, the core of the original plan submitted by U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke–buying distressed mortgage-backed securities at above-market rates from banks, which would then use the excess capital to begin lending money again–is solid, according to Larsen. The valuation specialist says, for instance, that if the government pays $40 per share for an instrument recorded on a bank’s books at $20 per share, the bank gets $20 of additional capital.

Depending on the leverage it can get, the bank could borrow 10 to 15 times that $20 of liquid capital and use it to provide “$200 of additional liquidity, or borrowing capacity, to the marketplace,” he said, noting that under such circumstances, “the bank’s balance sheet doesn’t just look better, it’s really is better because [it's] just changed that $20 of illiquid assets for $40 of cash.”

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