Fair value reporting seemed anything but fair last October when prices fell off a cliff.
Money managers argued that this type of accounting, also known as mark-to-market for the way it prices assets at whatever level the market is at, was undercutting their businesses and forcing even strong companies to write down billions of dollars of assets to fire-sale prices.
After a careful and thorough review of the practice, the Securities and Exchange Commission decided not to suspend or eliminate the rules, but acknowledged that there was room for improvement in terms of assessing risk, giving a counterparty time to weigh a security's true value and discounting unrelated volatility.
To that point, the SEC is working with the Financial Accounting Standards Board and the International Accounting Standards Board to simplify the reporting of complex financial instruments. The Commission will also be beefing up reporting and transparency.
"Mark-to-market accounting is a fundamental principle that will continue," said Gene Gohlke, associate director at the SEC's Office of Compliance Inspections and Examinations, speaking at the National Investment Company Service Association's East Coast regional meeting in Boston.
"I don't see how it can change," he said. "Perhaps it will be tweaked, but it's not going away."
The main reason for keeping fair-value accounting is the old standard that things are only worth what someone else is willing to pay you at the time you want to sell. Suspending mark-to-market accounting could amplify investor concerns and could lead to values that are completely out of touch with reality, but during irrational markets and periods of panic, marking down assets to fire-sale prices doesn't make much sense, either.
During the crisis last fall, "mark-to-market accounting exacerbated the situation," said Sean Kay, senior manager of investment management at PricewaterhouseCoopers. "It's difficult to measure risk in an instrument that has volatility."
Financial Accounting Statement 157 (FAS 157) defines fair value as the price that would be received to sell an asset or be paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Noting that mutual funds are required to calculate their net asset value every day, Gohlke said that that "value should reflect what a fund can dispose of at 4 p.m. It assumes that a person on the other side of the transaction would have time to understand the basket of risks when making the purchase."
The price should reflect current market factors as well as distressed prices, he said.
When determining the value, "funds should consider if there would be an informed buyer on the other side," Gohlke said. But therein lies the key problem. "How long would it take an informed buyer to come up with a risk assessment?" Gohlke asked. "A fund may not have the luxury to wait 10 to 15 days. If they can't do it within seven days, it's not a liquid instrument and shouldn't be considered as such."
Value at risk is an historical measurement, said Dan Kelly, chief risk officer at Harvard Management Company. "In times of stress, it's not a good value. You really need to value it at what an investor can get out of it. What are the forces that can influence a price?"
Investors should be demanding transparency from their fund manager, he said.
The value-at-risk models don't factor in 1% to 5% of risks, said Frank Knox, vice president and chief compliance officer for John Hancock Financial Services.
It's a good tool, he said, but "instead of being one tool in the toolbox, it became the primary measurement."
"Value at risk leaves off the tail events, but they do happen," Gohlke said. "One area where mark-to-market should be in place is with pooled investment vehicles. How many investment vehicles stop and ask the question 'What if?' What would that do to our vehicles if housing prices dropped by 20%? Our portfolios would disintegrate. You've got to do the what-ifs.
"The information we have about mutual funds is very limited," Gohlke said. "If you've ever tried to do anything with EDGAR filings, you can usually locate the fund, but that's about it. It's not terribly useful."
There should be a structured process where funds can provide useful and timely information to the Commission, he said.
In addition, the industry "can expect more talk about money market fund regulation going forward," he said. "There will be a greater focus on liquidity. Does Rule 2a-7 need tweaking?"
Up until six months ago, no one had challenged a price on a money market security, Knox said. After the Primary Fund money market fund broke the buck in September, investors panicked and started pulling assets.
The Treasury Department quickly stepped in with a guarantee program for money market funds, in a move that Gohlke said was well-timed and stopped the panic.
"Even though a money market fund broke a dollar, it didn't seem to have a spillover effect," Gohlke said, noting that money market fund assets are at all-time highs.
"In September, we asked all money market funds to report their [baskets] at a specific date," he said. "It gave us insight across all holdings and allowed us to see concentrations in various instruments."
During recent rough periods, though, you can see a 100% difference in price between advisors, Knox said.
Money market mutual funds are supposed to be stable, boring and predictable. If shadow pricing is causing their value to range from 80 cents to 20 cents for the same instrument on the same day, there is a real problem, Gohlke said. "Apparently, money market funds still need help," he said.
"Going forward, there will be a lot more emphasis on [Investment Company Act of 1940] exams and broker/dealer exams," Gohlke said. "It's part of the '40 Act inspection program to ask custodians of client assets, on a sample basis, what the custodian holds. We'll continue to do that going forward, but more on a 100% basis, not a sample." He said there are many cases where an affiliate of an advisor holds the clients assets, but the SEC doesn't know if they can trust the affiliate.
"It could be [the Depository Trust & Clearing Corporation]; it could be foreign depositaries," he said. "We don't trust what we see in books and records. Expect to see the SEC staff being aggressive up to client custodians and clients. "
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