The recent Policy Statement of the President's Working Group on Financial Markets makes the following recommendation (repeated twice in the document) concerning disclosures about fair value estimates:
- "Regulators should encourage financial institutions to improve the quality of disclosures about fair value estimates for complex and other illiquid instruments, including descriptions of valuation methodologies and information regarding the degree of uncertainty associated with such estimates;"
- "Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A: ... With regard to Level 3 assets or liabilities, a discussion of, to the extent material: ... whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views. ... [C]onsider providing the following additional information in your MD&A: A general description of the valuation techniques or models you used with regard to your material assets or liabilities. ... A discussion of how sensitive the fair value estimates for your material assets or liabilities are to the significant inputs the technique or model uses. For example, consider providing a range of values around the fair value amount you arrived at to provide a sense of how the fair value estimate could potentially change as the significant inputs vary. To the extent you provide a range, discuss why you believe the range is appropriate, identifying the key drivers of variability, and discussing how you developed the inputs you used in determining the range."
One big problem with this approach is that the regulators do not make clear how their recommended "disclosures" are to be used. Obviously, the regulators believe that the disclosures will convey "information." How and by whom should this information be used? For example, is this information to be used in the calculation of capital ratios? If not, then what use is to be made of it? If the regulators themselves do not make use of this information in calculating capital ratios, then, why should anyone else, in particular investors, make use of this information?
Consider, for example, the SEC's discussion of unrealized losses:
- "[Disclose] whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views."
- "AIG continues to believe that the unrealized market valuation losses on this super senior credit default swap portfolio are not indicative of the losses AIGFP may realize over time. Under the terms of these credit derivatives, losses to AIG would result from the credit impairment of any bonds AIG would acquire in satisfying its swap obligations. Based upon its most current analyses, AIG believes that any credit impairment losses realized over time by AIGFP will not be material to AIG’s consolidated financial condition, although it is possible that realized losses could be material to AIG’s consolidated results of operations for an individual reporting period. Except to the extent of any such realized credit impairment losses, AIG expects AIGFP’s unrealized market valuation losses to reverse over the remaining life of the super senior credit default swap portfolio."
It is clear how investors interpreted AIG's disclosure: on the day of the press release, AIG's common stock dropped 6.5%, wiping out billions in market capitalization. So, the disclosure did not help AIG at all. In fact, it likely hurt AIG by creating the impression that AIG was somehow trying to manipulate its numbers.
It is clear that the SEC's letter will have one benefit: it will allow auditors to sign off on financial statements that contain the kind of disclosure the SEC is recommending. This may prevent auditing firms from issuing conclusions of material weakness in internal control over financial reporting and oversight relating to the fair value valuation, as PWC concluded with respect to AIG's fair value calculations:
- "AIG has been advised by its independent auditors, PricewaterhouseCoopers LLC, that they have concluded that at December 31, 2007, AIG had a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the AIGFP super senior credit default swap portfolio. AIG’s assessment of its internal controls relating to the fair value valuation of the AIGFP super senior credit default swap portfolio is ongoing, but AIG believes that it currently has in place the necessary compensating controls and procedures to appropriately determine the fair value of AIGFP’s super senior credit default swap portfolio for purposes of AIG’s year-end financial statements."
Be that as it may, it is still unclear how the Treasury, the Fed, and the SEC intend their recommended disclosures be used. US regulators must address the question: In what sense will the new disclosures clarify instead of simply confusing more?
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