2/11/2008: Sylvain Raynes on fair-value accounting

Sylvain Raynes and Ann Rutledge are co-authors of The Analysis of Structured Securities: Precise Risk Measurement and Capital Allocation and principals of R&R Consulting, a consulting firm that specializes in the rating and valuation of structured securities. The following is an excerpt from Chris Whalen's article MBIA: Is Fair Value Accounting a Good Deal for Investors?, in which he summarizes recent remarks made by Mr. Raynes.

Last September, at the meeting of PRMIA at the Harvard Club in New York, Sylvain Raynes, a veteran of MCO's structured finance unit who lectures at Baruch College, talked about the idiocy of applying fair value to finance:

Valuation is not the most important problem of finance. It is not the most interesting problem of finance. Valuation is the only problem of finance. Once you know value, everything happens. Cash moves for value. More price does not mean more value. If we do not recognize the fundamental difference that exists between price and value, then we are doomed. Historically this distinction did not really matter in corporate finance because the two, price and value, were supposed to be the same, to remain equal forever. Who has been telling us that? These people do not live in New York; they live in Chicago. The Chicago School of Economics has been telling us for a century that price and value are identical, i.e. that they are the same number . This means that there is no such thing as good deal or a bad deal, only fair deals. When I was a kid, my father took me to a car dealership and showed me a Mercedes Benz and he said '$10,000.' Now I thought, 'Wow, this is a good deal.' And I grew up and went to school, and all of a sudden they started to tell me that this not a good deal, but a fair deal. No, my father was right. I think the Chicago School is wrong."

Valuing assets that are not freely traded in a public market is problematic and fraught with conflicts, but that is precisely what the FASB and SEC have done to investors with the "three levels of hell" method for fairly valuing assets. To review, below are the three buckets into which assets must fall under fair value accounting:

Level 1: assets that have observable market prices.

Level 2: assets don't have an observable market price, but are based on them, like a swap contract.

Level 3: assets where valuation is reliant on management estimates.

In our view, use of fair value accounting is making financial statements more difficult for investors to understand. Assets which are marked for sale and do not fit into either Level 1 or 2 should be accounted for based on historical cost, not thrown into the subjective mosh pit of "management estimates." Observed prices for real transactions are the only "values" which matter to investors. As one senior banker told The IRA last week, changes such as fair value accounting "make GAAP accounting increasingly useless for judging the true cash performance of a company.