Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [92]
Accountants do not seem to know what they are doing, either.
Accountants allow corporations to put assets into three “levels.” The “level” indicates how easy it is for someone to check your work, with Level 1 being the easiest. Level 2 requires you to accept assumptions that you can supposedly recreate with enough hard work and data. Do you have several hundred thousand dollars and an army of geeks? Level 3 requires you to trust management assumptions that you cannot see and they do not disclose—it is reminiscent of teenage boys at their first prom: trust me, I will love you in the morning.
Level 1 is mark-to-market-based on observable market prices. For example, if you own stocks, you can find the prices very easily online. It is easy to calculate the value of your stocks every day. This is what accountants mean by mark-to-market. Since it is easy to do and anyone can check your work, it is transparent.
Level 2 is mark to model. Prices are based on models using observable assumptions. Accounting gives you some room to make assumptions. You cannot easily find prices in the market on many CDOs.You can debate mark-to-model prices. For instance, the creditors of BSAM challenged the April 2007 prices of the two hedge funds. Since management can control the assumptions, even with “observable” inputs, Level 2 can be “mark to myth.”
Level 3 accounting allows management to come up with prices based on models using unobservable inputs. In the absence of any other disclosure, I consider Level 3 purely mark to myth. It is a black box. You have no evidence that management is leveling with you.
Benjamin Graham put it another way. The formulas may be precise, but the assumptions may be self-serving and can be used “to justify practically any value .. however high.”26
FASB board member Donald Young says that mark-to-market accounting is “most valuable”27 when markets are tough. If prices decline, it signals investors that assets are under stress. If managers make up their own estimates instead of marking-to-market, it can be “mark-to-management”28 or as Warren Buffett says again, it can be “mark to myth.”29 If companies think prices will recover in future, they can explain it in their regular reports (the regulatory filings with the SEC).
In August 2007, Warren told me that if financial institutions sell 5 percent of their position, they will get the market price, and it will still be a higher price than they would get if they tried to sell 100 percent of a large illiquid position. He laughed as he added: “No one wants to do that.” In September 2007, Fortune reported that some financial institutions might appear healthy, but leveraged institutions might actually be insolvent if they marked-to-market instead of marked to model. “Many institutions,” Warren said, “that publicly report precise market values for their holdings or [sic] CDOs are in truth reporting fiction,” adding “I’d give a lot to mark my weight to ‘model’ rather than to ‘market. ’”30 Warren explained that selling 5 percent of their positions would reflect reality. I wrote Warren that I call this Warren Buffett’s Five Percent Solution. He wrote back: “In the print edition of Fortune they changed “of ” to “or” in the first sentence, though I got it corrected online.” I responded: “I am usually fast and accurate, but rarely impeccable and precise.” He sets a high bar.
The SEC seemed to have another idea. The last weekend in March 2008 (a couple of weeks after the Fed said it would exchange AAA assets for Treasuries), the SEC’s Division of Corporate Finance issued a letter that could have been called Retroactive Amnesty for Potential Alleged Accounting Fraud. The letter concerned public companies and disclosure issues they “may wish to consider”31 when preparing their regulatory filings. It said that under current (tough) market