Measuring Fair Value

I was very pleased to see that my friends at Goldman Sachs as always have their own view or dare I say it "interpretation" of the rules and are now apparently fully behind the Mark-to-Market (M-T-M) Plan of the Financial Accounting Standards Board (FASB).

Accounting is an arcane science. One of the basic tenants is a desire for consistency which allows for comparisons to be made. This approach has its advantages, but also its pitfalls.

Specifically in this case the discussion is centered on how to value loans, which is not as straightforward as one might have thought. Without going into the details the new holy grail is mark-to-market. This is intended to be a more realistic value of a loan as it values it at the current market rate regardless of the acquisition price.

Of course there is more than one way to determine the market price depending on the nature of the loan.

Generally speaking the simplest method is for Level One assets which are considered to be actively traded and therefore have a market price. Level Two is for assets which don't have an active market, but for which a standard model could be applied thus creating a fair value. Level Three is for those assets which don't have any recognizable market indicator to determine the price and essentially ends up being an estimation, otherwise known as a guess. As an aside it is always interesting to see what portion of a bank's balance sheet is classified as Level Three. As a rule of thumb the more the scarier.

But I am straying from my subject.

In the post Credit Crisis world there is a move for banks to move away from focusing primarily on the cost of a loan (credit cost) and then arguing about its value going forward to a new paradigm which focuses on cross-selling.

Of course banks have been promoting cross-selling for ever. At Goldman it is called Relationship Banking.

You build relationships with accounts and then try and find as many selling points within the client to market your products.

Now Goldman is admitting that one of the tools of Relationship Banking is to offer credit/loans at below market rates as a means of garnering favor for other more lucrative bits of business.

Cost-accounting "hid" this practice, and now Goldman wants everyone to have to mark these loans to market.

Sounds reasonable. It is. Every bank is involved in loss-leader business. The trick is to demonstrate to management, and to the regulators, that the bank knows the real value/cost of the loan and can accurately measure the overall profitability of a relationship.

It is not an easy thing to do, and potentially will expose the fact that many banks service a large number of low or non-profitable accounts. The 80-20 rule is that you make 80% of your profit from 20% of your accounts. That leaves a lot of questionable accounts.

I don't know why Goldman is doing this. Perhaps they think they have a much higher percentage of profitable accounts and that mark-to-market will knock-out a number of weaker competitors. Maybe they want to undermine the idea of M-T-M and are only posturing.

What I do know is that they never do anything for the fun of it.