The problematic notion of valuation February 12, 2010 at 6:39 am

One of the great advances in 20th century critical thinking was the realisation that seemingly simple notions like race, sexuality, or power, are actually rather nuanced and complex. It’s time to do the same to another 19th century idea that is too simple for the general good: valuation.

The issue is that some accountants, regulatorys, commentators, and other interested parties still cling to the idea that there is a single correct valuation for a security or a derivative which, with sufficient effort, can be discovered. Obviously in this paradigm failure to discover and use this value is at best incompetance and at worst fraud. The usually excellent Jonathan Weil falls for this in a recent Bloomberg article about Lehman, for instance:

The requirement that publicly owned corporations disclose complete and accurate financial reports is part of the bedrock of U.S. securities laws.

It is impossible to prove that your financials are accurate if your balance sheet involves illiquid instruments. A better requirement would be to require publicly owned corporations to disclose complete financial reports, to disclose the basis of their valuations, and to disclose an estimate of the uncertainty in them. Indeed with the three levels of FAS 157 and increasing tolerance for valuation adjustments, accounting standards are starting to move towards acknowledging the inherent uncertainties in valuation anyway.

I am not saying, by the way, that Lehman did not break the law – just that it is rather difficult to prove that they did, given the nature of their balance sheet. It may well be true that

one pile of bad investments … had been carried by Lehman at $52 billion, but after their analyses the firms [considering buying Lehman before the bankruptcy] estimated their value at closer to $27 billion to $30 billion.”

This alone does not prove fraud. It shows that there is a huge difference between going concern and liquidation value in a crisis. It shows that Lehman was almost certainly under reserved on a moral basis. But a 30% uncertainty in valuation on illiquid instruments in troubled markets is not that surprising.

It is only by acknowledging how hard it is to value some instruments, and how wrong you can be while performing the process honestly, that we can prove who isn’t being at all honest.

Comments are closed.