Risk Management, PRMIA

May 06, 2008

SEC Unveils 'Cloaking Device' to Hide Problems

The writers of the sci-fi franchise Star Trek long ago realized the importance of plot devices to keep the viewer interested and make problems more intractable. Thus, they had the bad guys use a technology that the good guys did not have: a 'cloaking device' that would hide the existence of their starships despite being in proximity of the good guys' Enterprise.

With the good guys (?) at financial firms being pummeled by write downs due to marking securities down to values that are, themselves, pummeled by a market low in liquidity and high in fear, the writers of the non-fiction franchise SEC have come up with their own 'cloaking device': www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm

It grants all publicly listed companies the ability to use unobservable inputs for pricing securities (Level 3 under FAS 157) when those securities are being observably priced in a 'forced liquidation or distressed sale'. It does not appear to define what is meant by such distress, but does require significantly more disclosure about how securities found their way into Level 3 and how they were priced using those unobservable inputs.

This appears to be the SEC's attempt to temporarily derail their inexorable march to mark to market, while allowing the markets to return to 'normalcy' (more normal liquidity and less fear). The theory here may be that time heals all wounds.

However, as all Star Trek fans know, the 'cloaking device' does have unintended consequences.

How will investors be able to fully trust the earnings reported at companies holding many Level 3 securities? And, how will that impact the very markets the SEC is attempting to calm? And, will those firms using this 'cloaking device' be able to more as adroitly as those that do not?

This starts to appear very similar to what happened under 'regulatory accounting' at thrifts in the early 1980s. That accounting treatment kept many thrifts in business despite a 'mark to market' problem. The government reacted by loosening many regulations on thrifts. Developers/promoters stepped in and took advantage of those regulations and many of those thrifts were later taken over or merged by the Resolution Trust Corp in the late 1980s and early 1990s. The ultimate cost being borne by the US taxpayer.

One would think that policymakers would have learned about the perils of using the 'cloaking device' to hide or delay the resolution of problems. But, perhaps that only happens in science fiction.

Posted by cogert at 11:53 AM | Comments (0)