Volume 21, No. 10: Fair Value Reporting: Surveying Financial Institutions At 1Q2012
Disclosures of fair values of financial instruments don’t make the front page of quarterly earnings releases. In fact, they don’t even make the back page. Yet they tell a story about asset quality behind those “headline earnings” that drive so many split-second buy or sell decisions. Tucked away in the nooks and crannies of the footnotes to the quarterly financial statements, investors actually have to look for the disclosures, then tease their story out of them. No wonder most investors choose to ignore them – they’re in too much of a hurry.
All too often, investors make flawed associations when they hear the phrase “fair value of financial instruments.” (Another reason they don’t search for them.) They’ll think of firms booking “gains” from the declining value of their liabilities – even though these are just disclosures, and not liabilities where firms have taken the fair value option and generated weird gains. Some investors jump to the conclusion that capital is somehow being “wiped out” by reporting assets and liabilities at their fair value – secure in their belief that if they don’t acknowledge the fact that assets are in fact impaired, why, then the capital is really just fine. (See also: “whistling past the graveyard.”) You’ll also hear them say the information is unreliable or too hypothetical – from the same people who build their own “sum of the parts” valuations for a company – a standard operating procedure for most value-style investors. Substituting disclosed fair values for historical values, and using the results to test one’s beliefs about the financial condition of a particular company is no different.
Investors might never warm up to the disclosures in a big way, but that shouldn’t prevent one from using the insights they provide. Here, we take a look at what the disclosures are telling investors in both macro and micro views.