September 30, 2008
Problem: As I'm sure you are well aware, the shift to mark-to-market asset valuation causes problems when:
- the market-value for assets is undergoing a bubble expansion. Assets become significantly overvalued by the market relative to long-term trends, which is dangerous for businesses, investors, and the general economy.
- the market-value undergoes a sudden collapse of value, often the result of a prior bubble. Assets become significantly undervalued relative to long-term trends, which is even more dangerous to business, investors, and the general economy.
Proposed Improvement: I propose the following approach to asset valuation in order to significantly reduce these problems without going back to the bad old days of asset value reporting:
Assets are revalued each year (say) according to the following recursive formula. For the nth year, the value is:
V(n) = (1-a)*V(n-1) + a*MV(n),
where V(n-1) is the valuation provided by the process for the previous year, MV(n) is the current market value of the asset, and a is chosen to be somewher around ) 0.1.
This recursive moving average will be no more prone to manipulation than the current rules, and will significantly reduce the overvaluation in a bubble market. It will significantly reduce the dangerous under-valuation during a collapse, and will allow businesses time to handle and recover from cases where the market-values of assets drop to very low values suddenly.
The SEC can monitor what is happening to the MV by examining the rate of decrease in V(n). A drop of more than 5% in any one category in one year (if you choose a=0.1) would trigger a very close look, I would think.
If you have any questions, I will happy to respond to an email from your office.
Patrick Keating (PhD)