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Keith Sellers
University of North Alabama

Goldman Sheds Some Light on Valuing Illiquid Assets


By: Tammy Whitehouse | August 09, 2010

Many accounting and financial reporting executives still wonder how they should report the fair market value of assets that are trapped in frozen or otherwise illiquid markets. Now investment banking giant Goldman Sachs has given a glimpse into how it has approached the problem.

Goldman submitted a nine-page memo to the Financial Crisis Inquiry Commission last month outlining how it arrived at fair values for its most troubled securities in 2007 and 2008. Those securities, mostly backed by residential mortgages, were insured by American International Group. As the housing market tanked in 2008, Goldman used its values as the basis for collateral calls it imposed on AIG—which ultimately led to AIG’s insolvency, followed by a government bailout of $182 billion.

Given that history, the FCIC has taken a keen interest in the methods Goldman used to value its mortgage-backed securities, which were essentially illiquid by late 2008. The firm said it followed U.S. Generally Accepted Accounting Principles for measuring fair value, which require the company to consider what willing buyers and sellers would accept in an arm’s length transaction. “We believe our marks were accurate and reflected the value markets were placing on the transactions,” Goldman told the FCIC.

Goldman said it is “one of the few financial institutions in the world” that carries virtually all of its financial instruments at current market value. The memo to the FCIC focuses on Goldman’s approach for measuring the fair value of collateralized debt obligations and residential mortgage-backed securities. The firm said its numbers were based on “the best available market information at the time,” including observed trades, actionable bids or offers from other parties, and other market information sourced through the franchise.

In late 2007 and 2008, however, it was not unusual to see no transactions in mortgage-backed securities and CDOs. In those cases, Goldman said, it studied transactions in comparable instruments, or those with similar underlying collateral structures or similar risk-reward profiles. To value CDO securities when there was little or no trading activity, Goldman said it also sometimes relied on an analysis of net asset values, which focuses on the underlying collateral.

Goldman said it made its first collateral call to AIG in July 2007, after rating agencies downgraded hundreds of subprime mortgage-backed securities and put hundreds more on watch for further downgrades. The rating action led to sharp drops in pricing, which spurred significant revaluation of CDO liabilities, the investment bank said.

Thought Experiments

Espen Robak, president of Pluris Valuation Advisers, says Goldman’s explanation of its valuation process seems to reflect a genuine effort to follow accounting guidance at a time when doing so was difficult. The accounting rule in force at the time, Financial Accounting Standard No. 157, Fair Value Measurement, required companies to use a three-step scale to value assets, using observable market data about prices as much as possible.

“You have to make sure there’s a qualitative process for how judgments are made. It would appear from the memo, though it’s limited in what it shares, that [Goldman] followed the appropriate steps. ”

—Mary Ann Travers,
Principal, Crowe Horwath

As assets became more illiquid and pricing data grew harder to find—which happened to mortgage-backed securities in 2007 and 2008—FAS 157 allowed companies to use a blend of market data and internally produced models to calculate fair value. When markets were entirely frozen, companies had to rely on model-driven estimates of fair value without any pricing data at all.

Robak says Goldman’s description of events suggests it continued to rely on market pricing, however thinly instruments were trading, even at a time when many financial institutions were moving to pricing models because they considered market pricing to be irrational. (It was at this point in time, in late 2007 and early 2008, that the Financial Accounting Standards Board started to hear calls for it to soften fair-value requirements and allow banks to establish values based on their expectations of future cash flow and eventual recovery.)

“Overall, to be fair, this looks very good,” Robak says of Goldman’s explanation. “It contrasts with what we saw a lot of other people arguing at the time. This is what fair value is supposed to mean. You look at the market and look at what’s going on and base the value on that, not just a lot of hopes and dreams or what some model might show.”

Scott Palka, a partner with consulting firm Tatum, says Goldman’s valuation process can’t be fully assessed from a nine-page memo alone, since the document doesn’t provide enough technical detail to understand what went into the valuation. “It’s kind of like having a picture of a house, not the architectural drawing,” he says. Nevertheless, he adds, the analytical process looks sound.


The following excerpt provides Goldman’s conclusion contained in its statement to the FCIC:

We believe that our marks on the GS-AIG trades were accurate for a number of reasons, including:

  • As we have demonstrated, our fair value marks were based upon the best available market information at that time because we were an active market maker in cash and credit default swap mortgage products throughout 2007 and 2008.
  • We were willing and ready to make a two-way market. If AIG believed that our marks were too low relative to the rest of the market, it could have bought additional risk at those significantly lower prices. It did not.
  • We told AIG that it could offer our prices to other counterparties in an effort to find clearing levels for the specific reference obligations if it was not interested in adding risk.
  • The prices at which we marked the securities were consistent with the prices we had on similar securities that we held in our inventory.
  • We used consistent prices to post collateral to clients on the other side of the AIG transactions.
  • We felt confident enough in the accuracy of our marks to pay a premium to other financial institutions in order to hedge our uncollateralized credit risk to AIG.

We questioned AIG’s view of the value of super senior CDO risk they insured because:

  • We provided our individual marks to AIG on a daily basis, but AIG did not provide us with its marks, despite repeated requests to do so. This was not consistent with how other counterparties looked to resolve valuation disputes.
  • AIG stated on numerous occasions in our discussions with them that they were not actively trading in the market.
  • AIG depended on third party marks but confirmed on multiple occasions that it could not buy or sell on those prices. In other words, the marks they cited were not actionable.
  • During early discussions with AIG, they stated they were looking at their positions on a “more fundamental” basis and were accordingly not incorporating actual current market values.

Indeed, as AIG stated during its testimony before the FCIC, it did not have an internal pricing system to value the securities on which they sold credit protection until December 2007.


Goldman Sachs Statement to FCIC (July 2010)

The key to the valuation tension in this case wasn’t so much the estimating process, Palka says; it was the “cliff” that developed when trading in mortgage-backed securities evaporated, which “eroded the theoretical floor value of the instrument.” In that sort of market environment, valuation becomes a daily exercise, he says.


Mary Ann Travers, a principal with Crowe Horwath, says the Goldman memo provides an object lesson on the importance of having and following a documented process to manage risk. Especially in areas such as measuring fair value (a task steeped in judgment), a well-documented process is vital to defend the company during any subsequent regulatory probe or examination—like, say, a blue-ribbon commission exploring your possible role in the financial crisis.

“You have to make sure there’s a qualitative process for how judgments are made,” Travers says. “It would appear from the memo, though it’s limited in what it shares, that they followed the appropriate steps.”

The Bigger Picture

Palka says it’s possible that an entity might use slightly different valuation methods for different purposes. Financial reporting is meant to reflect a single point in time, or the financial condition of the company as of the closing date for a particular period. Collateral calls, on the other hand, are more dynamic, where repricing happens frequently. Counter-parties should agree on the formula they’ll follow, he says, but it may not be the same as the process the company might follow for financial reporting.

Goldman says in its memo to the FCIC that it called for and paid collateral “consistent with the marks we use for our internal and external reporting purposes.” A spokeman told Compliance Week the firm was “entirely consistent” in its valuation methods for different purposes. “The marks that we derived for our collateral calls on AIG were the marks that we used in our books and records, and they were the marks we used to calculate collateral we owed to counter-parties on the other side,” the spokesman said.

Goldman posted earnings of $11 billion in 2007 and $2.3 billion in 2008, although it claims its exposure to residential mortgage-related instruments was small relative to the rest of its holdings, and that it lost $1.7 billion in mortgage-related products in 2008.