Do Investors Perceive Marking-to-Model as Marking-to-Myth? Early Evidence from FAS 157 Disclosure

Abstract

Capitalizing on the disclosure mandated by FAS 157, I examine the equity market’s perception of the reliability of internally generated fair value estimates. For the sample of S&P 1,500 financial institutions for the first three quarters of 2008, I document a significantly positive association between stock price and fair values measured using unadjusted market prices (FAS 157 Level 1), other observable inputs (Level 2), and significant unobservable inputs (Level 3), with valuation coefficients generally increasing in the observability of the measurement inputs. Using the reconciliation of the change in Level 3 net assets, I then directly examine the periodic re-measurement of the fair value estimates and document a significantly positive association between Level 3 net gains and quarterly returns. This result manifests even among observations with thin capital cushion, poorer information environment, and weaker corporate governance. Collectively, the findings are consistent with the conjecture that investors perceive the management-provided, mark-to-model, fair value estimates sufficiently reliable to use in firm valuation and do not discard them as “markings-to-myth.”

Keywords: mark-to-market, mark-to-model, internally generated estimates, FAS 157, Level 3, reliability of fair value estimates

JEL Classification: M41, M44, G12