"Credit Standing and the Fair Value of Liabilities: A Critique," by Philip Heckman, January 2004/AUTHOR'S REPLY/RESPONSE TO AUTHOR

North American Actuarial Journal, Jul 2004 by Wallace, Marsha

MARSHA WALLACE*

Philip Heckman advances a number of arguments in opposition to reflecting credit risk in the fair valuation of liabilities. Since these arguments continue to surface and are a source of concern to a number of people, I feel it is important to address each major argument with the goal of showing how these arguments may in fact lead to the wrong conclusion, in spite of their apparent logic.

ARGUMENT 1: LIABILITIES SHOULD NOT BE VALUED IN THE SAME MANNER As ASSETS

In his article, Dr. Heckman cites another article by Grooch and Upton (2001). In reference to an example from this article, Dr. Heckman notes on page 72 that one result of fair valuation is that "[tjwo companies [that] undertake identical obligations . . . [would] post different liabilities." According to Dr. Heckman, "company A [which has better credit risk] suffers a penalty relative to company B [which has worse credit risk] because of its superior credit."

Dr. Heckman maintains that " [although the same financial and economic principles apply to the valuation of liabilities as to the valuation of assets, these principles emphatically do not lead to identical valuations for the same obligation considered as an asset and as a liability" (p. 72). He proposes that, instead, a liability should be valued solely on the basis of the contractual terms ''under the assumption that the contract 'will be performed as written and in the full amount, that is, as if it were default-free" (p. 81).

ARGUMENT 1: AN ALTERNATIVE VIEW

The argument above reflects a misunderstanding of the nature of the products involved. In particular, a commitment to pay a fixed amount from a company with less capacity to pay this obligation is not the same as a commitment to pay the same fixed amount in the same time frame from a company with more capacity to pay. And this is true even if both companies have the same intent to pay their obligations ultimately. Therefore, these two commitments are not identical obligations (they involve different levels of risk), and this should be reflected in the pricing of each of these obligations.

Note that this is essentially the same concept as pricing a burger from an A-rated restaurant differently from a burger from a B-rated restaurant. They may both be burgers, but they have different quality levels (e.g., different levels of risk).

Often, subtle differences in products (such as a difference in the level of risk) are in fact perceived by the individuals to whom these products are marketed. This explains, for example, the price difference between bonds with similar maturity values, but different levels of credit risk.

For instance, if Company A has more capacity to pay off its debts, then people will regard its promises as low risk (e.g., A-rated). So the rate of return they will want to earn on investments of this type (given that debt is an asset on the balance sheet of the bondholder) should be equivalent to that required for any other asset with comparable risk (e.g., an A-bond rate). If, as in the Grooch and Upton article, Company A is issuing 10-year zero-coupon debt with a maturity value of $10,000, and the individuals to whom this debt will be issued want to receive an earned rate equal to the A rate on this debt (7% per year), then they will be willing to pay a present value equal to $5,083 ($10,000/1.07^sup 10^) at the time the bond is issued. And this also holds for other liabilities with similar credit risk issued by Company A.

Note however, that the same individuals will not be willing to pay $5,083 for a promise to receive $10,000 in 10 years if this commitment is issued by a company with less likelihood of fulfilling this obligation. Instead, they will want to be paid a higher return (say 12% as in the Crooch and Upton article). Thus, the amount this person will be willing to pay at present for a promise of the same final payout is less. Why? Because it's a riskier (e.g., lower quality) investment. And how much less will they pay? The answer is: enough to give them an expectation of receiving the same return they would on comparable risk (e.g., B-rated) investments. Assuming B-rated investments are currently earning 12% per year, that means they will pay only $3,220 ($10,000/1.12^sup 10^) for such a promise.

Yet both of these prices are "fair" prices to both the issuer of the debt and the bondholders. In the one case, the bondholder receives lower risk and a lower return. In the second case, the bondholder receives higher risk and a higher return. Note that this is the point that Crooch and Upton are so ably trying to illustrate in their article.

Note also that the "penalty" for the lower credit risk of Company B is already built into this "fair" pricing of the debt, as the B-rated company will only receive $3,220 for issuing an obligation to pay $10,000 in 10 years, whereas the A-rated company will receive $5,083 for making this same commitment (albeit with more capacity and a greater likelihood of actually paying). Thus, if the A-rated company issues a $10,000 face value obligation that matures in 10 years, it should record both an asset (cash received) and a liability (value of the bond) of $5,083.