An unforgiving eye
Tuesday, 18 March 2008
Jennifer Hughes and Gillian Tett
ACCOUNTING rules rarely top senior executives' agendas. But when Axa, the mighty French insurance firm, recently unveiled its results, its bosses were unusually outspoken in voicing their criticism of bean-counters.
"If you are in the medical business, you want to be sure that the thermometer is the right one for benchmarking things properly," said Henri de Castries, chief executive of Axa. "The accounting systems in the economy are the thermometer, and I'm not sure their measurement scale is the right one."
It is a sentiment now being echoed with increasing vigour by financiers, particularly given the impending round of results from Wall Street brokers. As the credit turbulence has spread this winter, financial companies have unveiled a staggering swath of losses on instruments such as mortgage bonds. Axa itself, for example, recently revealed some €600m (£460m, $940m) of writedowns; meanwhile, western investment banks have reported hits of more than $181bn (£89bn, €116bn).
Many observers expect this tide of red ink to swell further this month, when US brokers such as Bear Stearns announce results for the December to February period. The price of mortgage securities, as measured by indices such as the ABX, is continuing to fall, and there is pressure on banks to make large writedowns for corporate leveraged loans as well.
As the losses rise, anxiety is growing over the way these hits are being measured. At present, accounting is dominated by a concept of "fair value": companies are expected to report the value of their holdings in as "current" a manner as possible, which in practice means marking to market prices.
However, there is mounting concern that this approach creates distortions when markets are as dysfunctional as they are now. Indeed, some bankers fear that the system is actually making the crisis worse. Far from offering a reassuring yardstick, it is forcing banks and hedge funds to sell assets in a manner that is stoking investor panic - or so the criticism of men such as Mr de Castries goes.
The issue is particularly critical because the current financial crisis is the first to have occurred in a context dominated by fair value rules. In truth, the concept of fair value is not new. On the contrary, an academic debate about its merits - and demerits - has been under way for years. Many banks and insurers have been fair-valuing at least some of their holdings for decades. Most notably, US brokers with trading businesses -- such as Goldman Sachs and the other banks that will report soon -- have always marked their holdings to market prices.
However, the use of fair value accounting has never been uniform: institutions have traditionally used different models for assets such as loans that they intended to hold until maturity, allowing them to ignore irrelevant market fluctuations. In past financial crises - such as the US Savings and Loans shock two decades ago - many affected institutions were not marking such loans to market prices.
Far more institutions are now entangled in the fair value net, due in part to changes in accounting rules and in part to new business models. This decade, more banks have embraced the so-called "originate and distribute" model, in which they typically pass on the risk of the loans they make by packaging them into marketable securities. As such securities are not intended to be held until maturity, most became liable for fair value treatment: banks had swapped the credit risk of holding the loans for the volatility risk inherent in any tradeable financial instrument. On top of this, derivatives have become increasingly commonplace - and these are also marked to market.
Until very recently, there was a widespread assumption in the market that this shift towards fair value was a thoroughly good thing. After all, this approach injects more objectivity into the system by not allowing managers to use their own idiosyncratic models and supports the supremacy of the market as an independent verifier of value. Moreover, until recently bankers had a vested interest in applauding these changes. Between 2002 and 2007, the value of many credit instruments rose sharply - which in turn boosted the value of assets reported on balance sheets, flattering bank results.
In the last eight months, however, this once-benign pattern has gone into reverse. As the value of assets such as mortgages has tumbled, so has the value of portfolios. This has not just hurt balance sheets but also hit profits directly, since the value changes of some instruments, particularly derivatives, feed through to the bottom line. Take Axa's recent €600m writedown from fair valuing its holdings: of this, €300m dented income and €300m remained on the balance sheet. Similarly, American International Group, its US rival, recently suffered a direct $11bn profit hit from writing down the fair value of derivatives. Martin Sullivan, AIG chief executive, recently said that fair value accounting had had "unintended consequences" and called for its suspension.
At the same time, "mark to market" accounting has encountered growing practical challenges. The intellectual framework that supported the creation of complex derivatives - and application of fair value concepts - has tended to assume in recent years that capital markets had reached a level of sophistication that meant they were unlikely ever to freeze up too widely or for too long. Indeed, when the credit crunch started last summer, some auditors joked that the timing was good, since a summer crisis would probably be over by Christmas.
Such comforting assumptions are now being blown apart. The sense of panic in some corners of the credit world has become so extreme that buyers have completely disappeared - making it extremely hard to get genuine trading "prices". That in turn has created a dilemma for bankers and their auditors, who are trained to view the market as the ultimate independent arbiter. "As markets become less and less functional, what use is that price to understanding valuation? If I'm a large client of a broker dealer, I can get any 'print' or price that I want," says Christopher Whalen of Institutional Risk Analytics, a consultancy.
Accountants are trying to deal with this challenge in several overlapping ways. Some have scoured the markets for any evidence of deals that could be used to determine quasi-market prices. Many mortgage-linked securities, for example, are currently being valued on the books of the largest banks not according to the price of the actual security, but rather from an extrapolated value taken from associated derivatives such as the ABX. At the same time, if market prices cannot be determined - even via derivatives - then banks and auditors are using models to calculate a value. The instruments subject to this treatment are known in the industry as "Level Three" assets, referring to terminology in the accounting rules that ranks financial instruments in terms of how easy it is to find their value.
However, all of these approaches have flaws. Many investors are sceptical about the accuracy of models used to estimate the price of untraded assets. "When markets dry up there are problems with mark-to-market disclosure because there are no markets. Then people have to use mark to model but there are big problems with that too," observes Charles Goodhart, professor of finance at the London School of Economics.
Many banks are even more dubious about the wisdom of deriving mark-to-market values from the activity currently under way. Derivatives indices such as the ABX are relatively recent creations and tend to be highly volatile; meanwhile, fire-sale prices - such as those caused by hedge funds forced to liquidate holdings - are often also extreme. Indeed, many bankers now complain that some of the so-called "market" prices being used by auditors offer such a poor guide to intrinsic value that current writedowns will almost certainly be reversed in the future.
"You can see [bankers'] point that the market is irrational right now," says Tony Clifford, a partner in the financial services practice at Ernst & Young. "If you look at some credit derivatives right now, their prices are consistent with the assumption that a huge number of very well regarded firms are going to go bust in the next few years, which won't actually happen unless you believe - and very few really do - that we're heading for a complete meltdown of the financial system."
Meanwhile, placing assets in the so-called "Level Three" category creates another headache for banks. Regulators typically require banks to hold higher reserves against assets placed in this accounting pot. Thus, as more assets have moved into this pot in recent months, the capital pressure on banks is effectively increasing - in addition to the write-offs they are making on the assets that can be valued.
This in turn is threatening to create a vicious circle in the markets. As banks come under pressure to improve capital ratios, many are trying to cut their lending to heavy-borrowing counterparties such as hedge funds. Lately Carlyle Group, the private equity giant, was forced to admit it could not save its highly leveraged $22bn mortgage-backed-securities fund - which had $31 of debt for every $1 of its own equity - after the fund's bankers made higher margin calls, in effect demanding more collateral against their loans. Funds are forced into fire-sales to meet the calls or, if they collapse as Carlyle's has, then banks will take control of the remaining assets and liquidate them. Either way, the sales are depressing prices - which in turn is reducing the recorded value of banks' assets and increasing the pressure on them to cut lending further.
"The stock of leveraged credit assets overhanging the market now, combined with acceleration of margin calls, forced liquidations and capital write-downs, creates a self-reinforcing dynamic towards . . . even greater capital destruction at the banks," Credit Suisse wrote in a recent report. Or, as Paul Tucker, head of markets at the Bank of England, observed: "There are lots of people out there now saying that risk is overpriced. So why aren't long-term investors stepping in? Because people think prices could fall further."
Given this, many policymakers and financiers think that a wider debate is needed about the way that fair value accounting rules are being applied to the financial world. Indeed, behind the scenes some industry officials are already lobbying for change - and banking groups are discussing potential reforms. "We need to have a debate about whether the application of mark-to-market accounting to a wide range of assets creates some distortions," says Charles Dallara of the Institute of International Finance, a Washington-based banking group that is creating a reform blueprint.
However, many accounting officials retort that these complaints simply smack of special pleading by the banks. After all, they argue, bankers were happy to describe these securities as "tradeable" when they were packaging them for investors earlier this decade, or valuing them on their own books at ever rising prices. Thus these instruments do have a market price, even if the banks dislike where it now stands - or so the argument goes.
"If you'd asked these [financial] firms six months ago, I think they'd have said of course these securities are fairly valued," says Michael McMurtry, partner at Eisner, the New York-based accounting firm. "Now they recognise that probably wasn't the case and they think the current values are too low. Well, only time will tell."
In practice, members of the International Accounting Standards Board, the body regarded by many as the torchbearer for fair value, remain strongly opposed to any suggestion that the use of fair value should be watered down. "Market volatility is often referred to as accounting volatility but this isn't something made up, it is the reporting of economic volatility - the change in the value of assets and liabilities as a result of entities' exposure to risk," says John Smith, a board member of the IASB.
"All business is exposed to some kind of risk - currency, credit, price, liquidity and others. That exposure is what I view as economic volatility," he says. "Fair value is simply showing the volatility that exists. Accounting standards are based on the economic reality that exists currently - not on management's optimistic view of what will occur in the future."
Quite irrespective of the longer-term philosophical debate, in the short term policymakers admit that it would be extremely difficult to rip the current rules up. In recent months, some financial officials have held quiet debates about whether there might be any way to soften the impact of the accounting rules - or, as one central banker puts it, "break this downward spiral".
However, implementing any such co-ordinated action would be a daunting task. During Japan's bank crises a decade ago, the Japanese regulators performed a unified audit of the banks in a bid to offer investors better transparency and prevent market confidence from being damaged by a continual "drip feed" of bad news. But it would be hard to repeat this approach today, since the banks affected by the crisis are spread across numerous jurisdictions, and policymakers lack the resources to conduct independent forensic analysis.
Similarly, forging a single agreement between banks, auditors and policymakers to, say, soften the rules would also be extremely difficult. One policy model that is sometimes hailed by older bankers, for example, is the approach used during the Latin American debt crisis of the 1980s, when a tacit deal was reached that the auditors would not be too tough on the banks for a few years - as long as these institutions devised a strategy to deal with their bad loans.
"Back then, regulators knew perfectly well that values were impaired, but there were three-way agreements between the banks, audit firms and the regulators where the banks were placed under draconian oversight and the auditors agreed to slow down the pace of writedowns to proper value until the banks could earn enough to afford these writedowns without undue damage to their capital," says David Green, a former senior banking supervisor.
However, in the 1980s these Latin American loans were classified as being "held to maturity", meaning they were not usually recorded at fair value -- which in effect gave auditors and banks more flexibility in how they could be measured. Repeating this approach in today's market, with so many tradeable assets, would consequently be far more difficult.
In addition, the audit profession is extremely reluctant to take any step that might make them look "soft" and potentially expose them to Enron-sized lawsuits from angry shareholders. Bankers complain that the audit profession currently appears more inclined to tighten the rules -- or at least apply them scrupulously -- than cut the industry some slack. Indeed, the biggest firms took a path-breaking step last year by producing a joint paper outlining the fair value rules to ensure more cross-industry consistency - and protect the industry from external pressure. "These guys [now] want to prove they are whiter than white to stay out of jail, which just makes the situation worse," says one senior banker.
Given this, most bankers and regulators now accept that there is unlikely to be any easy fix to the current woes; instead, they seem resigned to hunkering down to weather the storm - and praying that the bottom is reached as soon as possible. "Mark-to-market accounting is changing the dynamics of this crisis - the pain comes very fast," says Danièle Nouy, head of the French bank commission. "But hopefully the recovery will come very fast too."
However, if the recovery does not emerge soon, and the industry instead slips deeper into a vortex of hedge fund sales and bank write-offs, the controversy about accounting will almost certainly grow. The forthcoming results from the brokers, in other words, could carry critical significance -- not just for beleaguered investors and bankers, but for the accounting that underpins the capital markets as well.
FT Syndication Service
ACCOUNTING rules rarely top senior executives' agendas. But when Axa, the mighty French insurance firm, recently unveiled its results, its bosses were unusually outspoken in voicing their criticism of bean-counters.
"If you are in the medical business, you want to be sure that the thermometer is the right one for benchmarking things properly," said Henri de Castries, chief executive of Axa. "The accounting systems in the economy are the thermometer, and I'm not sure their measurement scale is the right one."
It is a sentiment now being echoed with increasing vigour by financiers, particularly given the impending round of results from Wall Street brokers. As the credit turbulence has spread this winter, financial companies have unveiled a staggering swath of losses on instruments such as mortgage bonds. Axa itself, for example, recently revealed some €600m (£460m, $940m) of writedowns; meanwhile, western investment banks have reported hits of more than $181bn (£89bn, €116bn).
Many observers expect this tide of red ink to swell further this month, when US brokers such as Bear Stearns announce results for the December to February period. The price of mortgage securities, as measured by indices such as the ABX, is continuing to fall, and there is pressure on banks to make large writedowns for corporate leveraged loans as well.
As the losses rise, anxiety is growing over the way these hits are being measured. At present, accounting is dominated by a concept of "fair value": companies are expected to report the value of their holdings in as "current" a manner as possible, which in practice means marking to market prices.
However, there is mounting concern that this approach creates distortions when markets are as dysfunctional as they are now. Indeed, some bankers fear that the system is actually making the crisis worse. Far from offering a reassuring yardstick, it is forcing banks and hedge funds to sell assets in a manner that is stoking investor panic - or so the criticism of men such as Mr de Castries goes.
The issue is particularly critical because the current financial crisis is the first to have occurred in a context dominated by fair value rules. In truth, the concept of fair value is not new. On the contrary, an academic debate about its merits - and demerits - has been under way for years. Many banks and insurers have been fair-valuing at least some of their holdings for decades. Most notably, US brokers with trading businesses -- such as Goldman Sachs and the other banks that will report soon -- have always marked their holdings to market prices.
However, the use of fair value accounting has never been uniform: institutions have traditionally used different models for assets such as loans that they intended to hold until maturity, allowing them to ignore irrelevant market fluctuations. In past financial crises - such as the US Savings and Loans shock two decades ago - many affected institutions were not marking such loans to market prices.
Far more institutions are now entangled in the fair value net, due in part to changes in accounting rules and in part to new business models. This decade, more banks have embraced the so-called "originate and distribute" model, in which they typically pass on the risk of the loans they make by packaging them into marketable securities. As such securities are not intended to be held until maturity, most became liable for fair value treatment: banks had swapped the credit risk of holding the loans for the volatility risk inherent in any tradeable financial instrument. On top of this, derivatives have become increasingly commonplace - and these are also marked to market.
Until very recently, there was a widespread assumption in the market that this shift towards fair value was a thoroughly good thing. After all, this approach injects more objectivity into the system by not allowing managers to use their own idiosyncratic models and supports the supremacy of the market as an independent verifier of value. Moreover, until recently bankers had a vested interest in applauding these changes. Between 2002 and 2007, the value of many credit instruments rose sharply - which in turn boosted the value of assets reported on balance sheets, flattering bank results.
In the last eight months, however, this once-benign pattern has gone into reverse. As the value of assets such as mortgages has tumbled, so has the value of portfolios. This has not just hurt balance sheets but also hit profits directly, since the value changes of some instruments, particularly derivatives, feed through to the bottom line. Take Axa's recent €600m writedown from fair valuing its holdings: of this, €300m dented income and €300m remained on the balance sheet. Similarly, American International Group, its US rival, recently suffered a direct $11bn profit hit from writing down the fair value of derivatives. Martin Sullivan, AIG chief executive, recently said that fair value accounting had had "unintended consequences" and called for its suspension.
At the same time, "mark to market" accounting has encountered growing practical challenges. The intellectual framework that supported the creation of complex derivatives - and application of fair value concepts - has tended to assume in recent years that capital markets had reached a level of sophistication that meant they were unlikely ever to freeze up too widely or for too long. Indeed, when the credit crunch started last summer, some auditors joked that the timing was good, since a summer crisis would probably be over by Christmas.
Such comforting assumptions are now being blown apart. The sense of panic in some corners of the credit world has become so extreme that buyers have completely disappeared - making it extremely hard to get genuine trading "prices". That in turn has created a dilemma for bankers and their auditors, who are trained to view the market as the ultimate independent arbiter. "As markets become less and less functional, what use is that price to understanding valuation? If I'm a large client of a broker dealer, I can get any 'print' or price that I want," says Christopher Whalen of Institutional Risk Analytics, a consultancy.
Accountants are trying to deal with this challenge in several overlapping ways. Some have scoured the markets for any evidence of deals that could be used to determine quasi-market prices. Many mortgage-linked securities, for example, are currently being valued on the books of the largest banks not according to the price of the actual security, but rather from an extrapolated value taken from associated derivatives such as the ABX. At the same time, if market prices cannot be determined - even via derivatives - then banks and auditors are using models to calculate a value. The instruments subject to this treatment are known in the industry as "Level Three" assets, referring to terminology in the accounting rules that ranks financial instruments in terms of how easy it is to find their value.
However, all of these approaches have flaws. Many investors are sceptical about the accuracy of models used to estimate the price of untraded assets. "When markets dry up there are problems with mark-to-market disclosure because there are no markets. Then people have to use mark to model but there are big problems with that too," observes Charles Goodhart, professor of finance at the London School of Economics.
Many banks are even more dubious about the wisdom of deriving mark-to-market values from the activity currently under way. Derivatives indices such as the ABX are relatively recent creations and tend to be highly volatile; meanwhile, fire-sale prices - such as those caused by hedge funds forced to liquidate holdings - are often also extreme. Indeed, many bankers now complain that some of the so-called "market" prices being used by auditors offer such a poor guide to intrinsic value that current writedowns will almost certainly be reversed in the future.
"You can see [bankers'] point that the market is irrational right now," says Tony Clifford, a partner in the financial services practice at Ernst & Young. "If you look at some credit derivatives right now, their prices are consistent with the assumption that a huge number of very well regarded firms are going to go bust in the next few years, which won't actually happen unless you believe - and very few really do - that we're heading for a complete meltdown of the financial system."
Meanwhile, placing assets in the so-called "Level Three" category creates another headache for banks. Regulators typically require banks to hold higher reserves against assets placed in this accounting pot. Thus, as more assets have moved into this pot in recent months, the capital pressure on banks is effectively increasing - in addition to the write-offs they are making on the assets that can be valued.
This in turn is threatening to create a vicious circle in the markets. As banks come under pressure to improve capital ratios, many are trying to cut their lending to heavy-borrowing counterparties such as hedge funds. Lately Carlyle Group, the private equity giant, was forced to admit it could not save its highly leveraged $22bn mortgage-backed-securities fund - which had $31 of debt for every $1 of its own equity - after the fund's bankers made higher margin calls, in effect demanding more collateral against their loans. Funds are forced into fire-sales to meet the calls or, if they collapse as Carlyle's has, then banks will take control of the remaining assets and liquidate them. Either way, the sales are depressing prices - which in turn is reducing the recorded value of banks' assets and increasing the pressure on them to cut lending further.
"The stock of leveraged credit assets overhanging the market now, combined with acceleration of margin calls, forced liquidations and capital write-downs, creates a self-reinforcing dynamic towards . . . even greater capital destruction at the banks," Credit Suisse wrote in a recent report. Or, as Paul Tucker, head of markets at the Bank of England, observed: "There are lots of people out there now saying that risk is overpriced. So why aren't long-term investors stepping in? Because people think prices could fall further."
Given this, many policymakers and financiers think that a wider debate is needed about the way that fair value accounting rules are being applied to the financial world. Indeed, behind the scenes some industry officials are already lobbying for change - and banking groups are discussing potential reforms. "We need to have a debate about whether the application of mark-to-market accounting to a wide range of assets creates some distortions," says Charles Dallara of the Institute of International Finance, a Washington-based banking group that is creating a reform blueprint.
However, many accounting officials retort that these complaints simply smack of special pleading by the banks. After all, they argue, bankers were happy to describe these securities as "tradeable" when they were packaging them for investors earlier this decade, or valuing them on their own books at ever rising prices. Thus these instruments do have a market price, even if the banks dislike where it now stands - or so the argument goes.
"If you'd asked these [financial] firms six months ago, I think they'd have said of course these securities are fairly valued," says Michael McMurtry, partner at Eisner, the New York-based accounting firm. "Now they recognise that probably wasn't the case and they think the current values are too low. Well, only time will tell."
In practice, members of the International Accounting Standards Board, the body regarded by many as the torchbearer for fair value, remain strongly opposed to any suggestion that the use of fair value should be watered down. "Market volatility is often referred to as accounting volatility but this isn't something made up, it is the reporting of economic volatility - the change in the value of assets and liabilities as a result of entities' exposure to risk," says John Smith, a board member of the IASB.
"All business is exposed to some kind of risk - currency, credit, price, liquidity and others. That exposure is what I view as economic volatility," he says. "Fair value is simply showing the volatility that exists. Accounting standards are based on the economic reality that exists currently - not on management's optimistic view of what will occur in the future."
Quite irrespective of the longer-term philosophical debate, in the short term policymakers admit that it would be extremely difficult to rip the current rules up. In recent months, some financial officials have held quiet debates about whether there might be any way to soften the impact of the accounting rules - or, as one central banker puts it, "break this downward spiral".
However, implementing any such co-ordinated action would be a daunting task. During Japan's bank crises a decade ago, the Japanese regulators performed a unified audit of the banks in a bid to offer investors better transparency and prevent market confidence from being damaged by a continual "drip feed" of bad news. But it would be hard to repeat this approach today, since the banks affected by the crisis are spread across numerous jurisdictions, and policymakers lack the resources to conduct independent forensic analysis.
Similarly, forging a single agreement between banks, auditors and policymakers to, say, soften the rules would also be extremely difficult. One policy model that is sometimes hailed by older bankers, for example, is the approach used during the Latin American debt crisis of the 1980s, when a tacit deal was reached that the auditors would not be too tough on the banks for a few years - as long as these institutions devised a strategy to deal with their bad loans.
"Back then, regulators knew perfectly well that values were impaired, but there were three-way agreements between the banks, audit firms and the regulators where the banks were placed under draconian oversight and the auditors agreed to slow down the pace of writedowns to proper value until the banks could earn enough to afford these writedowns without undue damage to their capital," says David Green, a former senior banking supervisor.
However, in the 1980s these Latin American loans were classified as being "held to maturity", meaning they were not usually recorded at fair value -- which in effect gave auditors and banks more flexibility in how they could be measured. Repeating this approach in today's market, with so many tradeable assets, would consequently be far more difficult.
In addition, the audit profession is extremely reluctant to take any step that might make them look "soft" and potentially expose them to Enron-sized lawsuits from angry shareholders. Bankers complain that the audit profession currently appears more inclined to tighten the rules -- or at least apply them scrupulously -- than cut the industry some slack. Indeed, the biggest firms took a path-breaking step last year by producing a joint paper outlining the fair value rules to ensure more cross-industry consistency - and protect the industry from external pressure. "These guys [now] want to prove they are whiter than white to stay out of jail, which just makes the situation worse," says one senior banker.
Given this, most bankers and regulators now accept that there is unlikely to be any easy fix to the current woes; instead, they seem resigned to hunkering down to weather the storm - and praying that the bottom is reached as soon as possible. "Mark-to-market accounting is changing the dynamics of this crisis - the pain comes very fast," says Danièle Nouy, head of the French bank commission. "But hopefully the recovery will come very fast too."
However, if the recovery does not emerge soon, and the industry instead slips deeper into a vortex of hedge fund sales and bank write-offs, the controversy about accounting will almost certainly grow. The forthcoming results from the brokers, in other words, could carry critical significance -- not just for beleaguered investors and bankers, but for the accounting that underpins the capital markets as well.
FT Syndication Service