The subprime crisis would make a fantastic pulp murder mystery: bodies of funds, banks and senior executives are piling up. Whodunit? Perhaps it was the foolish borrowers, the duplicitous lenders, or the greedy securitisers. But it could have been the gullible investors, the naive rating agencies, or the complacent regulators and central banks. Amidst all the finger-pointing, name-calling and intrigue, one group - the accountants - looked set to slip out of the back door unnoticed. That has changed in recent months, with mammoth full-year and first-quarter losses focusing attention on what exactly those numbers mean, how they are calculated, and whether the accounting standards played a part in exaggerating the scale and accelerating the speed of the crisis.
Wayne Upton, the director of research at the International Accounting Standards Board (IASB), isn't too upset: "Harry Truman used to have an expression: if you want a friend, buy a dog. Whenever we have a crisis, everyone looks around for someone to blame, and that's the way a standard setter's life always is. But I've been around for a long time and a lot of it just rolls off. A lot of it is kind of silly."
Tell that to the head of credit portfolio management at one large US bank, who says his firm is sitting on credit default swaps that are referenced to illiquid leveraged loans. "I'm required to fair-value them and I have no way of doing it. There is no market for these things - none. So how do you do it? It's just a guess," he says.
Or tell it to AIG's former chief executive, Martin Sullivan, who - prior to his resignation in mid-June - had seen his company report an $11.1 billion writedown in March, and railed against accounting standards, contending that the company's own estimates reckoned the worst-case loss on those assets was more like $900 million.
When fair isn't fair
These cases illustrate two distinct criticisms. Fair-value accounting works by reporting changes in the market value of financial instruments as though they were profits or losses. The first criticism is that when markets are illiquid and instruments aren't trading, it can be difficult to work out what their fair value is. As a result, reported values are at best a hazy estimate and, at worst, are cooked up or manipulated by reporting institutions to suit themselves. The second criticism is more serious, that market prices become detached from fundamental values during periods of illiquidity; in other words, that fair-value accounting forces institutions to report exaggerated losses, which fuels market panic, creating a destructive downward spiral of vanishing liquidity, falling prices, and ever-greater writedowns.
In its most recent half-yearly Financial Stability Report, published in April, the Bank of England lent some credence to this second criticism. By analysing the probability of default in subprime mortgage loans, the central bank calculates that securities containing these assets can be expected to eventually lose $170 billion over the next five years. In contrast, the report points out the family of indices that banks have used to derive market values during the crisis - the ABX - implies losses of around $380 billion, or more than twice the figure produced by credit analysis. The report concludes that "using a mark-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately incur. It will exaggerate to an even greater extent the potential damage to the real economy these losses might inflict."
Standard setters don't buy this argument. Their first retort is to ask why - if the risk of losses on mortgage-backed securities is so exaggerated - banks aren't hoovering up the assets with a view to making some hefty relative-value gains. Their other response is more principled: fair value provides an objective standard for companies to follow. Ron Lott, research director at the US standard setter, the Financial Accounting Standards Board (FASB), says: "Fair value is what it is. It's a market price, or an estimate of a market price, based on what people in the market are willing to pay on that day. It isn't necessarily some real, intrinsic, inherent value."
Keeping it real
But shouldn't this real, longer-term value be the goal of the accounting standards? The IASB's Upton thinks not: "This argument has been out there a long time and it's usually taken up by a bank that has had a big writedown and wants an excuse. Essentially, they say 'I'm not going to sell into this market. I don't want to sell into this market. If I can just hold on, it will be OK'. But the person to whom the bank is making that claim - the analysts and investors - has no idea whether the bank really has that kind of staying power in a market that is falling and falling."
If banks genuinely feel market prices are producing wildly overstated writedowns, they should simply say so in their financial statements, Upton argues; there's nothing preventing institutions from adding a commentary to their numbers, explaining why their assets are worth more than the market currently thinks and inviting analysts and investors to use their own judgement about whether the company can hold onto those assets until prices rebound.
The standard setters may have been on the defensive in recent months, but they have allies - "almost every financial analyst anybody has bothered to ask," says Upton.
Pauline Wallace, a partner at PricewaterhouseCoopers (PWC) in London, is also in favour of the current rules. "Fair-value accounting standards mean you are pinning bank earnings back to a market. Just because we've had some big shifts in numbers this year, it doesn't mean the process is broken and, frankly, nobody has come up with a better way of presenting the underlying cashflows and the risks in assets. I'm a believer," she says.
So are some bankers, who see a flip side to the argument that fair value exaggerates losses and has accelerated the spread of the crisis. During a webcast organised by the FASB in early June, Matt Schroeder, the global head of accounting policy at Goldman Sachs in New York, argued that by carrying asset price deterioration into profit and loss, fair-value reporting has actually enhanced financial system stability: "There are real economic losses here and to say they're not happening is not the case. One of the things that fair-value accounting has forced banks to do is take those losses and raise capital more expeditiously than the industry used to."
Tushar Morzaria, chief financial officer for JPMorgan's investment banking business in the Europe, Middle East and Africa region, makes the same claim and uses the spectre of Japan's 'lost decade' to illustrate the alternative. "In that situation," he says, "banks were sitting on stacks of non-performing loans that were reported at their historical value, and it just dragged on and on until finally being flushed out of the system. During the past 12 months, you've seen banks taking much quicker and more appropriate action to shore up their capital position, and I think it's a healthy thing for investors and banks to face the truth in these circumstances."
But truth can be an elusive thing - and that's where the first criticism comes into play. With markets for many structured credit instruments locked down or trading only occasionally - and then at huge discounts - banks have been forced to estimate fair values, and doubts have grown about how accurate these estimates are.
For their part, banks complain they are being compelled to wildly underestimate their assets. Conversely, some cynics in the analyst community charge that banks are using the opacity of the estimation process to their own ends, by goosing their asset values or, in some cases, exaggerating writedowns to get them out of the way quickly.
"I mark my credit to market, but it's not an accurate basis for accounting," says the head of credit portfolio management. "It's not a reflection of earnings: it just leads to absurdities and tremendous volatility that is not reflective of the true risk I've taken."
So how does the process work? US accounting standards separate fair values into three types: level I assets, which are those where reliable, quoted prices are available from an active market; level II assets, which aren't traded actively so some degree of modelling is required - but all of the significant inputs to those models are taken from external, observable sources such as proxies, comparable assets and services that aggregate price data from individual banks; and level III assets, which are those for which one or more significant inputs are unobservable - in other words, they rely heavily on the bank's own estimates and assumptions. The IASB's accounting standards don't have the same, clear categorisation, but they operate on the same principles.
Currently, the problem assets at the centre of the crisis - like collateralised debt obligations, residential mortgage-backed securities, leveraged loans and credit default swaps referenced to any of these instruments - fall primarily into level II. JPMorgan, for example, had just over $1 trillion in level II assets at the end of 2007, and only $44 billion in level III. The huge imbalance is because the accounting rules insist on the use of observable inputs over unobservable assumptions wherever possible. So, if a bank has to value a structure containing subprime exposure, it is expected to use the ABX index, or some other external value, as an input, rather than relying on its own internally generated numbers.
Unfortunately for the banks, the ABX index has been massively exaggerating the losses expected on those structures for much of the crisis, as the Bank of England noted in April.
"The problem for banks is that although these things are still trading, they're trading at a very bizarre price," says PWC's Wallace. "It's not quite so bad now; but at one point, the ABX was suggesting anyone holding the underlying instruments was going to be paid just the next few interest payments and lose everything else. It got to a stage where it didn't reflect the underlying cashflows."
That's not all, according to the head of credit portfolio management at the US bank. He charges that consensus prices - like the ABX - aren't capturing the actual prices seen in the market. "Everyone gets these pricing feeds - it's an accepted pricing service - so I look at what those mark at. But then I go and look at our loans and we start marking where we can actually sell them and the two values bear no relation to each other at all," he complains. "There is no real market. People have curves they submit to these services, but no one really sees a market for these names. It's all a bit of a fiction."
If proxies are both exaggerating credit risk and failing to capture genuine market prices, can banks just ignore them and go to level III? In theory, yes, says Wallace. "If you can demonstrate the observable input is not the right basis for a valuation, then you've got to find something that is. If you were looking at CDOs, for example, you'd have to demonstrate the underlying assets in the deal you were trying to value were very different from the assets that underlie the instruments that make up the ABX."
In some cases, that's exactly what banks are doing - but it has raised eyebrows among regulators. Since October last year, a team of regulators chaired by Patrick Amis, head of accounting affairs at France's Commission Bancaire, has been working under the auspices of the Committee of European Banking Supervisors (CEBS) on a report about valuation challenges in illiquid markets, due to be submitted for endorsement by CEBS.
Amis says one of the issues raised by the paper is the apparent inconsistency in banks' use of indices like the ABX. Prior to the crisis, financial institutions saw consensus pricing services as an observable input that was used in conjunction with level II assets, he says. Now, some are arguing the services don't qualify as level II inputs, allowing them to move the assets into level III and value them using their own models - a tactic that might be a deliberate ploy to avoid the massive writedowns associated with level II inputs. "We have an issue with the consistency of methods that banks have used over time," says Amis.
If banks have some leeway over the inputs they use, the weights they give those inputs and when they can apply their own models, could they be manipulating their reported figures? PWC's Wallace, whose team has audited bank financials during the crisis, doesn't think so: "I've seen no evidence of that happening. People have crawled all over this stuff more than they have ever crawled over it before, so I actually think we have better information to make those judgements than we've ever had before."
JPMorgan's Morzaria says the bank has "a very rigorous and sophisticated process to make sure we do get to our best estimate of fair value, so it's not simply a matter of a single person on the dealing floor making a judgement. It's reviewed across different departments and from different perspectives to ensure we get to the right answer." He also says he'd be surprised if other institutions were trying to game the accounting rules.
The debate about the appropriateness of fair value in illiquid markets is bound to rumble on, but Morzaria says JPMorgan is in favour of maintaining the status quo. That's a view shared by the Commission Bancaire's Amis, who says the current system works reasonably well; but he warns that regulators would not be in favour of the long-mooted expansion of fair value to encompass a greater array of assets.
"Strategically, it wouldn't be a great move for banks to give standard setters the idea they might be trying to game the rules. If they do that, the IASB will go to a full fair value model - and we don't want full fair value. All in all, we just want to be sure that banks aren't shooting themselves in the foot."
Goldman exits IIF in fair value dispute
Opposition to fair-value accounting reached a new pitch in April, when the Institute of International Finance (IIF) - which represents more than 350 banks globally - threw its considerable weight behind calls for reform by circulating a document outlining two options for changes to existing standards. The would-be lobbying effort was brought to a shuddering halt a month later, however, when Goldman Sachs - an IIF member - got wind of the proposals and threatened to quit the organisation. Goldman made good on that threat at the start of June, despite a volte-face by the top brass at the IIF.
A member of Goldman's risk management team had participated in drafting the IIF proposals, but only in terms of technical discussions around the paper's appendices, says an official at the firm. When senior figures at Goldman saw the full paper, they were aghast: "The idea you should revert to some kind of normalised numbers in an illiquid market just flies in the face of common sense. Surely that's when you should be making most effort to get the numbers right; it's not something you do only when you're comfortable with it," he says.
Goldman was so incensed by the proposals that it reviewed its membership of the IIF, decided its views were out of line with the group, and then wrote a letter to resign.
The most contentious of the two IIF proposals was a mechanism that would have allowed banks to abandon fair-value accounting when some pre-defined measure of market distress was reached, says Wayne Upton, the director of research at the International Accounting Standards Board (IASB). The idea was for banks to switch to some other accounting approach - like accruals - but to keep the last reported fair value as a ceiling so that asset values did not suddenly yo-yo up. "I think it's a lousy idea. At the very time you're most worried about the market value of assets, you quit reporting them," says Upton, who met with the IIF to discuss its proposals earlier this year.
After Goldman had gone public with its opposition to the proposals, the IIF rushed out a clarification of its position on May 28, in which it stressed that fair-value accounting "remains an essential element of global capital markets as it fosters transparency, discipline and accountability". It didn't stop the investment bank from leaving.