
The blame game
Accounting

The subprime crisis would make a fantastic pulp murder mystery: the bodies of funds, banks and senior executives are piling up. Whodunnit? 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.
Amid 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 the past few months, with mammoth full-year and first-half losses focusing attention on what exactly those numbers mean, how they are calculated and whether accounting standards played a part in exaggerating the scale and accelerating the speed of the crisis.
Wayne Upton, 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'," he says. "Whenever we have a crisis, everyone looks for someone to blame, and that's the way a standard-setter's life always is."
That makes it sound like any gripes about accounting are just a case of scapegoating. Tell that to the head of credit portfolio management at a large US bank, who says his firm is sitting on credit default swaps (CDSs) referenced to illiquid leveraged loans. "I'm required to fair-value them and I have no way of doing it," he says. "There is no market for these things. So how do you do it? It's just a guess."
Or you could ask AIG's former chief executive, Martin Sullivan, who - before he resigned in June - saw 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.
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 complaint is that when markets are illiquid and instruments aren't trading, it can be difficult to work out their fair value. 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, fair-value accounting forces institutions to report exaggerated losses, that fuel 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 May, the Bank of England lent some credence to this second criticism. By analysing the probability of default in subprime mortgage loans, the UK's central bank calculates that securities containing these assets can be expected to eventually lose $170 billion over the next five years. Yet the report points out that the family of indexes banks have used to derive market values during the crisis - the ABX - in fact 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' response
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 big 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."
Yet shouldn't this real, longer-term value be the goal of accounting standards? The IASB's Upton thinks not. "This argument has been out there a long time - it's usually taken up by a bank that has had a big writedown and wants an excuse," he says. "Essentially, they say: 'I don't want to sell into this market. If I can just hold on, it will be OK.' But without fair-value information, the people to whom the bank is making that claim - the analysts and investors - have no idea whether it really has that kind of staying power in a market that is falling."
If banks genuinely believe market prices are producing wildly overstated writedowns, they should simply say so in their financial statements. Upton says there's nothing preventing institutions from adding a commentary to their numbers, explaining why their assets are worth more than the market thinks and inviting analysts and investors to use their judgement about whether the company can hold on to those assets until prices rebound.
Accounting body allies
The standard-setters may have been on the defensive in recent months, but they have allies, says Upton: "Almost every financial analyst anybody has bothered to ask."
Pauline Wallace, a partner at professional services firm PricewaterhouseCoopers (PwC) in London, is in favour of the current rules. "Fair-value accounting standards mean you are pinning bank earnings back to a market," she says. "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."
So are some bankers, who see a flip-side to the argument that fair value exaggerates losses and has hastened the spread of the crisis. In a webcast organised by the FASB in early June, Matt Schroeder, 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," he says. "One of the things 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 JP Morgan's investment banking business for Europe, the Middle East and Africa, makes the same claim and uses Japan's 'lost decade' to illustrate the alternative. "In that situation, 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," says Morzaria. "During the past 12 months, you've seen banks taking much quicker and more appropriate action to shore up their capital position. It's a healthy thing for investors and banks to face the truth in these circumstances."
But truth can be elusive - and that's where the first criticism comes into play. With the market 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 that they are being forced to wildly underestimate the value of their assets. Conversely, the more cynical analysts say banks are using the opacity of the estimation process to their own ends, by overstating 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 US bank's 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 1 assets - those where reliable, quoted prices are available from an active market;
- level 2 assets, which aren't traded actively, so some degree of modelling is required. But all the significant inputs to those models come from external, observable sources, such as proxies, comparable assets and services that aggregate price data from individual banks; and
- level 3 assets - 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 such clear categorisation, but they operate on the same principles.
The problem assets at the centre of the current crisis - such as collateralised debt obligations (CDOs), residential mortgage-backed securities, leveraged loans and CDSs referenced to any of these instruments - fall primarily into level 2. JP Morgan, for example, had just over $1 trillion in level 2 assets at the end of 2007, and only $71 billion in level 3 (see figure 1). 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 another external value as an input, rather than rely on its own internally generated numbers. Unfortunately for banks, the sheer number of people shorting the index means the ABX has been massively exaggerating the losses expected on those structures for much of the crisis, something the Bank of England noted in May.
"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."
Lack of consensus
What's more, consensus pricing services aren't capturing the prices seen in the market, says the US bank's head of credit portfolio management. "Everyone gets these pricing feeds," he says. "It's an accepted pricing service, so I look at what they mark at. But then I look at our loans, and we start marking where we can actually sell them, and the two values bear no relation to each other. 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 3? In theory, yes, says Wallace: "If you can demonstrate the observable input is not the right basis for a valuation, 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, 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. CEBS published the paper on June 18. One of the issues it raises is a concern about the use of consensus pricing services and the need for consistency in the way banks use indexes such as the ABX.
Before the crisis, some banks saw consensus pricing services as observable inputs, to be used in conjunction with level 2 instruments, says Amis. Today, in some cases, the same inputs are being reclassified as unobservable, allowing banks to use level 3 treatment. "There is a strong need to clarify how fair values should be calculated in illiquid markets," says Amis, adding that the IASB is working on this.
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, who advises auditors that worked on bank financials during the crisis, thinks not. "I've seen no evidence of that," she says. "People have crawled all over this stuff more than they ever have before, so we have better information to make those judgements than ever before."
JP Morgan'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 adds that he'd be surprised if other institutions were trying to play with the accounting rules.
The debate about the appropriateness of fair value in illiquid markets is bound to rumble on, but Morzaria says JP Morgan is in favour of maintaining the status quo. The Commission Bancaire's Amis shares that view, saying that the current accounting model - with its mixture of fair-value and other approaches - works reasonably well. Amis adds that most regulators would not be in favour of the long-mooted expansion of fair value to encompass a greater array of assets, provided the existing system prevents potential abuses. But any suspicion banks are trying to game the system could prompt standard-setters to push for a full fair-value model, he warns.
GOLDMAN SACHS 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.
However, the would-be lobbying effort was brought to a shuddering halt a month later, when Goldman Sachs - an IIF member - got wind of the proposals and threatened to quit the organisation. The bank made good on that threat at the start of June, despite a u-turn by the top brass at the IIF.
A member of Goldman Sachs' 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 Sachs 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," he says. "Surely, that's when you should be making most effort to get the numbers right."
The bank was so incensed by the proposals that it reviewed its IIF membership, decided its views were out of line with the group and wrote a resignation letter.
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, director of research at the International Accounting Standards Board. The idea was for banks to switch to some other accounting approach - such as accruals - but to keep the last reported fair value as a ceiling, so that asset values did not suddenly yo-yo up.
"It's not a good idea," says Upton. "At the very time you're most worried about the market value of assets, you quit reporting them." Upton met with the IIF to discuss its proposals earlier this year.
After Goldman Sachs went public with its opposition, 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 Goldman Sachs from leaving.
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