By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
In 2007, as the credit crisis commenced, paradoxically, nobody actually defaulted. Outside of sub-prime delinquencies, corporate defaults were at a record low. Instead, investors in high quality (AAA or AA) rated securities, that are unlikely to suffer real losses if held to maturity, faced paper – mark-to-market (“MtM”) – losses.
In modern financial markets, market values drive asset values, profits and losses, risk calculations and the value of collateral supporting loans. Accounting standards, both in the U.S.A. and internationally, are now based on theoretically sound market values that are problematic in practice. The standards emerged from the past financial crisis where the use of “historic cost” accounting meant that losses on loans remained undisclosed because they continued to be carried at face value. The standards also reflect the fact that many modern financial instruments (such as derivatives) can only be accounted for in MtM framework.
MtM accounting itself is flawed. There are difficulties in establishing real values of many instruments. It creates volatility in earnings attributable to inefficiencies in markets rather than real changes in financial position.
Alan Greenspan once noted that: “It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making.” He may be the only one qualified to understand modern financial statements.
MtM accounting falls well short of its objective – the provision of accurate, reasonably objective and meaningful information about financial position. In the present crisis, it has heightened uncertainty and confusion about the position of banks and investors.
MtM accounting requires financial instruments to be valued at current market prices. This assumes a market and a price. As Michael Milken (the progenitor of “junk bonds” at Drexel Burnham Lambert) once noted: “Liquidity is an illusion. It is always there when you don’t need it and rarely there when you do.”
In volatile times, liquidity becomes concentrated in government bonds, large well known stocks and listed derivatives. For anything that is not liquid, MtM means mark-to-model. This assumes universally accepted pricing methodologies with verifiable inputs. Valuation for all but the simplest instruments today requires a higher degree in a quantitative discipline, a super computer and a vivid imagination. For complex structured securities and exotic derivatives, the only available price is from the bank that originally sold the security to the investor. Prices available from the purveyor of the instrument (a concept known as mark-to-myself) strain reasonable concepts of independence and objectivity.
A current market price of 85% for a AAA security does not actually mean that you will lose 15% of the face value. It is only an estimate of likely losses. It may reflect the opportunity loss of being able to invest in the same or similar security at the time of valuation. In volatile markets, excessive uncertainty or risk aversion means that values deviate significantly from actually cash values.
MtM prices may be prone to manipulation. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission (“SEC’) to allow MtM accounting to be used in the natural gas industry allowing the company to record current earnings based on the future value of long term contracts.
In dealings with hedge funds and structured investment vehicles (“SIVs”), banks have an incentive to mark positions at high prices thereby preventing complex and illiquid securities being sold at a discount and pushing down prices in the market. If these securities actually traded then the lower market price would have to be used to value positions increasing losses and margin calls on already cash strapped investors.
A lower price can be used to force margin calls and selling that may allow a dealer to buy the assets cheaply. Long Term Capital Management (“LTCM”) believed that the dealers brought about their downfall by moving the market values against their positions. In the current credit crisis, at one time markets resorted to barter – you exchange what you want to sell for something else – to avoid recording low prices for securities.
MtM prices, no matter how dubious, drive real investment and credit decisions. Holders of AAA rated securities may be forced to sell securities showing losses because MtM losses reach “stop loss” levels. Where investors have borrowed against these securities, the falling MtM value supporting the borrowing means finding money to top up the collateral or selling the securities thus realizing the loss. In the case of SIVs, the MtM losses trigger breaches of tests that require selling securities to liquidate the structure.
MtM values are used to establish current portfolio values and allow investors to invest or withdraw funds. Errors in pricing lead to transfers in wealth between incoming and outgoing investors; for example, a low value punishes a redeeming investor but rewards the new investor. In 2007, difficulties in establishing MtM values caused some funds to suspend redemptions. Sound investments may be sold off to prevent further losses or realize earnings to cover other losses even where the market does not fairly value the asset penalizing investors.
In the global financial crisis, with the capital markets virtually frozen, the extent of losses on bank inventories of hard-to-value products and commitments (structured debt and leveraged loans) was difficult to establish.
Financial Accounting Standard Board (“FASB”) Standard 157 (“FAS157”), which became effective for fiscal years after November 2007, is designed to provide “clarity” to the issue of fair valuation of assets and liabilities.
The centerpiece of FAS157 is the three level hierarchy of valuation (better referred to as the “three levels of enlightenment”).
The Fair Value Hierarchy prioritizes the valuation inputs used to determine fair value into:
Level 1 – this requires observable inputs that reflect quoted prices for identical assets or liabilities in active markets and assumes that the entity can access the markets at the measurement date (known as Mark-To-Market). In practice, this means a liquid asset or instrument that is actively traded; for example, where two-way prices are readily available.
Level 2 – this requires inputs other than quoted market prices included within Level 1 that are observable either directly or indirectly (known as Mark-To-Model). In practice, this means instruments that cannot be priced based on trade prices but are valued using observable inputs; for example, comparable assets or instruments or using interest rates/ curves, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values.
Level 3 – this relates to unobservable inputs reflecting the reporting entity’s own assumptions used in pricing an asset or liability (known as Mark-To-Make Believe or Mark-to-Myself). In practice, this means that the asset or liability cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions.
FAS157 valuations should be based on the exit price (the price at which it would be sold) regardless of whether the entity plans to hold or sell the asset. FAS157 emphasises that fair value is market-based rather than entity-specific.
FAS157’s fair value hierarchy ranks the quality and reliability of information used to determine fair values – market prices are regarded as reliable valuation inputs, whereas model values that include unobservable inputs are regarded less reliable. The lowest level of significant input drives placement in the hierarchy and the level within the hierarchy drives financial statement disclosures.
The objectives of FAS157 are laudable and unobjectionable. Unfortunately, the standard provides significant discretion to companies in determining the values of assets and liabilities, although detailed disclosure is required. It also may create significant uncertainty in the values of assets and liabilities and financial condition of the reporting entity. This is especially true of Level 3 assets. It is also relevant to the valuation of Level 2 assets.
The problem is compounded by the fact that many major global financial institutions have increased their holdings of Level 3 assets in recent years. Major areas of valuation concern include:
1. Structured finance securities such securitised mortgages including subprime mortgages, securitised credit card obligations, asset backed commercial paper and collateralised debt obligations (“CDOs”).
2. Leveraged and private equity loans.
3. Distressed debt.
4. Principal investments by financial institutions in private equity, unlisted securities or physical assets for which there are no true market.
5. Complex derivative contracts including exotic options.
Level 3 assets of the leading 20 U.S. banks as at 31 March 2009 were reported to be $657.5 billion (as reported by the Congressional Oversight Panel in its Oversight Report dated 11 August 2009 “The Continued Risk Of Troubled Assets”). This represented a 14.3 % increase in Level 3 assets compared to three months prior (December 31, 2008). Bank of America, PNC Financial, and Bank of New York Mellon had twice as many assets (in terms of dollars) classified as Level 3 in the first quarter of 2009 compared to year-end 2008. Morgan Stanley had more than ten percent of their total assets categorized as Level 3.
The panel noted that: “The risks troubled assets continue to pose for the banking system depend on how many troubled assets there are. But no one appears to know for certain….It is impossible to ever arrive at an exact dollar amount of troubled assets, but even the challenges of making a reliable estimate are formidable.”
The key issue is that a relatively small change in the values of these Level 3 assets has the potential to reduce the capital base of the entity significantly.
The valuation of Level 2 assets may be more problematic than generally assumed especially under condition of market stress. This reflects the impact of model risk and lack of disclosure of the instruments treated as Level 2. Importantly, if market conditions deteriorate then some of these assets classified as Level 2 may need to be reassessed and treated as Level 3 assets.
It is not clear where in the Fair Value Hierarchy specific instruments are currently being valued. The correlation between disclosed bank write-offs and Level 3 assets is imperfect. This may be because individual institutions are classifying assets within the three level hierarchy using different criteria. It may also mean that there is actually no correlation between the classification and “real” losses. The lack of correlation may also reflect behavior, such as new chief executives wishing to write-off assets to be able to “blame” previous management.
Level 3 securities and derivatives cannot be valued using observable prices in liquid public markets. Market values must be based on models and estimates. Where losses are reduced (substantially) by MtM “hedging” gains, the exact nature of the hedges is not disclosed. Some banks and hedge funds have indicated that some losses resulted from hedges that did not function as intended. The hedge counterparty is undisclosed. As the gains are unrealized, if the counterparty (a thinly capitalized hedge fund) is unable to perform, then the hedge gains would be illusory. The lack of disclosure around the value of the hedges, their nature and hedge counterparties makes it difficult to gauge whether they are truly effective in reducing losses.
There are other oddities in current MtM accounting, such as the fair valuation of an entity’s own liabilities. FAS157 and Statement 159 (“Fair Value Option for Financial Assets and Financial Liabilities” issued in February 2007 by the FASB) allows the entity’s own credit risk to be used in establishing the value of its liabilities.
Changes in the entity’s credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades. For example, if a bank has $100 million of bonds that are subject to mark-to-market accounting and the market price drops to $80 (80%) then, it records a “gain”. As credit spreads increased, U.S. banks have taken substantial profits to earnings from revaluing their own liabilities. These MtM profits on liabilities have helped banks offset recent write-downs. But the revaluation of a bank’s liabilities is problematic. The face value of the liability must still be repaid. The gain from a higher credit spread is unlikely to result in cash profits. It is only if the entity can re-purchase its debt that the “theoretical” gain can be realised.
The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to Statement 159 prior to its passage. They argued that would the MtM of a bank’s liabilities in this way would “have the contrary effect” of increasing a bank’s net worth at the same time its “financial condition is deteriorating.”
The revaluation of a bank’s liabilities may also create volatility of earnings. Major financial institutions have recently been forced to issue substantial amounts of debt to finance “involuntary asset growth” as assets returned onto their balance sheets. This debt has been issued at relatively high credit spreads reflecting current debt market conditions. This means that if the market conditions improve, these institutions may record the mark-to-market losses on their liabilities even as their credit condition improves.
The International Accounting Standards Board (“IASB”) is understood to be considering the issue. Under proposals being considered, gains on falls in the value of an issuer’s own debt my no longer be allowed to be recognised. This would remove one of the most controversial elements of MtM accounting.