Fair value has been one of the dominant themes in financial reporting over the last decade but to what extent is it the appropriate measure for all types of financial instruments? Dr Brian O’Kelly explores how it may have contributed to the current credit crisis.
Who could argue against ‘fair value’ accounting? Attempting to do so almost implies that one is endorsing ‘unfair’ valuation. Little wonder then that the accounting bodies are promoting the ever more widespread use of the approach. In its recent discussion paper1, the International Accounting Standards Board (IASB) concludes: “The many ways of measuring financial instruments and the associated rules are one of the main causes of today’s complexity. A long-term solution to address such measurement-related problems is to measure in the same way all types of financial instruments within the scope of a standard for financial instruments. Fair value seems to be the only measure that is appropriate for all types of financial instruments.” But is fair value accounting the very best way to represent the performance of all financial market participants?
Is the market right?
There are certainly many sectors of the market for which fair value accounting appears logical and reasonable. When investment banks acquire assets in the course of their business, invariably their intention is to divest themselves of these assets as quickly as they can. For example, they may underwrite a loan issue for a private equity firm to enable it buy a company. They are paid fees primarily for their ability to commit to providing the financing. Their intention usually is to sell down the loans they have given the private equity firm at the earliest possible opportunity. In such a case, the only price that is relevant is that at which they can sell these loans. If, as has often happened in the past nine months, they fail to find buyers, they should be obliged to mark their assets to market. The market may be cruel but, if you’re a forced seller, it’s always right!(2)
The same logic would dictate that the trading desks within commercial banks should mark their holdings to market. Likewise, there are many nonbank market participants – hedge funds, structured investment vehicles (SIV), conduits – that are funded on repo or some other secured financing arrangement linked to the market value of their assets. It is hardly plausible to suggest that such entities could account for their assets other than at market prices.
If these entities should fair value their assets, it is easy to see why they would demand the same approach be taken to the valuation of their liabilities. After all, the debt of one financial institution is an asset on the books of the institution that purchased that debt; why should two institutions treat the same instrument differently? UBS and a few other European banks have begun to fair value their liabilities through the profit and loss account.(3)
Fair value – a panacea for bank auditor ills?
It is easy to see the attractions of fair value accounting to those charged with auditing commercial banks. If there is a deep, liquid market for that financial instrument, is the market price not the fair price? No longer need we worry whether to make a provision for loss based on an assessment of whether or not there has been permanent diminution in value. The binary nature of this assessment of diminution is deeply unsatisfactory, to say the least; it is plain that a loan’s value does not fall from 100 to 60 in one jump.
Additionally, there is always the suspicion – justified or otherwise – that banks try to manage their reported earnings. It is often suggested that banks are inclined to be far more conservative in a year when profits have grown strongly than in the current environment when profit growth is well below recent levels and everyone is concerned with their regulatory capital ratios. The bank is far better placed than the auditor to assess if a customer is likely to repay its loan; but the bank has also the most to gain in the short term from managing its reported performance.
Value – what is fair?
Against that background, one can appreciate why the IASB concludes as it does. Unfortunately, however, the argument is not quite so clear-cut.
There is an implicit assumption that the market price is fair. Implicit too is the belief that anybody can transact at that price, in whatever quantity desired. Would that it were the case! While price transparency and liquidity for bank assets had improved in recent years, as soon as the credit crisis struck, bid-ask spreads widened dramatically and prices became almost unobservable as liquidity evaporated. In a scramble for cash and in the absence of clearly observable prices, many institutions providing funding on repo to hedge funds and other investment vehicles marked down the prices of the pledged collateral and made further margin calls.
What selling took place was very often on foot of such calls. In a market in which very few participants had cash or, more particularly, the willingness to spend it, prices wentinto free-fall. The prices at whichtrades took place were determined by the few players remaining that had not stopped buying. But those prices were then applied to all in the market. A distressed sale of $10m of a security by an SIV became the price at which the remaining €990m of the same security was marked in the market for banks that were not distressed sellers.(4)
Efficient market theory says that prices will not depart materially from what is fair. As always, efficient markets died as liquidity ebbed away. Once the market is entirely ‘trading on technicals’, the relevance of the price at which that trading takes place is questionable. Some would suggest that it represents the price at which the holder of the instrument could trade. In truth, it is likely to overestimate the price the next forced seller is likely to achieve. And, more importantly, it is almost entirely irrelevant for any institution which has bought this instrument that plans on holding it to maturity.
Unintended consequences
Once fair value accounting is applied to an asset class, the dynamics of that market change. A bank that provides commercial property loans to its domestic customers can concentrate on carefully underwriting each loan and monitoring the loans in its portfolio thereafter. The bank may also choose to diversify its portfolio, taking exposure to property loans in another country by purchasing commercial real-estate mortgagebacked securities (CMBS). While the first portfolio is, for now at least, afforded accrual accounting treatment, increasingly, the latter is being fair valued through the equity account.
When the financial markets become paralysed, as at present, both portfolios would suffer a drop in value as both the property loans and the CMBS created from property loans would need to be discounted in order to sell them. But, whereas the holder of the property loan portfolio can make a calm assessment of whether permanent diminution in value has occurred, since its portfolio will be classified as ‘loans and receivables’ and will be afforded accrual accounting, the CMBS holder, may be obliged to account for its portfolio on an ‘available for sale’ basis because the CMBS is traded in a supposedly ‘active market’, and may not be afforded the same latitude. But as individual CMBS are very thinlytraded, it has become practice to adopt the price of a rather less illiquid index of similarly-rated tranches issued in the same period.
That index, the CMBX, has become the vehicle of choice for hedge funds and other participants to express a negative view on the US commercial property market. The CMBS holder may be quite comfortable with the loans underpinning its CMBS and the structural features which provide it protection from losses. However, since the CMBX price is the de facto price for its CMBS tranche, it may feel compelled to purchase protection to limit reported losses and avoid further eroding its capital base. Unwittingly, fair value accounting adds to the downward price momentum in the index.
Having purchased protection, the CMBS holder is no longer exposed to reporting loss – while the recorded value of its portfolio may decline further, the CMBX hedge will record an offsetting gain. However, it is paying an ongoing premium for the protection. Should the CMBS holder decide to take off the hedge to avoid paying further premium and to crystallise its reported gain, it is likely to encounter the problem which has beset many others in the market: because of the illiquidity of the index, any purchase in size is likely to drive the index price up, substantially diluting the supposed gain.
Pro-cyclicality
Much has already been written about the dangerously pro-cyclical nature of Basel II, the recently-implemented capital standard for banks. The argument is made that Pillar I of the standard requires the least capital of a bank at the most benign point in the credit cycle when it is best equipped to build capital reserves only to demand it hold most capital at the worst point in the cycle when it’s at its weakest. The authors of Basel II, the Bank for International Settlements, counter that the Supervisory Review Process prescribed in Pillar II of the same document guards against such swings by insisting banks stress test their portfolios and provide capital sufficient to absorb the simulated losses, over-riding the Pillar I capital requirement.
Fair value accounting, arguably, is also pro-cyclical but lacks an over-ride mechanism. When the credit markets are at their most ‘irrationally exuberant’, and tight spreads grind ever tighter, fair value accounting reports gains on credit instruments which are already under-priced for the risks they present. When the cycle turns, and fear replaces greed as the driver of the market, only the brave will purchase assets which provide ample reward for risk lest the same assets could provide even more compelling value some time later, at which time they lose their job.
The current system of accounting for loans and receivables affords banks the opportunity to accrue earnings, thus dampening earnings volatility. Indeed, the now discontinued practice of creating a general reserve did the same thing, but much more explicitly. Many bankers would argue that this was sensible, not just prudent; the potential for loss exists every year even if significant losses are only realised in one or two years every decade. Better to make a general provision in advance of the loss, they say, than to run the risk of catastrophic loss in one year. Market value is over-optimistic in the good times and over-pessimistic in the bad, they claim, and hence using these prices as the basis for accounting is inappropriate. Since Basel II demands that banks should adopt ‘through the cycle’ internal ratings, it is logical, they suggest, that provisioning policy should follow that principle. Providing for loss ex ante is more prudent and counter-cyclical, the argument runs. Auditors fear this opens the door to earnings management.
Meaningful or fair?
While the IASB clearly sees fair value as the solution to measurement related problems, few in the commercial banking community would concur. Most of them would protest that meaningful valuation cannot be undertaken without taking account of intent. They would suggest that it is not meaningful to demand that they fair value portfolios which they intend to hold for term. Any change to the accrual treatment currently afforded these assets would serve to confuse rather than illuminate, they contend.
Investors, too, are divided on the subject. Some suggest that fair value makes it harder to assess performance and hanker for the ‘old days’ when the P&L reported current year performance and the balance sheet the sum of all prior years’ performance. Many view with suspicion the decision taken by some banks to mark down their liabilities when their own creditworthiness deteriorates and suggest it is merely a ruse to save them from reporting even lower capital ratios.
Other observers worry that fair value will deter banks from continuing to undertake what has been their key role in society, namely, to provide financing for the long-term. Since banks’ funding position has implicit regulatory support, they question the relevance of the secondary market price and the behaviour it might induce. Some would even argue for reversing the changes brought in by IAS 39 that oblige institutions to fair value all derivative exposures, regardless of intent. They would argue that whether credit risk is taken through granting a loan or writing a credit derivative is irrelevant; if the institution has the intention of taking the risk until the instrument matures and has the capacity to do so, the form in which that risk is taken is immaterial.
“ … if banks have to report their assets on a fair value basis, there will be much greater variability in reported earnings, and, consequently, in bank equity …”
Role of commercial banks
Commercial banks play a crucial role in supporting enterprise; it is vital that credit is available on competitive terms if an economy is to thrive. However, if banks have to report their assets on a fair value basis, there will be much greater variability in reported earnings, and, consequently, in bank equity. If bank loans and receivables are marked down to the same degree as their capital markets equivalents, more than half of the world’s commercial banks would have capital ratios substantially less than the regulatory minimum required to retain their banking licence, and many would have negative equity. (The only way this could be avoided in a fair value framework is to allow banks fair value their liabilities also, a practice, as noted, that is greeted with scepticism.) If fair value became the standard, banks would need to hold substantially more capital than they are currently obliged to do. To rectify this, banks would have to charge much more for credit and long-term funding would be more difficult to access. Society will hardly thank the IASB if this is the result.
But banks also engage in other investment activities which are of less value to society. In recent years, many have created off-balance sheet structures, such as conduits, in which they held assets that were too lowyielding to be profitably held on balance sheet. They held all the risk of these assets since they provided them with a liquidity backstop. Had banks been obliged to fair value their exposure to these vehicles, it is quite likely they would never have created them and much of the current credit chaos would not have occurred. The IASB understands this only too well.
Conclusion
Even a casual observer of the accounting regulations could not fail to observe the fair value theme which runs through many of the standards created in the past fifteen years. If the IASB has its way, we may expect to see many further changes in a similar vein.
While it’s clear that fair value accounting has its uses, it is far from clear that our understanding of commercial bank performance is improved by its more widespread adoption. Furthermore, the repercussions of fair value may be felt far beyond the accounting profession. Fair value is certainly the simplest solution to the problem of complexity but it’s not necessarily the best.
It’s hard to be fair!
Notes:
1 Reducing Complexity in Reporting Financial Instruments, IASB, March 2008.
2 IAS39.AG69 states: “Fair value is not … the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distress sale.” However, when involuntary sales are the norm, it becomes increasingly difficult to rely on this clause.
3 The IASB, conscious of the potential for abuse, has restricted the application of fair value to liabilities. IAS39.9 states: “Upon initial recognition it is designated as at fair value through profit or loss. An entity may use this designation only … when doing so results in more relevant information, because … it … reduces a measurement or recognition inconsistency”.
4 IAS39.48A states: “The best evidence of fair value is quoted prices in an active market. If the market for a financial instrument is not active, an entity establishes fair value by using a valuation technique.” But, the practice of marking-to-model – or marking-to-myth as it is more derisively termed by some – is increasingly mistrusted in the market.
Dr. Brian O’Kelly is a Principal at QED Equity, a financial services private equity firm in the IFSC, and Adjunct Professor of Finance at Dublin City University.