Mark to Market Accounting – What are the Issues?

            A number of
respected people have blamed accounting rules for much of the current financial
crisis. “Fair value” or “mark to market” accounting aims to present a more
accurate picture of a bank’s condition and should not be abandoned. The
application of fair value accounting, however, especial to assets like Mortgage
Backed Securities (MBSs) that do not trade or trade in thin, distressed
markets, is flowed and should be improved. The SEC’s recently revised guidance
on valuing such assets is a very positive step in this direction. Accounting
rules should not be perverted to achieve other laudable objectives, such as
moderating the pro-cyclical increases and decreases in bank capital that result
from the pro-cyclical variations in the value of bank assets.

 

Accounting rules can be complicated
but their purpose is simple, which is to provide as accurate a picture as
possible of the financial performance and condition of an enterprise. Business
and other decisions depend on such information. In the case of banks, an
assessment of its soundness is critical to uninsured depositors and investors
before intrusting their funds to the bank. A bank is insolvent if it does not
have positive net worth or capital, the difference between the value of its
assets and its deposit and other liabilities. One of the most important lessons
of banking supervision of the last half century is that it is very unwise to
allow an insolvent (but liquid) bank, i.e. a bank with negative capital, to
continue to operate. Its losses almost always grow larger until it is finally
closed.

 

            Market
participants will do their best to evaluate the soundness of banks before
buying their debt or placing large (i.e. uninsured) deposits there. If they can
rely on accounting statements to reflect soundness to the extent that it is
possible to do so, they will do so. If accounting statements cannot be trusted
or disguise the truth investors will not rely on them, estimating the bank’s
condition as best they can. But not having the best possible statement of
condition increases market uncertainty and the associated risk premiums about
what the true condition really is.

 

            It has long
been recognized that book values of loans or other assets do not generally
reflect the actual market value of such assets. If a borrower is not making its
payments on a loan (mortgage or otherwise) it is obvious that its book value
(the contractual principle and interest payments first entered into the banks
books) to the bank overstates and potentially greatly overstates its actual
realizable value. It over states the resources the bank has with which to honor
its deposit and other liabilities. The best possible statement of its value
would be to record the present value of the expected income to be received from
such loans (discounting the expected income with the prevailing market interest
rate). This requires judgment and can’t be know perfectly, but it is not too
difficult to arrive at a far more likely value than from using its original
book value.

 

            This is
quite obvious and uncontroversial for non performing loans but for some reason
the same truth is not so easily recognize for assets that will be fully repaid
but with interest rates that are no longer attractive. If a bank buys a
treasury bond for $1000 with a 6% dividend per year for thirty years and market
interest rates go up to 12%, its real (market) value is reduced significantly
even though its interest and principal will all be paid on time and in full. If
the bank needed to liquidate the bond now it could only sell it for a bit more
than $500. Holding it to maturity just doesn’t change the fact that it has lost
value. Reporting it at face value (its purchase price) would be a fraud, a
deliberate misstatement of the facts. The S&L crisis of the 1980s reflected
exactly such a phenomenon. Savings and Loan banks lost money and became
insolvent not because borrowers were defaulting on their mortgages more than
usual (as now) but because market interest rates increased dramatically and
these banks were stuck with otherwise good long term mortgages that yielded
much less than they now had to pay to their depositors to keep their money
there—the money that financed these mortgages. These good mortgages were producing
huge loses that bankrupted almost 2,000 banks.

 

Rules for classifying and
provisioning against loans kept on a bank’s books are reasonably well defined.
However, when loans are securitized and resold in the market, different rules
apply. Basically, the prices received or prevailing in the market for similar
loans or pools of loans provide the market’s assessment of current value and
are generally expected to be used to value similar, potentially marketable
loans still held by the bank.

 

            The
movement to mark to market accounting is an attempt to more correctly account
for a bank’s performance and condition (net worth) by valuing its assets at
their current market price. As such it is an important improvement over earlier
book value accounting. Its implementation, however, is not without problems.
Take mortgages and Mortgage Backed Securities (MBSs), for example. Mortgage
defaults this year and last were much higher than had been expected, especially
for Adjustable Rate Mortgages (ARMs) to Subprime and Alt-A borrowers. Banks and
other owners of these MBSs have experienced unexpected losses and this should
be reflected in lower valuations for these assets in their books. Existing loan
classification rules for non traded loans (including mortgages) would require
provisioning against expected losses on these loans (writing down the expected
value) in light of recent experience even if they are not traded. Banks need to
have the best estimate of the likely value of their loans (even if they are
fully performing up till now). But for traded mortgages the secondary markets
in which these assets trade are very thin and currently non existent (frozen)
and thus market prices in this case might not be a fair measure of the expected
return from holding them. Furthermore, unlike trading government securities or
corporate bonds, which are homogeneous within their class so that the market
price of a 10 year treasury bond clearly should apply to an identical bond held
by the bank, MBSs are heterogeneously and not fully comparable.

 

            Criticisms
of fair value or mark to market accounting fall into two main classes. The
first is that the actual application of fair value accounting in some cases
does not actually result in the best valuation of the asset. The second, which
is misguided, is that even if it results in the best measure of actual value it
should not be used because it contributes to undesirable pro-cyclical swings in
bank capital. These are examined in turn.

 

Accounting rules formally define
“fair value” as “the price that would be received to sell an asset… in an
orderly transaction between market participants at the measurement date.”[1]  Peter J. Wallison, Chief Legal Council of the
U.S. Treasury during the Reagan administration, criticized the rules for
applying mark to market requirements to MBSs in a study for the American
Enterprise Institute. “It seems an unavoidable conclusion, however, that the
doubts about the financial stability of these institutions were sown by the
drastic cuts in asset prices required by the mark-to-market valuations of fair
value accounting, instead of a fair appraisal of the value of the cash flows their
assets were producing,” he wrote.[2]  Wallison pointed to many legitimate problems
with valuing MBSs when distressed sales and a lack of market liquidity are
believed by many, including the U.S. Treasury, to have resulted in the
undervaluation of these assets in the market. However, he persistently refers
to the present value of “cash flow” as a preferred basis, when it is the
“expected cash flow” that is relevant. On September 30 when the Securities and
Exchange Commission, in junction with the Financial Accounting Standards Board,
issued guidelines under "fair value" accounting rules for financial
firms trying to value of hard-to-trade assets on their balance sheets, they
correctly referred to “expected cash flow” as a proper bases for valuing assets
that are not trading or are trading in disorderly markets.[3]
The fact that the current (historical) cash flow from a mortgage pool is what it
is does not change the fact that it is now generally expected to be lower in
the future and thus the best estimate of the true value of the pool will be
lower because of that.

 

Earlier SEC FASB interpretations of
the rules for valuing MBSs leaned much more heavily toward current market
prices as long as there were any at all, while the new clarification admits
that current market conditions are not orderly and thus internal expected cash
flow estimates may be appropriate. “Fannie has an underwriting and valuation
shop with models for valuing mortgages that are up and running.”[4] They
forecast default rates for different assumptions about price declines and have
a good track record. They might be deployed to establish valuations in lieu of
reliable market prices until markets return to normal. This new SEC clarification
is welcomed and should increase bank capital in much the way the Treasury’s new
$700 billion TARP program was expected to.[5]  It should also do much to diminish the call
to abandon mark to market accounting.

 

The other criticism, also made by
Wallison, is that “Procyclicality is obviously an unintended consequence of
fair value accounting, but nonetheless an issue for policymakers…. The central
purposes of fair value accounting were good—to make financial statements easier
to compare and to bring asset values more in line with reality—but these goals,
even if they had been achieved, are not as important as avoiding or reducing
asset bubbles, producing steady growth in the economy, and encouraging stability
in our financial institutions.”[6]

 

            The
pro-cyclical behavior of asset values is an economic reality. No good policy
purpose would be served by attempting to hide the fact by corrupting accounting
standards. Full transparency is desirable. However, an honest accounting of the
pro-cyclical behavior of asset values does not prevent taking policy measures
designed to moderate the effect of asset value swings on bank lending or other
behavior. A far better approach to the tendency for raising asset values to
encourage banks to expand lending or risk taking pro-cyclically would be to
vary capital requirements over the business cycle such that banks are required
to hold more capital relative to their liabilities during the up side and less
during the down side of business cycles.

 

            This issue
is reminiscent of the slow evolution of central banks toward acceptance of
International Accounting Standards (IAS) for themselves. Traditionally central
banks rejected the use of IAS they required commercial banks to follow in order
to hid their unrealized foreign exchange valuation gains and losses (“paper”
gains and losses), which can be considerable for a typical central bank. The
banks’ accounts are in their local currency and they necessarily have an
exposure (open position) to foreign currency values through their reserves of
foreign currencies. European central banks resisted the adoption of IAS with
regard to the reporting of these gains and losses because their laws required
them to surrender profits above some minimum to their Finance Ministries and
during the first two or three decades after World War II they generally enjoyed
valuation gains from their foreign exchange reserves because of the tendency
for European currencies to depreciate against the U.S. dollar in which most of
their reserves were held. They did not wish to report these unrealized gains
because they did not wish to pay them to their Finance Ministries. Thus they
hid them by not including them in income. However, in the 1980s the German mark
and some other European currencies appreciated against the dollar for a number
of years causing the famous Bundesbank to become insolvent. The Bundesbank was
recapitalized by the German Government and there after led the field by
amending its accounting standards to reflect unrealized as well as realized
valuation gains and losses.

 

Drawing on the precedent set by the
Bundesbank, I convinced the Bosnian authorities in 1997 (and the IMF’s legal
advisor) to adopted IAS standards for reporting the Central Bank of Bosnia and Herzegovina’s
income. As we all agreed that it would not be desirable as a matter of policy
to remit to the government unrealized valuation gains (what some might call
purely paper profits from changes in exchange rates when no transactions
occurred), the rules for determining income subject to remittance were adjusted
to exclude unrealized gains. This is far more transparent than the traditional
central bank practice of hiding them from income in their financial statements.

 

While efforts to improve the
implementation of fair market accounting are welcomed and should continue, the
gains made in making financial statements a more accurate reflection of
outcomes and conditions are helpful and important to the efficient functioning
of markets.