Excerpts from 'Bear Raid' Stock Manipulation: How and When It Works, and Who Benefits
When Bear Stearns collapsed in March, some insiders argued it was wrong to blame the firm's risky bets on mortgaged-backed securities. They had another culprit: malevolent traders working together in the upside-down world of short sales -- making money by knocking down Bear's stock.
No one openly admits to conducting a "bear raid," since deliberately manipulating stock prices is illegal. But Wall Street has long believed bear raids can and do take place. There has, however, been little academic research to explain the forces at work. Now two finance experts have shed some light on the process. "We basically describe a theory of how bear raid manipulation works," says Wharton finance professor Itay Goldstein. He and Alexander Guembel of the Saïd Business School and Lincoln College at the University of Oxford describe the procedure in their paper titled, "Manipulation and the Allocational Role of Prices."
Their key finding illuminates the interplay between a firm's real economic value and its stock price, showing how traders who deliberately drive the share price down can undermine the firm's health, causing the share price to fall further in a vicious cycle.
"What we show here is that by selling [the stock], you have a real effect on the firm," Goldstein notes. "The connection with real value is the new thing.... That is the crucial element."
...
[I]f the falling share price caused by a bear raid does real economic damage to the firm, other investors are likely to dump the stock as well, causing a vicious cycle of falling share prices and economic damage that would make the bear raid more profitable.
Sabaziotatos says:
This is precisely the kind of manipulation that I discussed in Sabaziotatos calls on SEC to investigate "gaming" of ABX. "Wash trades" at depressed price levels in the illiquid OTC market tracked by the ABX index most definitely could damage the "real value" of a financial services firm: fair value accounting would require the firm to mark its assets to market against the index; the lower mark would result in writedowns of asset values on the balance sheet; the writedowns would not only reduce capital ratios, but also cause a loss of confidence, which would feed back into the ABX. As the good professors point out, this rapid, self-reinforcing, pro-cyclical loss of confidence can be deadly.
Thursday, April 17, 2008
4/17/2008: Hardest to value assets escalate
Excerpts from Hardest-to-value assets escalate: 'Mark to myth' data at big banks provide clues to write-downs
By Dominic Elliott and Tom Fairless
Were it not for the credit crunch, reading the phrase "assets valued without observable market inputs" would be enough to glaze the eyes of most investors without advanced accountancy qualifications.
But in an uncertain climate of write-downs at investment banks, the term has drawn attention from analysts and shareholders.
International Financial Reporting Standards rules that applied from the start of last year require banks to break down their assets under fair-value accounting into three categories: those with market prices [Level 1]; those modeled on observable market prices [Level 2]; and those that banks are forced to value without any observable market data [Level 3].
The amount of assets on the balance sheets of Europe's largest banks in the third category, dubbed "mark to myth" or "mark to make-believe" by some analysts, almost tripled by the end of last year, according to Financial News analysis. ... The average ratio of opaque assets to total assets also rose to 3.8% last year from 1.8% at the end of 2006. Total assets under fair-value accounting for the five banks rose 23% to more than €4 trillion at the end of last year, as lenders were forced to bring more assets on their balance sheet under stricter capital-adequacy requirements and tougher market conditions.
...
In part, the jump is a reflection of markets where trading has ground to a halt and caused price tags to disappear. "A lot of assets are now in no-man's land," said Christopher Wheeler, a senior research analyst at Bear Stearns.
...
Assets modeled without reference to market prices can be of good or bad quality. However, the fact they are illiquid and difficult to value has fueled fears among some investors that they may lead to further write-downs.
The International Monetary Fund's Global Financial Stability Report, published last week, stated: "Market analysts may judge, correctly, that such a move reflects further illiquidity in the market or, incorrectly, that the firm's re-categorization of fair value methodologies represents a deliberate overestimation of the value that the assets would generate in a sale."
Matthew Clark, a European banks analyst at broker-dealer Keefe, Bruyette and Woods, said, "Some failed auction-rate certificates will be included in the bucket but, given the municipal underlying, are likely to be of sound asset quality and so not much of a concern. At the other end of the spectrum, subprime collateralized debt obligations will be complex to model and have much riskier underlyings -- these are a greater concern."
In the U.S., analysts have estimated that about 15% of Wall Street banks' so-called Level 3 assets, which are broadly comparable to those valued by European banks without observable market inputs, could be written down depending on the extent to which they are hedged.
Goldman Sachs Group Inc. increased its holdings of Level 3 assets by 39% during its fiscal first quarter ended in February to $96.4 billion, according to a regulatory filing with the U.S. Securities and Exchange Commission last week.
Goldman's ratio of Level 3 to total assets also rose, to 8.1% from 6.2%. Morgan Stanley's Level 3 assets rose 6.1% to $78.2 billion in the three months to February, while Lehman Brothers Holdings Inc.'s rose 1.3% to $42.5 billion for the same fiscal period. U.S. banks are required to reveal Level 3 assets under Generally Accepted Accounting Principles, while banks outside the U.S. follow their own jurisdictions or use International Financial Reporting Standards.
"Assets that are tough to value could or could not be problematic. That uncertainty is in itself problematic," said Mamoun Tazi, an analyst at MF Global Securities.
Banks may also have different ways of valuing such assets, making it harder for investors to compare rivals in the same sector.
A report published last month by independent research provider CreditSights showed European banks' valuations of their CDO holdings vary more than previously thought. This is partly because different regulators across Europe offer banks leeway in pricing assets under fair-value accounting.
"Consistency in accounting across the banking sector, auditors and countries is essential," said Leigh Goodwin, an analyst at consultants Fox-Pitt, Kelton.
European Commission accounting advisers this month added their voices to calls from bankers and insurers for fair-value accounting to be changed in order to prevent write-downs, as liquidations of assets lower market prices and cause banks to suffer more losses.
Last week the International Monetary Fund said, "Weaknesses in the implementation of fair-value accounting results should be addressed." It added that in a recession, banks could be required to make further write-downs while increasing capital reserves.
However, Mr. Goodwin said the additional insight into banks' asset structures under fair-value accounting is good for investors. "It would be terrible if fair-value accounting was abandoned," Mr. Goodwin said. "In tough market conditions, investors need to have as much information as possible.
"This is the time when we need mark-to-market information and as much disclosure as possible" he continued. "If banks were allowed to fudge asset values and not reflect market reality this may boost accounting profits and capital ratios, but it could backfire as investors, the interbank market, credit-rating agencies and perhaps regulators lost trust in the banks' figures."
Sabaziotatos says:
Once again we hear the argument: "We must not abandon mark-to-market accounting since we need its transparency now more than ever." This argument would make sense if mark-to-market accounting ensured transparency. It does not. The critique being leveled at mark-to-market accounting now is precisely that it introduces price distortion into the markets because of its pro-cyclicality. Advocates must stop boldly asserting that mark-to-market accounting ensures transparency, and instead try to demonstrate that it is not not pro-cyclical. For, if it is pro-cyclical, it must be abandoned or at least modified.
As for the movement of assets from Levels 1 or 2 into Level 3 when observable inputs disappear, this treatment is consistent with the guidance the SEC gave in its Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)
By Dominic Elliott and Tom Fairless
Were it not for the credit crunch, reading the phrase "assets valued without observable market inputs" would be enough to glaze the eyes of most investors without advanced accountancy qualifications.
But in an uncertain climate of write-downs at investment banks, the term has drawn attention from analysts and shareholders.
International Financial Reporting Standards rules that applied from the start of last year require banks to break down their assets under fair-value accounting into three categories: those with market prices [Level 1]; those modeled on observable market prices [Level 2]; and those that banks are forced to value without any observable market data [Level 3].
The amount of assets on the balance sheets of Europe's largest banks in the third category, dubbed "mark to myth" or "mark to make-believe" by some analysts, almost tripled by the end of last year, according to Financial News analysis. ... The average ratio of opaque assets to total assets also rose to 3.8% last year from 1.8% at the end of 2006. Total assets under fair-value accounting for the five banks rose 23% to more than €4 trillion at the end of last year, as lenders were forced to bring more assets on their balance sheet under stricter capital-adequacy requirements and tougher market conditions.
...
In part, the jump is a reflection of markets where trading has ground to a halt and caused price tags to disappear. "A lot of assets are now in no-man's land," said Christopher Wheeler, a senior research analyst at Bear Stearns.
...
Assets modeled without reference to market prices can be of good or bad quality. However, the fact they are illiquid and difficult to value has fueled fears among some investors that they may lead to further write-downs.
The International Monetary Fund's Global Financial Stability Report, published last week, stated: "Market analysts may judge, correctly, that such a move reflects further illiquidity in the market or, incorrectly, that the firm's re-categorization of fair value methodologies represents a deliberate overestimation of the value that the assets would generate in a sale."
Matthew Clark, a European banks analyst at broker-dealer Keefe, Bruyette and Woods, said, "Some failed auction-rate certificates will be included in the bucket but, given the municipal underlying, are likely to be of sound asset quality and so not much of a concern. At the other end of the spectrum, subprime collateralized debt obligations will be complex to model and have much riskier underlyings -- these are a greater concern."
In the U.S., analysts have estimated that about 15% of Wall Street banks' so-called Level 3 assets, which are broadly comparable to those valued by European banks without observable market inputs, could be written down depending on the extent to which they are hedged.
Goldman Sachs Group Inc. increased its holdings of Level 3 assets by 39% during its fiscal first quarter ended in February to $96.4 billion, according to a regulatory filing with the U.S. Securities and Exchange Commission last week.
Goldman's ratio of Level 3 to total assets also rose, to 8.1% from 6.2%. Morgan Stanley's Level 3 assets rose 6.1% to $78.2 billion in the three months to February, while Lehman Brothers Holdings Inc.'s rose 1.3% to $42.5 billion for the same fiscal period. U.S. banks are required to reveal Level 3 assets under Generally Accepted Accounting Principles, while banks outside the U.S. follow their own jurisdictions or use International Financial Reporting Standards.
"Assets that are tough to value could or could not be problematic. That uncertainty is in itself problematic," said Mamoun Tazi, an analyst at MF Global Securities.
Banks may also have different ways of valuing such assets, making it harder for investors to compare rivals in the same sector.
A report published last month by independent research provider CreditSights showed European banks' valuations of their CDO holdings vary more than previously thought. This is partly because different regulators across Europe offer banks leeway in pricing assets under fair-value accounting.
"Consistency in accounting across the banking sector, auditors and countries is essential," said Leigh Goodwin, an analyst at consultants Fox-Pitt, Kelton.
European Commission accounting advisers this month added their voices to calls from bankers and insurers for fair-value accounting to be changed in order to prevent write-downs, as liquidations of assets lower market prices and cause banks to suffer more losses.
Last week the International Monetary Fund said, "Weaknesses in the implementation of fair-value accounting results should be addressed." It added that in a recession, banks could be required to make further write-downs while increasing capital reserves.
However, Mr. Goodwin said the additional insight into banks' asset structures under fair-value accounting is good for investors. "It would be terrible if fair-value accounting was abandoned," Mr. Goodwin said. "In tough market conditions, investors need to have as much information as possible.
"This is the time when we need mark-to-market information and as much disclosure as possible" he continued. "If banks were allowed to fudge asset values and not reflect market reality this may boost accounting profits and capital ratios, but it could backfire as investors, the interbank market, credit-rating agencies and perhaps regulators lost trust in the banks' figures."
Sabaziotatos says:
Once again we hear the argument: "We must not abandon mark-to-market accounting since we need its transparency now more than ever." This argument would make sense if mark-to-market accounting ensured transparency. It does not. The critique being leveled at mark-to-market accounting now is precisely that it introduces price distortion into the markets because of its pro-cyclicality. Advocates must stop boldly asserting that mark-to-market accounting ensures transparency, and instead try to demonstrate that it is not not pro-cyclical. For, if it is pro-cyclical, it must be abandoned or at least modified.
As for the movement of assets from Levels 1 or 2 into Level 3 when observable inputs disappear, this treatment is consistent with the guidance the SEC gave in its Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)
- "Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157." [emphasis added]
- JPM CFO Michael Cavanagh: "And last comment, a little bit of increase - from 5% to 6% would be my estimate - in terms of Level 3 assets for the firm for the quarter, so not something that gives me any pause."
Wednesday, April 16, 2008
4/15/2008: CEO of M&T calls for rethink of mark-to-market accounting
Excerpt from Remarks to Annual Meeting of Shareholders, April 15, 2008
By Robert Wilmers, CEO of M&T Bank
In normal times, I might focus mainly this morning on several specific factors which have had the most pronounced effects on our net income. But these are not normal times for the banking industry.
No discussion of any individual bank’s results today can take place without reflecting more broadly—much more broadly—on the extraordinary time in which we find ourselves, a time in which there is a crisis of confidence in the financial services industry.
It is a crisis which has already prompted unprecedented forms of government intervention, but which calls for more—much more—action to ensure the long-term stability of our capital markets.
...
What, then, to do? There is no quick fix. However, among the approaches that must be considered are these.
...
Re-examination of the appropriateness of mark-to-market accounting for balance sheet purposes, in periods of illiquid markets. The ability to reasonably determine the fair value of certain assets in times like these is, at best, severely limited—for those that previously made markets in such assets, for all practical purposes, have gone fishing.
By Robert Wilmers, CEO of M&T Bank
In normal times, I might focus mainly this morning on several specific factors which have had the most pronounced effects on our net income. But these are not normal times for the banking industry.
No discussion of any individual bank’s results today can take place without reflecting more broadly—much more broadly—on the extraordinary time in which we find ourselves, a time in which there is a crisis of confidence in the financial services industry.
It is a crisis which has already prompted unprecedented forms of government intervention, but which calls for more—much more—action to ensure the long-term stability of our capital markets.
...
What, then, to do? There is no quick fix. However, among the approaches that must be considered are these.
...
Re-examination of the appropriateness of mark-to-market accounting for balance sheet purposes, in periods of illiquid markets. The ability to reasonably determine the fair value of certain assets in times like these is, at best, severely limited—for those that previously made markets in such assets, for all practical purposes, have gone fishing.
Tuesday, April 15, 2008
4/15/2008: State Street's unrealized mark to market losses
Excerpt from State Street's Q108 conference call (starting at about 24 minutes in)
Ed Resch, CFO of State Street:
A lot has been said over the past few months and quarters regarding the extraordinary events impacting the fixed income markets. These are not ordinary times and these are not orderly markets. Despite the high credit quality of the investment portfolio, the illiquidity in the marketplace and resulting prices affecting fixed income securities have caused the unrealized pre-tax loss on our portfolio to increase to $3.2B at 3/31/2008, up from an unrealized pre-tax loss of $1.1B at 12/31/2007, and an unrealized pre-tax loss of $309M a year ago. We believe that these prices are not reflective of the underlying value of the securities. Several examples will help me illustrate that point.
Look at the element of the portfolio we hold in student loans, about $9.2B, the vast majority, about 90% of which is covered by a 97% Federal government guarantee. At 12/31/2007, these securities were trading at 98% of par. Today, they are trading at 92% of par. There has been no significant change in the credit quality of these securities, so what are the markets telling us? I think that the market is confirming that it is illiquid. In fact, there are few buyers or few sellers at this price.
Or look at the 18 subprime securities that the rating agencies put on credit watch at the end of January. They just recently reaffirmed the ratings on 17 of these, leaving only one on watch due to its downgrade of its insurance wrap provider. They are all rated AA, but are priced between 40% and 89% of par at March month end.
These are just two examples of the impact that the current market dislocations and sporadic forced selling have had on market prices for investment grade bonds. We continue to believe that our portfolio is not at risk of permanent impairment and is not currently other than temporarily impaired. We base this belief on the results of the extensive credit analysis we have performed and continue to perform on the portfolio and believe that we will recover the principal at maturity.
I would like to stop here and provide you with a deeper look into the securities within the portfolio. If you would turn to Slide 3 in the Investment Portfolio Slide Package, you can see some of the data I am presenting. First, 15 securities have been downgraded as of 3/31/2008. These 15 securities do not include those securities that were downgraded based on downgrades of the insurance wrap provider. Based on the total number [535] of securities downgraded by the rating agencies during the past two quarters, we believe the number of rating agency actions affecting our securities is very modest and is a testimony to the quality of the assets in our portfolio.
Lastly, I'll address the asset-backed securities that are collateralized by first-lien subprime mortgages, a portfolio which I have been commenting on since the second quarter of last year. This section of the portfolio has a $933M unrealized pre-tax loss at 3/31/2008, which is about 1/3 of the total unrealized pre-tax mark-to-market loss for the entire portfolio. If you turn to slides 4 and 5, first of all, the portfolio has performed as we have expected. Our portfolio of asset-backed securities collateralized by subprime mortgages is $5.9B as of 3/31/2008, down from $6.2B as of 12/31/2007. 70% of the portfolio is rated AAA and the remaining 30% is rated AA. 3 of the securities have been downgraded, again a very small number in light of the downgrades issued by the rating agencies over the last few quarters. We have a 41% average credit enhancement based on the structure itself, which gives us confidence that these securities will mature at par. You can see this credit enhancement grow over time with pay downs that we've received. Last March, the credit enhancement was 34%, which has increased to the 41% I mentioned as of 3/31/2008. This means that even if every mortgage backing an asset were to default, we would not lose one dollar until the recovery rate for those assets fell below 59%. And further we believe the assets are well-diversified by vintage, geography, and originator. As I just noted, the negative mark-to-market on this portion of the portfolio has increased to about $933M with no securities on credit watch. Since so many securities in this category have been downgraded industry-wide over the past two quarters, we have confidence that our credit process at State Street has served us well to date and that we expect these securities to mature at par.
However, during the quarter we recorded $11.5M in other than temporary impairment, which was one asset-backed security collateralized by HELOC's and wrapped by FGIC as the insurance provider. Based on our credit analysis of the underlying collateral, and our assessment of the wrap provider, we concluded that a portion of the fair value decline was attributable to credit, and therefore we wrote the security down to its current fair value.
If you review slides 6 through 8, you can also get some further detail about the monoline coverage we have on the portfolio, mostly in the municipal bond book. Note that our overall rating would decline only slightly, from 94% to 92%, if all the wraps were simultaneously removed. The last slide gives you a breakdown of the assets by wrap provider, where you can see that 99% of the coverages is due to the municipal bond investments, usually a very high performing asset class.
So, in conclusion to my remarks on the unrealized mark-to-market loss in the securities portfolio, why do we have such confidence in our portfolio when many others are writing down assets? We are very selective in the assets we buy and put these choices through a rigorous credit process. On an ongoing basis, we monitor the performance of these securities and have found them all to be performing well. Our investment portfolio consists of securities with significant levels of structural credit enhancement, which provides protection against difficult economic environments. I hope my remarks have given you some comfort in reviewing our portfolio so that you can understand the source of our confidence.
Ed Resch, CFO of State Street:
A lot has been said over the past few months and quarters regarding the extraordinary events impacting the fixed income markets. These are not ordinary times and these are not orderly markets. Despite the high credit quality of the investment portfolio, the illiquidity in the marketplace and resulting prices affecting fixed income securities have caused the unrealized pre-tax loss on our portfolio to increase to $3.2B at 3/31/2008, up from an unrealized pre-tax loss of $1.1B at 12/31/2007, and an unrealized pre-tax loss of $309M a year ago. We believe that these prices are not reflective of the underlying value of the securities. Several examples will help me illustrate that point.
Look at the element of the portfolio we hold in student loans, about $9.2B, the vast majority, about 90% of which is covered by a 97% Federal government guarantee. At 12/31/2007, these securities were trading at 98% of par. Today, they are trading at 92% of par. There has been no significant change in the credit quality of these securities, so what are the markets telling us? I think that the market is confirming that it is illiquid. In fact, there are few buyers or few sellers at this price.
Or look at the 18 subprime securities that the rating agencies put on credit watch at the end of January. They just recently reaffirmed the ratings on 17 of these, leaving only one on watch due to its downgrade of its insurance wrap provider. They are all rated AA, but are priced between 40% and 89% of par at March month end.
These are just two examples of the impact that the current market dislocations and sporadic forced selling have had on market prices for investment grade bonds. We continue to believe that our portfolio is not at risk of permanent impairment and is not currently other than temporarily impaired. We base this belief on the results of the extensive credit analysis we have performed and continue to perform on the portfolio and believe that we will recover the principal at maturity.
I would like to stop here and provide you with a deeper look into the securities within the portfolio. If you would turn to Slide 3 in the Investment Portfolio Slide Package, you can see some of the data I am presenting. First, 15 securities have been downgraded as of 3/31/2008. These 15 securities do not include those securities that were downgraded based on downgrades of the insurance wrap provider. Based on the total number [535] of securities downgraded by the rating agencies during the past two quarters, we believe the number of rating agency actions affecting our securities is very modest and is a testimony to the quality of the assets in our portfolio.
Lastly, I'll address the asset-backed securities that are collateralized by first-lien subprime mortgages, a portfolio which I have been commenting on since the second quarter of last year. This section of the portfolio has a $933M unrealized pre-tax loss at 3/31/2008, which is about 1/3 of the total unrealized pre-tax mark-to-market loss for the entire portfolio. If you turn to slides 4 and 5, first of all, the portfolio has performed as we have expected. Our portfolio of asset-backed securities collateralized by subprime mortgages is $5.9B as of 3/31/2008, down from $6.2B as of 12/31/2007. 70% of the portfolio is rated AAA and the remaining 30% is rated AA. 3 of the securities have been downgraded, again a very small number in light of the downgrades issued by the rating agencies over the last few quarters. We have a 41% average credit enhancement based on the structure itself, which gives us confidence that these securities will mature at par. You can see this credit enhancement grow over time with pay downs that we've received. Last March, the credit enhancement was 34%, which has increased to the 41% I mentioned as of 3/31/2008. This means that even if every mortgage backing an asset were to default, we would not lose one dollar until the recovery rate for those assets fell below 59%. And further we believe the assets are well-diversified by vintage, geography, and originator. As I just noted, the negative mark-to-market on this portion of the portfolio has increased to about $933M with no securities on credit watch. Since so many securities in this category have been downgraded industry-wide over the past two quarters, we have confidence that our credit process at State Street has served us well to date and that we expect these securities to mature at par.
However, during the quarter we recorded $11.5M in other than temporary impairment, which was one asset-backed security collateralized by HELOC's and wrapped by FGIC as the insurance provider. Based on our credit analysis of the underlying collateral, and our assessment of the wrap provider, we concluded that a portion of the fair value decline was attributable to credit, and therefore we wrote the security down to its current fair value.
If you review slides 6 through 8, you can also get some further detail about the monoline coverage we have on the portfolio, mostly in the municipal bond book. Note that our overall rating would decline only slightly, from 94% to 92%, if all the wraps were simultaneously removed. The last slide gives you a breakdown of the assets by wrap provider, where you can see that 99% of the coverages is due to the municipal bond investments, usually a very high performing asset class.
So, in conclusion to my remarks on the unrealized mark-to-market loss in the securities portfolio, why do we have such confidence in our portfolio when many others are writing down assets? We are very selective in the assets we buy and put these choices through a rigorous credit process. On an ongoing basis, we monitor the performance of these securities and have found them all to be performing well. Our investment portfolio consists of securities with significant levels of structural credit enhancement, which provides protection against difficult economic environments. I hope my remarks have given you some comfort in reviewing our portfolio so that you can understand the source of our confidence.
4/15/2008: ABX, CMBX, any kind of X, out of control
Excerpts from Swaps Tied to Losses Became `Frankenstein's Monster'
By Neil Unmack and Sarah Mulholland
The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.
The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.
"ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market," Swiss Re's Aigrain said at the Dubai conference.
...
"In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals," wrote Dottie Cunningham, chief executive officer of the New York-based CMSA.
Sabaziotatos says:
Remember these are the indices that the IMF used to estimate global losses from broad credit market deterioration of $945B, that Meredith Whitney used to estimate her latest round of losses for Citigroup, and that William Tanona used to make recent estimates for Citigroup.
By Neil Unmack and Sarah Mulholland
The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.
The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.
"ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market," Swiss Re's Aigrain said at the Dubai conference.
...
"In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals," wrote Dottie Cunningham, chief executive officer of the New York-based CMSA.
Sabaziotatos says:
Remember these are the indices that the IMF used to estimate global losses from broad credit market deterioration of $945B, that Meredith Whitney used to estimate her latest round of losses for Citigroup, and that William Tanona used to make recent estimates for Citigroup.
Monday, April 14, 2008
4/7/2008: CFA roundtable on mark to market
Journalists Invited to Hear Investor Perspective on Fair Value (“Mark to Market”) at CFA Institute Centre for Financial Market Integrity Media Roundtable
Sabaziotatos says:
Unfortunately, I have not yet been able to get a webcast or a transcript. Here are some excerpts from the only report on the roundtable I have seen:
Sabaziotatos says:
Unfortunately, I have not yet been able to get a webcast or a transcript. Here are some excerpts from the only report on the roundtable I have seen:
- Jeffrey Diermeier, president and CEO of the CFA Institute, posed a question to the members of the institute recently asking whether fair value requirements are aggravating the global credit crisis. Fifty-five percent of 2,006 respondents said yes, while 45 percent said no. ... "We believe fair value gives you more transparency into the underlying assets," said Russell Golden, director of technical application and implementation activities at the Financial Accounting Standards Board and chairman of the Emerging Issues Task Force."
2/29/2008: Leveraged Losses: Lessons from the Mortgage Market Meltdown
Abstract from Leveraged Losses: Lessons from the Mortgage Market Meltdown
By David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin
This report discusses the implications of the recent financial market turmoil for central banks. We start by characterizing the disruptions in the financial markets and compare these dislocations to previous periods of financial stress. We confirm the conventional view that the current problems in financial markets are concentrated in institutions that have exposure to mortgage securities. We use several methods to estimate the ultimate losses on these securities. Our best (very uncertain) guess is that the losses will total about $400 billion, with about half being borne by leveraged U.S. financial institutions. We then highlight the role of leverage and mark-to-market accounting in propagating this shock. This perspective implies an estimate of the eventual contraction in balance sheets of these institutions, which will include a substantial reduction in credit to businesses and households. We close by exploring the feedback from credit availability to the broader economy and provide new evidence that contractions in financial institutions balance sheets’ cause a reduction in real GDP growth.
By David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin
This report discusses the implications of the recent financial market turmoil for central banks. We start by characterizing the disruptions in the financial markets and compare these dislocations to previous periods of financial stress. We confirm the conventional view that the current problems in financial markets are concentrated in institutions that have exposure to mortgage securities. We use several methods to estimate the ultimate losses on these securities. Our best (very uncertain) guess is that the losses will total about $400 billion, with about half being borne by leveraged U.S. financial institutions. We then highlight the role of leverage and mark-to-market accounting in propagating this shock. This perspective implies an estimate of the eventual contraction in balance sheets of these institutions, which will include a substantial reduction in credit to businesses and households. We close by exploring the feedback from credit availability to the broader economy and provide new evidence that contractions in financial institutions balance sheets’ cause a reduction in real GDP growth.
9/2007: Liquidity and Leverage
Abstract of Liquidity and Leverage
By Tobias Adrian and Hyun Song Shin
In a financial system where balance sheets are continuously marked to market, asset price changes show up immediately in changes in net worth, and elicit responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in aggregate balance sheets for intermediaries forecast changes in risk appetite in financial markets, as measured by the innovations in the VIX index. Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.
By Tobias Adrian and Hyun Song Shin
In a financial system where balance sheets are continuously marked to market, asset price changes show up immediately in changes in net worth, and elicit responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in aggregate balance sheets for intermediaries forecast changes in risk appetite in financial markets, as measured by the innovations in the VIX index. Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.
11/2007-2/2008: Nouriel Roubini on mark to market accounting
Excerpt from Liquidity and Credit Crunch in Financial Markets is Back to Summer Peaks, Only Much Worse and More Dangerous
By Nouriel Roubini
The credit boom and easy liquidity of the 2001-2006 period led to a massive releveraging of households, financial institutions and parts of the corporate sector in a credit boom that became a credit bubble and where we observed a Minsky credit cycle where asset prices went into bubble territory given the credit leverage. Now, capital losses, credit crunch and reintermediation is leading to the unraveling of this credit house of cards. Using analytical models developed by research scholars - such as Adrian and Shin - Goldman Sachs estimated that losses in the $400 billion range ($200 b among financial institutions) will lead to a deleveraging of credit of the order of $2 trillion. The overall deleveraging could be higher than that as a variety of institutions (financial and others including households and corporate firms) that will experience a hit to their balance sheet and net worth will have to start deleveraging their balance sheets. Indeed, the latest data suggest that corporate earnings have already fallen 8.5% in Q3 2007 relative to the third quarter of 2006.
Such academic and analytical research also suggests that illiquidity that forces fire sales of assets – of the sort we are starting to see in financial markets - has contagious effects from one financial institution to the other causing a chain of losses that can become systemic and exacerbate liquidity and capital losses (while implementation of FASB 157 will not prevent the past fudge of marking to model rather than marking to market such illiquid and impaired assets). So a contagious unraveling of the Minsky Credit Cycle is now underway.
And now a perverse cycle of financial conditions and credit crunch worsening leading to a worsening of the real economy and, in turn, a worsening of the real economy increasing the financial losses and worsening the liquidity and credit crunch is creating a vicious circle that has significantly increased the likelihood of a now effectively inevitable US recession and of a global economic slowdown. Bernanke and Mishkin know a lot about the “credit channel” and “financial accelerator” effects as they have extensively written about these in their former academic life. This vicious circle is leading to fall in asset prices, fall in net worth, deleveraging, tightening of the quantity and price of credit and fall in durable and non durable spending by households and financial and corporate firms that, in turn, will worsen the financial conditions.
Excerpt from The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster By Nouriel Roubini
Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.
By Nouriel Roubini
The credit boom and easy liquidity of the 2001-2006 period led to a massive releveraging of households, financial institutions and parts of the corporate sector in a credit boom that became a credit bubble and where we observed a Minsky credit cycle where asset prices went into bubble territory given the credit leverage. Now, capital losses, credit crunch and reintermediation is leading to the unraveling of this credit house of cards. Using analytical models developed by research scholars - such as Adrian and Shin - Goldman Sachs estimated that losses in the $400 billion range ($200 b among financial institutions) will lead to a deleveraging of credit of the order of $2 trillion. The overall deleveraging could be higher than that as a variety of institutions (financial and others including households and corporate firms) that will experience a hit to their balance sheet and net worth will have to start deleveraging their balance sheets. Indeed, the latest data suggest that corporate earnings have already fallen 8.5% in Q3 2007 relative to the third quarter of 2006.
Such academic and analytical research also suggests that illiquidity that forces fire sales of assets – of the sort we are starting to see in financial markets - has contagious effects from one financial institution to the other causing a chain of losses that can become systemic and exacerbate liquidity and capital losses (while implementation of FASB 157 will not prevent the past fudge of marking to model rather than marking to market such illiquid and impaired assets). So a contagious unraveling of the Minsky Credit Cycle is now underway.
And now a perverse cycle of financial conditions and credit crunch worsening leading to a worsening of the real economy and, in turn, a worsening of the real economy increasing the financial losses and worsening the liquidity and credit crunch is creating a vicious circle that has significantly increased the likelihood of a now effectively inevitable US recession and of a global economic slowdown. Bernanke and Mishkin know a lot about the “credit channel” and “financial accelerator” effects as they have extensively written about these in their former academic life. This vicious circle is leading to fall in asset prices, fall in net worth, deleveraging, tightening of the quantity and price of credit and fall in durable and non durable spending by households and financial and corporate firms that, in turn, will worsen the financial conditions.
Excerpt from The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster By Nouriel Roubini
Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.
4/8/2008: AEI conference on fair value accounting
On April 8, the American Enterprise Institute held a conference What Is Fair Value Accounting and Why Are People Concerned about It? Panelists were:
Craig Gifford, Guaranty Financial Group, Inc.
Harvey L. Pitt, Kalorama Partners LLC
Vincent R. Reinhart, AEI
Mark Scoles, Grant Thornton LLP
Leslie Seidman, Financial Accounting Standards Board
Gerald I. White, Grace & White, Inc.
Peter J. Wallison, AEI
Craig Gifford, Guaranty Financial Group, Inc.
Harvey L. Pitt, Kalorama Partners LLC
Vincent R. Reinhart, AEI
Mark Scoles, Grant Thornton LLP
Leslie Seidman, Financial Accounting Standards Board
Gerald I. White, Grace & White, Inc.
Peter J. Wallison, AEI
Sunday, April 13, 2008
4/12/2008: GE's Q108 and mark-to-market accounting
Excerpts from transcript of GE’s Q108 earnings conference call:
Keith Sherin – GE’s CFO: “So here is a summary of the financial businesses in the first quarter. Our miss was in commercial finance. As Jeff said, we had $270 million of negative marks and impairments versus our plan and they basically were in three categories. They were in public equities, they are in retained interest valuations from things that we have securitized where we still own the equity tranche and they are in warehouse marks. … The index, loan index for the comparable products was about $0.95 on the dollar as we started the year and that went down as low as $0.85 on the dollar through the quarter and towards the end of the quarter was between $0.85 and $0.88 or so. So that was about $55 million. … The last two weeks of March were a different world, particularly in financial services. And like I said, I don't want to -- I don't want this to be a company that is about excuses, but I think the $500 million plus in commercial finance that we missed in the quarter fundamentally took place with really the inability to do transactions in the last two weeks that we normally could get done and marks that basically we do at the end of the quarter that basically all went negative. And that is the vast majority of what we saw and what we experienced.”
…
Keith Sherin – GE’s CFO: “And then retained interest, we have about $1.5 billion of retained interest in the commercial finance book related to the securitizations we have done. Again, that is a mark -- that is not a credit mark, that is a mark based on the fact that the yields investors expect for securities like this have risen and so the present value of the discounted cash flow really came down and that is about $55 million in the quarter. I mean the spreads widened from the end of the year from 400 basis points to 1000 basis points depending upon those securitizations and what we had to discount the cash flows by. I think the dramatic mark to market there is totally based on the market conditions and basically, as long as we hold those securities to maturity, we are going to earn that back.”
Sabaziotatos says:
In other words, a material portion of the losses GE reported were due to the fact that the “loan index” (not further specified) against which GE marks loans to market plunged at the end of March, requiring GE to take significant marks on its commercial loans. On the other hand, the losses were unrealized (“that is not a credit mark … as long as we hold those securities to maturity, we are going to earn that back”).
As George Feiger commented:
Keith Sherin – GE’s CFO: “So here is a summary of the financial businesses in the first quarter. Our miss was in commercial finance. As Jeff said, we had $270 million of negative marks and impairments versus our plan and they basically were in three categories. They were in public equities, they are in retained interest valuations from things that we have securitized where we still own the equity tranche and they are in warehouse marks. … The index, loan index for the comparable products was about $0.95 on the dollar as we started the year and that went down as low as $0.85 on the dollar through the quarter and towards the end of the quarter was between $0.85 and $0.88 or so. So that was about $55 million. … The last two weeks of March were a different world, particularly in financial services. And like I said, I don't want to -- I don't want this to be a company that is about excuses, but I think the $500 million plus in commercial finance that we missed in the quarter fundamentally took place with really the inability to do transactions in the last two weeks that we normally could get done and marks that basically we do at the end of the quarter that basically all went negative. And that is the vast majority of what we saw and what we experienced.”
…
Keith Sherin – GE’s CFO: “And then retained interest, we have about $1.5 billion of retained interest in the commercial finance book related to the securitizations we have done. Again, that is a mark -- that is not a credit mark, that is a mark based on the fact that the yields investors expect for securities like this have risen and so the present value of the discounted cash flow really came down and that is about $55 million in the quarter. I mean the spreads widened from the end of the year from 400 basis points to 1000 basis points depending upon those securitizations and what we had to discount the cash flows by. I think the dramatic mark to market there is totally based on the market conditions and basically, as long as we hold those securities to maturity, we are going to earn that back.”
Sabaziotatos says:
In other words, a material portion of the losses GE reported were due to the fact that the “loan index” (not further specified) against which GE marks loans to market plunged at the end of March, requiring GE to take significant marks on its commercial loans. On the other hand, the losses were unrealized (“that is not a credit mark … as long as we hold those securities to maturity, we are going to earn that back”).
As George Feiger commented:
- “[GE i]s a huge lender and they fund these loans through commercial paper,” says George Feiger, CEO of Contango Capital Advisors, the wealth management arm of Zions Bancorporation. “Why should it be better off than Merrill Lynch or Citigroup or anybody? Essentially, it’s a collateralized lender on a huge scale. Nobody should be surprised GE is having the same mark-to-market problems that every other CLO is having.”
4/12/2008: Mark-to-market accounting in Japan
This translation from Japan's Nikkei sheds light on international aspects of mark-to-market accounting and the credit crisis (all figures in JPY).
The U.S. subprime loan problem may affect the auditing of Japanese companies which closed books in March 2008. Amid the confusion of the securitization market, not just banks but also business companies like Marubeni are reporting appraisal losses of securitized products they hold. While there is talk about the need to review market-value accounting, the Japanese Institute of Certified Public Accountants (JICPA) has urged its members to be strict in evaluating securitized products in term-end auditing.
Marubeni is the domestic business company that suffered the largest loss from securitized products. It will post an appraisal loss of \17.6 billion on financial assets worth about \20 billion in book value including CDO and ABS held by its British fund management subsidiary.
The JICPA on March 26 issued guidelines for evaluation of securitized products to audit corporations, intending it as a warning to both sides that accountants will be strict with companies they audit. (Nikkei P14 4/12)
The U.S. subprime loan problem may affect the auditing of Japanese companies which closed books in March 2008. Amid the confusion of the securitization market, not just banks but also business companies like Marubeni are reporting appraisal losses of securitized products they hold. While there is talk about the need to review market-value accounting, the Japanese Institute of Certified Public Accountants (JICPA) has urged its members to be strict in evaluating securitized products in term-end auditing.
Marubeni is the domestic business company that suffered the largest loss from securitized products. It will post an appraisal loss of \17.6 billion on financial assets worth about \20 billion in book value including CDO and ABS held by its British fund management subsidiary.
The JICPA on March 26 issued guidelines for evaluation of securitized products to audit corporations, intending it as a warning to both sides that accountants will be strict with companies they audit. (Nikkei P14 4/12)
3/25/2008: John McCain on mark-to-market accounting
Excerpt from Address on the Housing Crisis
By John McCain
I am prepared to examine new proposals and evaluate them based on these principals. But I think we need to do two things right away. First, it is time to convene a meeting of the nation's accounting professionals to discuss the current mark to market accounting systems. We are witnessing an unprecedented situation as banks and investors try to determine the appropriate value of the assets they are holding and there is widespread concern that this approach is exacerbating the credit crunch.
By John McCain
I am prepared to examine new proposals and evaluate them based on these principals. But I think we need to do two things right away. First, it is time to convene a meeting of the nation's accounting professionals to discuss the current mark to market accounting systems. We are witnessing an unprecedented situation as banks and investors try to determine the appropriate value of the assets they are holding and there is widespread concern that this approach is exacerbating the credit crunch.
4/7/2008: Steve Forbes on mark-to-market accounting
Excerpts from Here's How to End the Panic
By Steve Forbes
The Bush administration must take two steps immediately to quickly halt the unending, enervating credit crisis: shore up the anemic dollar and, for the time being, suspend "marking to market" those new financial instruments, such as packages of subprime mortgages.
...
The other measure: The Treasury Department and the Fed should get together with the SEC, the Comptroller of the Currency and other bank regulators and announce that financial institutions for the next 12 months will no longer write down the value of exotic financial instruments (primarily packages of subprime mortgages). Instead, writedowns will occur only when there have been actual losses on those assets. If a mortgage defaults, a bank will then--and only then--recognize the loss.
It's preposterous to try to guess what these new instruments are worth in a time of panic. Such assets are being marked down to increasingly arbitrary low levels. But when a bank books such a loss, it must replenish depleted capital, even though cash flows for most financial firms are still positive. Worse, when forced by panicky regulators and lawsuit-fearing accountants to write down the value of these securities, institutions will dump assets in a market where there are temporarily few or no buyers. The result is a spiraling disaster. So let's have a time-out on markdowns until we actually have real experience in what kind of losses are actually going to occur.
By Steve Forbes
The Bush administration must take two steps immediately to quickly halt the unending, enervating credit crisis: shore up the anemic dollar and, for the time being, suspend "marking to market" those new financial instruments, such as packages of subprime mortgages.
...
The other measure: The Treasury Department and the Fed should get together with the SEC, the Comptroller of the Currency and other bank regulators and announce that financial institutions for the next 12 months will no longer write down the value of exotic financial instruments (primarily packages of subprime mortgages). Instead, writedowns will occur only when there have been actual losses on those assets. If a mortgage defaults, a bank will then--and only then--recognize the loss.
It's preposterous to try to guess what these new instruments are worth in a time of panic. Such assets are being marked down to increasingly arbitrary low levels. But when a bank books such a loss, it must replenish depleted capital, even though cash flows for most financial firms are still positive. Worse, when forced by panicky regulators and lawsuit-fearing accountants to write down the value of these securities, institutions will dump assets in a market where there are temporarily few or no buyers. The result is a spiraling disaster. So let's have a time-out on markdowns until we actually have real experience in what kind of losses are actually going to occur.
3/11/2008: Paul Craig Roberts on mark-to-market
Excerpts from How to End the Subprime Crisis
By Paul Craig Roberts, Assistant Secretary of the Treasury in the Reagan administration
Reforms often do more harm than good. This is currently the case with the “mark-to-market” rule, which is imploding the US financial system by requiring financial institutions to value subprime mortgages at their current market values.
This makes a big problem for balance sheets. These financial instruments became troubled prior to a market being established for them, as they were marketed direct from issuers to investors. Now that they are troubled and with their true values unknown, no one wants them. Their lack of liquidity assigns them a low value.
The result is tremendous pressure on balance sheets. The plummeting value of subprime derivatives is pushing institutions that own them into insolvency, destroying their own stock values and forcing the financial institutions to sell untroubled liquid assets, thus resulting in an overall decline in the stock market.
The solution is to suspend the mark-to-market rule. Instead, allow financial institutions to keep the troubled instruments at book value, or 85-90% of book value, until a market forms that can sort out values, and allow financial institutions to write down the subprime mortgages and other troubled instruments over time.
Suspending the mark-to-market rule would take pressure off the stock market and make it unnecessary for the Fed to lower interest rates in an effort to force liquidity into the economy through an impaired banking system. The problem is not a general lack of liquidity, but liquidity for poorly conceived new financial instruments. Low US interest rates could worsen the crisis by accelerating the dollar’s decline. Now that inflation has raised its head, more liquidity from the Fed adds to the economic distress.
It is mindless to allow a “reform” to cause a financial crisis, but that is what is happening. Unfortunately, there are people who argue that anything less than financial armageddon would create a “moral hazard.”
By Paul Craig Roberts, Assistant Secretary of the Treasury in the Reagan administration
Reforms often do more harm than good. This is currently the case with the “mark-to-market” rule, which is imploding the US financial system by requiring financial institutions to value subprime mortgages at their current market values.
This makes a big problem for balance sheets. These financial instruments became troubled prior to a market being established for them, as they were marketed direct from issuers to investors. Now that they are troubled and with their true values unknown, no one wants them. Their lack of liquidity assigns them a low value.
The result is tremendous pressure on balance sheets. The plummeting value of subprime derivatives is pushing institutions that own them into insolvency, destroying their own stock values and forcing the financial institutions to sell untroubled liquid assets, thus resulting in an overall decline in the stock market.
The solution is to suspend the mark-to-market rule. Instead, allow financial institutions to keep the troubled instruments at book value, or 85-90% of book value, until a market forms that can sort out values, and allow financial institutions to write down the subprime mortgages and other troubled instruments over time.
Suspending the mark-to-market rule would take pressure off the stock market and make it unnecessary for the Fed to lower interest rates in an effort to force liquidity into the economy through an impaired banking system. The problem is not a general lack of liquidity, but liquidity for poorly conceived new financial instruments. Low US interest rates could worsen the crisis by accelerating the dollar’s decline. Now that inflation has raised its head, more liquidity from the Fed adds to the economic distress.
It is mindless to allow a “reform” to cause a financial crisis, but that is what is happening. Unfortunately, there are people who argue that anything less than financial armageddon would create a “moral hazard.”
4/13/2008: Edith Orenstein's blog
Another source of information and intelligent, balanced commentary on fair value and mark-to-market accounting (and a host of other issues relating to finance) is Edith Orenstein's blog on the Financial Executives International (FEI) website.
Saturday, April 12, 2008
4/2008: IMF's Global Financial Stability Report on fair value accounting
Excerpts from the IMF's Global Financial Stability Report: Containing Systemic Risks and Restoring Financial Soundness, April 2008
Losses for securities were next estimated by multiplying the outstanding stock of each type of security by the change in the market price of the relevant index over the course of a year. ... Beginning with the residential mortgage market, subprime-related ABS and CDO securities were priced using ABX and TABX derivative indices, respectively. Average losses on securities were estimated as 30 percent of principal for ABS and 60 percent for ABS CDOs since last year. ... The loss estimates are subject to the following caveats and uncertainties: The fall in market prices may be overshooting potential declines in cash flows over the lifetime of underlying loans ... Based on this approach, we estimate total losses from broad credit market deterioration of $945 billion globally, $565 billion of which is due to losses on residential mortgage debt, $240 billion on commercial real estate debt, $120 billion on corporate debt, and $20 billion on consumer credit debt. Securitized debt (rather than whole loans) accounts for the bulk of losses.
...
The abnormally tight market liquidity conditions during the crisis intensified discussions on the role of fair value in contributing to its severity. ... One argument suggests that fair value is compounding market instability by applying the valuations arising from sales in these abnormal market conditions across all fair-valued portfolios, regardless of the intention of holding them. While the need for liquidity drove values to discounts that were greater than the underlying cash flows would imply, the argument challenges the appropriateness of subjecting those portfolios to mark-to-market volatility where there is no intention or need to sell at the full amount of the liquidity induced discounts. This requirement to apply fair value without considering underlying conditions may be compounding instability by activating market-value triggers for liquidation in other portfolios. Even if the markdown does not force a sale, it may trigger margin calls or additional collateral requirements that would further compound market illiquidity by reducing a firm’s supply of assets available for further liquidity operations. ... While many view fair value as the best indicator of asset value at the time of measurement, taken on its own it may not be the best measure for making long-term, value-maximizing decisions. This arises because fair value reflects a single, point-in-time exit value for the sum of all the risks the market assigns to the asset, including credit and liquidity risks. If the market overreacts in its assessment of any risk component, then fair value will reflect this. Hence, the heavy discounting during the crisis of any asset containing securitized instruments produced fair values much lower than their underlying expected future cash flows would imply, even allowing for the possible impairment of subprime elements. Situations where firms use fair value levels to trigger decision rules, such as asset sales, may produce scenarios that both generate unnecessary realized losses for the individual firm and simultaneously contribute to a downward spiral of the asset price, thus compounding market illiquidity. It is therefore evident that the weaknesses arising from the use of fair value in a crisis need to be addressed.
Sabaziotatos says:
In other words, the IMF has issued a report stating that weaknesses in fair value accounting (which includes mark-to-market accounting) in a crisis need to be addressed, and in the same report they have estimated global losses from broad credit market deterioration ($945B) by marking outstanding par value to market against indices like the ABX. This seems problematic to me.
Alan Reynolds makes the same point in a recent column in the New York Post :
Losses for securities were next estimated by multiplying the outstanding stock of each type of security by the change in the market price of the relevant index over the course of a year. ... Beginning with the residential mortgage market, subprime-related ABS and CDO securities were priced using ABX and TABX derivative indices, respectively. Average losses on securities were estimated as 30 percent of principal for ABS and 60 percent for ABS CDOs since last year. ... The loss estimates are subject to the following caveats and uncertainties: The fall in market prices may be overshooting potential declines in cash flows over the lifetime of underlying loans ... Based on this approach, we estimate total losses from broad credit market deterioration of $945 billion globally, $565 billion of which is due to losses on residential mortgage debt, $240 billion on commercial real estate debt, $120 billion on corporate debt, and $20 billion on consumer credit debt. Securitized debt (rather than whole loans) accounts for the bulk of losses.
...
The abnormally tight market liquidity conditions during the crisis intensified discussions on the role of fair value in contributing to its severity. ... One argument suggests that fair value is compounding market instability by applying the valuations arising from sales in these abnormal market conditions across all fair-valued portfolios, regardless of the intention of holding them. While the need for liquidity drove values to discounts that were greater than the underlying cash flows would imply, the argument challenges the appropriateness of subjecting those portfolios to mark-to-market volatility where there is no intention or need to sell at the full amount of the liquidity induced discounts. This requirement to apply fair value without considering underlying conditions may be compounding instability by activating market-value triggers for liquidation in other portfolios. Even if the markdown does not force a sale, it may trigger margin calls or additional collateral requirements that would further compound market illiquidity by reducing a firm’s supply of assets available for further liquidity operations. ... While many view fair value as the best indicator of asset value at the time of measurement, taken on its own it may not be the best measure for making long-term, value-maximizing decisions. This arises because fair value reflects a single, point-in-time exit value for the sum of all the risks the market assigns to the asset, including credit and liquidity risks. If the market overreacts in its assessment of any risk component, then fair value will reflect this. Hence, the heavy discounting during the crisis of any asset containing securitized instruments produced fair values much lower than their underlying expected future cash flows would imply, even allowing for the possible impairment of subprime elements. Situations where firms use fair value levels to trigger decision rules, such as asset sales, may produce scenarios that both generate unnecessary realized losses for the individual firm and simultaneously contribute to a downward spiral of the asset price, thus compounding market illiquidity. It is therefore evident that the weaknesses arising from the use of fair value in a crisis need to be addressed.
Sabaziotatos says:
In other words, the IMF has issued a report stating that weaknesses in fair value accounting (which includes mark-to-market accounting) in a crisis need to be addressed, and in the same report they have estimated global losses from broad credit market deterioration ($945B) by marking outstanding par value to market against indices like the ABX. This seems problematic to me.
Alan Reynolds makes the same point in a recent column in the New York Post :
- "IMF Puts Cost of Crisis Near $1 Trillion," screamed a Washington Post headline April 9. ... [W]e're talking accounting losses - many of them only temporary. These are paper losses on mortgage-related securities - taken because accounting rules require financial firms to mark the securities down to some estimated "fair value." These securities still generate ample cash from mortgages - but, as the IMF explained, "Heavy discounting during the crisis . . . produced fair values much lower than their underlying expected future cash flows would imply." That is, many such securities are likely to be written up sooner or later.
4/08/2008: Paul Volcker on fair value and mark-to-market accounting
Excerpt from address before The Economic Club of New York, April 8, 2008
By Paul Volcker
The combination of herd behavior, opaque loan characteristics, and breakdowns of market function at times of crisis has also raised important questions about the characteristics and usefulness of "mark-to-market" accounting, particularly its extension in uncertain and illiquid markets to what is euphemistically known as "fair value" accounting. That is too complicated a subject for me to linger on today. Suffice it to say there cannot be much doubt that "mark-to-market" is an essential discipline for trading operations, hedge funds and other thinly capitalized financial firms. What is at issue is the extent to which it is suitable for regulated, more highly capitalized intermediaries, including commercial banks. Their ongoing customer relationships, the value of which is not automatically correlated with reversible swings in market interest rates, cannot be easily reduced to a market price or a mathematical model.
I know very well that the seemingly simple approach of "fair value" accounting is a highly complex matter extending beyond financial markets. As it should be, resolution of these questions is in the hands of independent standard setters. I am encouraged that the issues are under review, and I trust minds are not closed as to the appropriateness of "mark-to-market" under particular circumstances.
Other comments by Paul Volcker on fair value and mark-to-market accounting.
By Paul Volcker
The combination of herd behavior, opaque loan characteristics, and breakdowns of market function at times of crisis has also raised important questions about the characteristics and usefulness of "mark-to-market" accounting, particularly its extension in uncertain and illiquid markets to what is euphemistically known as "fair value" accounting. That is too complicated a subject for me to linger on today. Suffice it to say there cannot be much doubt that "mark-to-market" is an essential discipline for trading operations, hedge funds and other thinly capitalized financial firms. What is at issue is the extent to which it is suitable for regulated, more highly capitalized intermediaries, including commercial banks. Their ongoing customer relationships, the value of which is not automatically correlated with reversible swings in market interest rates, cannot be easily reduced to a market price or a mathematical model.
I know very well that the seemingly simple approach of "fair value" accounting is a highly complex matter extending beyond financial markets. As it should be, resolution of these questions is in the hands of independent standard setters. I am encouraged that the issues are under review, and I trust minds are not closed as to the appropriateness of "mark-to-market" under particular circumstances.
Other comments by Paul Volcker on fair value and mark-to-market accounting.
4/11/2008: Statement of G-7 Finance Ministers
Excerpt from Statement of G-7 Finance Ministers And Central Bank Governors
We have identified the following recommendations among the immediate priorities for implementation within the next 100 days:
• Firms should fully and promptly disclose their risk exposures, write–downs, and fair value estimates for complex and illiquid instruments. We strongly encourage financial institutions to make robust risk disclosures in their upcoming mid-year reporting consistent with leading disclosure practices as set out in the FSF's report.
• The International Accounting Standards Board (IASB) and other relevant standard setters should initiate urgent action to improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value accounting, particularly on valuing financial instruments in periods of stress.
• Firms should strengthen their risk management practices, supported by supervisors' oversight, including rigorous stress testing. Firms also should strengthen their capital positions as needed.
• By July 2008, the Basel Committee should issue revised liquidity risk management guidelines and IOSCO should revise its code of conduct fundamentals for credit rating agencies.
We have identified the following recommendations among the immediate priorities for implementation within the next 100 days:
• Firms should fully and promptly disclose their risk exposures, write–downs, and fair value estimates for complex and illiquid instruments. We strongly encourage financial institutions to make robust risk disclosures in their upcoming mid-year reporting consistent with leading disclosure practices as set out in the FSF's report.
• The International Accounting Standards Board (IASB) and other relevant standard setters should initiate urgent action to improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value accounting, particularly on valuing financial instruments in periods of stress.
• Firms should strengthen their risk management practices, supported by supervisors' oversight, including rigorous stress testing. Firms also should strengthen their capital positions as needed.
• By July 2008, the Basel Committee should issue revised liquidity risk management guidelines and IOSCO should revise its code of conduct fundamentals for credit rating agencies.
Friday, April 11, 2008
4/09/2008: IMF comments on fair value accounting
Excerpts from the International Monetary Fund's paper The Recent Financial Turmoil—Initial Assessment, Policy Lessons, and Implications for Fund Surveillance
Valuation, disclosure, and accounting. Weaknesses in the application of accounting standards and gaps associated with the valuation and financial reporting of structured products contributed to the current crisis. Further guidance is needed on how to apply fair value accounting through the cycle, particularly when markets are illiquid. Supervisors need to ensure financial institutions develop robust pricing, risk management, and stress testing models, and collaborate with international standard setters to achieve better cross-border convergence of accounting and disclosure practices. Additional effort is needed to provide markets with accurate and timely reporting of exposures to structured credit products and other illiquid assets, as well as the valuation and accounting methodology used.
...
The inter-relationship between regulation, accounting practices, and ratings may have exacerbated the market turbulence. Basel capital requirements encouraged securitization and off-balance-sheet funding, while fair value accounting, in combination with relatively illiquid markets for most structured credit products, contributed to procyclical selling pressures and significant price gapping once markets came under stress.
...
The accounting treatment of structured products may have resulted in procyclical valuations. Structured products are often classified in categories that are subject to fair value accounting. During the upturn, the booming demand for structured products boosted valuations and banks’ profits and equity. Conversely, during the downturn, valuations became depressed as demand and liquidity evaporated. It is thus arguable that fair value accounting did not provide accurate information about the banks’ true risk profile through the cycle. The frequent incremental revisions in bank losses after the onset of the turmoil further reduced market confidence.
...
The procyclicality of fair value accounting was amplified by the use of portfolio covenants or triggers. These triggers often required sales, margin calls, or additional collateral requirements as valuations declined, which induced a vicious cycle forcing sales that otherwise would not have been made. As assets lost value and were sold, the liquidity of financial institutions was impaired.
...
The challenge is to find better ways to apply fair value accounting through the cycle so as to mitigate procyclicality. Changing accounting standards at the height of the crisis would risk adversely impacting investor confidence. However, going forward, there is a need to provide more guidance on the calculation and application of fair value accounting rules, in particular for assets that are not actively traded. Specific disclosure of the origin of “write-ups” as well as “write-downs” should become the norm.
Valuation, disclosure, and accounting. Weaknesses in the application of accounting standards and gaps associated with the valuation and financial reporting of structured products contributed to the current crisis. Further guidance is needed on how to apply fair value accounting through the cycle, particularly when markets are illiquid. Supervisors need to ensure financial institutions develop robust pricing, risk management, and stress testing models, and collaborate with international standard setters to achieve better cross-border convergence of accounting and disclosure practices. Additional effort is needed to provide markets with accurate and timely reporting of exposures to structured credit products and other illiquid assets, as well as the valuation and accounting methodology used.
...
The inter-relationship between regulation, accounting practices, and ratings may have exacerbated the market turbulence. Basel capital requirements encouraged securitization and off-balance-sheet funding, while fair value accounting, in combination with relatively illiquid markets for most structured credit products, contributed to procyclical selling pressures and significant price gapping once markets came under stress.
...
The accounting treatment of structured products may have resulted in procyclical valuations. Structured products are often classified in categories that are subject to fair value accounting. During the upturn, the booming demand for structured products boosted valuations and banks’ profits and equity. Conversely, during the downturn, valuations became depressed as demand and liquidity evaporated. It is thus arguable that fair value accounting did not provide accurate information about the banks’ true risk profile through the cycle. The frequent incremental revisions in bank losses after the onset of the turmoil further reduced market confidence.
...
The procyclicality of fair value accounting was amplified by the use of portfolio covenants or triggers. These triggers often required sales, margin calls, or additional collateral requirements as valuations declined, which induced a vicious cycle forcing sales that otherwise would not have been made. As assets lost value and were sold, the liquidity of financial institutions was impaired.
...
The challenge is to find better ways to apply fair value accounting through the cycle so as to mitigate procyclicality. Changing accounting standards at the height of the crisis would risk adversely impacting investor confidence. However, going forward, there is a need to provide more guidance on the calculation and application of fair value accounting rules, in particular for assets that are not actively traded. Specific disclosure of the origin of “write-ups” as well as “write-downs” should become the norm.
4/11/2008: French Minister of Finance on mark-to-market
Excerpt from This crisis demands that we act, but not overeact
By Christine Lagarde, French Minister of Finance
The impact of writedowns of structured instruments on balance sheets and profit and losses through fair value may lead to a vicious circle where mark-to-market losses trigger fire sales, which in turn generate further market losses. Some have argued that a temporary change in accounting rules would be necessary. Once the turmoil is over, we will need to assess the “pro-cyclicality” of fair value accounting. Under the present circumstances, changing the thermometer to reduce the heat is not the way to go. However, the difficulties in valuing certain assets in severely stressed markets should be acknowledged and rapidly tackled by standard setters and supervisors in order to help financial institutions and auditors better address this challenge.
Sabaziotatos says:
Ms. Lagarde says "not to change the thermometer to reduce the heat." But, the rest of her comments imply that the thermometer is broken.
Imagine a "pro-cyclical" thermometer. With such a thermometer, the higher/lower the reading from the thermometer, the higher/lower the underlying heat would become, thereby influencing the reading from the thermometer, thereby influencing the underlying heat, and so on.
By Christine Lagarde, French Minister of Finance
The impact of writedowns of structured instruments on balance sheets and profit and losses through fair value may lead to a vicious circle where mark-to-market losses trigger fire sales, which in turn generate further market losses. Some have argued that a temporary change in accounting rules would be necessary. Once the turmoil is over, we will need to assess the “pro-cyclicality” of fair value accounting. Under the present circumstances, changing the thermometer to reduce the heat is not the way to go. However, the difficulties in valuing certain assets in severely stressed markets should be acknowledged and rapidly tackled by standard setters and supervisors in order to help financial institutions and auditors better address this challenge.
Sabaziotatos says:
Ms. Lagarde says "not to change the thermometer to reduce the heat." But, the rest of her comments imply that the thermometer is broken.
Imagine a "pro-cyclical" thermometer. With such a thermometer, the higher/lower the reading from the thermometer, the higher/lower the underlying heat would become, thereby influencing the reading from the thermometer, thereby influencing the underlying heat, and so on.
4/11/2008: Sabaziotatos on fair value disclosures
Sabaziotatos says:
The recent Policy Statement of the President's Working Group on Financial Markets makes the following recommendation (repeated twice in the document) concerning disclosures about fair value estimates:
One big problem with this approach is that the regulators do not make clear how their recommended "disclosures" are to be used. Obviously, the regulators believe that the disclosures will convey "information." How and by whom should this information be used? For example, is this information to be used in the calculation of capital ratios? If not, then what use is to be made of it? If the regulators themselves do not make use of this information in calculating capital ratios, then, why should anyone else, in particular investors, make use of this information?
Consider, for example, the SEC's discussion of unrealized losses:
It is clear how investors interpreted AIG's disclosure: on the day of the press release, AIG's common stock dropped 6.5%, wiping out billions in market capitalization. So, the disclosure did not help AIG at all. In fact, it likely hurt AIG by creating the impression that AIG was somehow trying to manipulate its numbers.
It is clear that the SEC's letter will have one benefit: it will allow auditors to sign off on financial statements that contain the kind of disclosure the SEC is recommending. This may prevent auditing firms from issuing conclusions of material weakness in internal control over financial reporting and oversight relating to the fair value valuation, as PWC concluded with respect to AIG's fair value calculations:
Be that as it may, it is still unclear how the Treasury, the Fed, and the SEC intend their recommended disclosures be used. US regulators must address the question: In what sense will the new disclosures clarify instead of simply confusing more?
The recent Policy Statement of the President's Working Group on Financial Markets makes the following recommendation (repeated twice in the document) concerning disclosures about fair value estimates:
- "Regulators should encourage financial institutions to improve the quality of disclosures about fair value estimates for complex and other illiquid instruments, including descriptions of valuation methodologies and information regarding the degree of uncertainty associated with such estimates;"
- "Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A: ... With regard to Level 3 assets or liabilities, a discussion of, to the extent material: ... whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views. ... [C]onsider providing the following additional information in your MD&A: A general description of the valuation techniques or models you used with regard to your material assets or liabilities. ... A discussion of how sensitive the fair value estimates for your material assets or liabilities are to the significant inputs the technique or model uses. For example, consider providing a range of values around the fair value amount you arrived at to provide a sense of how the fair value estimate could potentially change as the significant inputs vary. To the extent you provide a range, discuss why you believe the range is appropriate, identifying the key drivers of variability, and discussing how you developed the inputs you used in determining the range."
One big problem with this approach is that the regulators do not make clear how their recommended "disclosures" are to be used. Obviously, the regulators believe that the disclosures will convey "information." How and by whom should this information be used? For example, is this information to be used in the calculation of capital ratios? If not, then what use is to be made of it? If the regulators themselves do not make use of this information in calculating capital ratios, then, why should anyone else, in particular investors, make use of this information?
Consider, for example, the SEC's discussion of unrealized losses:
- "[Disclose] whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views."
- "AIG continues to believe that the unrealized market valuation losses on this super senior credit default swap portfolio are not indicative of the losses AIGFP may realize over time. Under the terms of these credit derivatives, losses to AIG would result from the credit impairment of any bonds AIG would acquire in satisfying its swap obligations. Based upon its most current analyses, AIG believes that any credit impairment losses realized over time by AIGFP will not be material to AIG’s consolidated financial condition, although it is possible that realized losses could be material to AIG’s consolidated results of operations for an individual reporting period. Except to the extent of any such realized credit impairment losses, AIG expects AIGFP’s unrealized market valuation losses to reverse over the remaining life of the super senior credit default swap portfolio."
It is clear how investors interpreted AIG's disclosure: on the day of the press release, AIG's common stock dropped 6.5%, wiping out billions in market capitalization. So, the disclosure did not help AIG at all. In fact, it likely hurt AIG by creating the impression that AIG was somehow trying to manipulate its numbers.
It is clear that the SEC's letter will have one benefit: it will allow auditors to sign off on financial statements that contain the kind of disclosure the SEC is recommending. This may prevent auditing firms from issuing conclusions of material weakness in internal control over financial reporting and oversight relating to the fair value valuation, as PWC concluded with respect to AIG's fair value calculations:
- "AIG has been advised by its independent auditors, PricewaterhouseCoopers LLC, that they have concluded that at December 31, 2007, AIG had a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the AIGFP super senior credit default swap portfolio. AIG’s assessment of its internal controls relating to the fair value valuation of the AIGFP super senior credit default swap portfolio is ongoing, but AIG believes that it currently has in place the necessary compensating controls and procedures to appropriately determine the fair value of AIGFP’s super senior credit default swap portfolio for purposes of AIG’s year-end financial statements."
Be that as it may, it is still unclear how the Treasury, the Fed, and the SEC intend their recommended disclosures be used. US regulators must address the question: In what sense will the new disclosures clarify instead of simply confusing more?
4/10/2008: ABX spins awry
Excerpts from Subprime barometer spins awry
By Saskia Scholtes
A recent dramatic turnaround of the ABX derivative index that tracks a portfolio of US subprime mortgage bonds has underscored a thorny dilemma faced by dealers and investors trying to price hard-to-value mortgage securities.
...
The AAA-rated slice of the ABX index for bonds issued in the first half of 2006 was down 24 per cent for the year in mid-March, but on Thursday was down only 10 per cent year-to-date. The same slice of the index for bonds issued in the second half of 2006, once down 32 per cent year-to-date, was on Thursday just 18 per cent lower for the year.
...
Liquidity is terrible and client inquiries have virtually ground to a halt. Trading is mostly happening on interdealer screens between eight to 10 guys, and this means that prices can move wildly on very light volume,” said one trader.
Jay Hallik, head of US ABS trading at Morgan Stanley agreed: “The past week or two, trading has been primarily dealer-driven, with the result that the index can quickly move a couple of points on relatively small size, sometimes $25m to $50m trades.”
By Saskia Scholtes
A recent dramatic turnaround of the ABX derivative index that tracks a portfolio of US subprime mortgage bonds has underscored a thorny dilemma faced by dealers and investors trying to price hard-to-value mortgage securities.
...
The AAA-rated slice of the ABX index for bonds issued in the first half of 2006 was down 24 per cent for the year in mid-March, but on Thursday was down only 10 per cent year-to-date. The same slice of the index for bonds issued in the second half of 2006, once down 32 per cent year-to-date, was on Thursday just 18 per cent lower for the year.
...
Liquidity is terrible and client inquiries have virtually ground to a halt. Trading is mostly happening on interdealer screens between eight to 10 guys, and this means that prices can move wildly on very light volume,” said one trader.
Jay Hallik, head of US ABS trading at Morgan Stanley agreed: “The past week or two, trading has been primarily dealer-driven, with the result that the index can quickly move a couple of points on relatively small size, sometimes $25m to $50m trades.”
Wednesday, April 9, 2008
4/9/2008: Interim Report of the IIF Committee on Market Best Practices comments on fair value accounting
Excerpt from Interim Report of the IIF Committee on Market Best Practices
Institute of International Finance
B. Widely Encountered Problems
73. Over the past decade, fair-value/mark-to-market accounting has generally proven highly valuable in promoting transparency and market discipline, and continues to be an effective and reliable accounting method for securities in liquid markets. When there is no or severely limited liquidity in secondary markets, however, it has the potential to create serious and self-reinforcing challenges that both make valuation more difficult and increase the uncertainties around those valuations. In addition, there is a wide perception that mark-to-market accounting in circumstances of widespread illiquidity deviates from underlying fundamental values. There are questions about whether fair-value accounting approaches have increased the severity of the market stress relative to other possible alternatives and, if so, whether this reflects a fundamental feature of such approaches or weaknesses in the current state of their implementation. In light of the magnitudes of the writedowns and their systemic impact, it is essential that these broadly encountered questions be addressed.
74. A critical subset of issues revolves around whether mark-to-market exacerbates the overall degree of risk aversion in the marketplace and thereby contributes in a procyclical manner to the continuation and possible worsening of market stress. The effect of these issues in the context of a fair-value accounting regime that covers a much wider scope of instruments than ever before has created the potential for confusion and even for possible misreading by investors. In circumstances where doubts about products and underlying credit quality undermine valuations inducing extensive margin calls, there is the danger of a precipitous and destructive downward spiral, which reinforces the procyclical impact.
75. For these reasons, the Committee believes that broad thinking is needed on how to address such consequences, whether through means to switch to modified valuation techniques in thin markets, or ways to implement some form of “circuit breaker” in the process that could cut short damaging feedback effects while remaining consistent with the basics of fair-value accounting. And, while there is no desire to move away from the fundamentals of fair-value accounting, the Committee feels that it is nonetheless essential to consider promptly whether there are viable sound proposals that could limit the destabilizing downward spiral of forced liquidations, writedowns and higher risk and liquidity premia. The Committee is developing specific proposals for consideration in a timely fashion.
76. The Committee recognizes that these are not new issues, but believes that the interactions observed between market liquidity and announced or anticipated writedowns are concerning and provide evidence of potentially destabilizing feedback effects. The Committee’s discussions on this topic have also noted the arguments that forbearance in assessing the scale of losses may prolong a crisis and worsen its ultimate impact. Moreover, the Committee stresses that any “circuit breaker” would be intended to address situations where the market fails substantially to provide inputs for valuations reasonably in line with underlying values; such a “circuit breaker” would not affect recognition of actual losses. Use of any “circuit breaker” would have to be subject to clear disclosures and would include provisions to prevent arbitrage or other abuse.
Institute of International Finance
B. Widely Encountered Problems
73. Over the past decade, fair-value/mark-to-market accounting has generally proven highly valuable in promoting transparency and market discipline, and continues to be an effective and reliable accounting method for securities in liquid markets. When there is no or severely limited liquidity in secondary markets, however, it has the potential to create serious and self-reinforcing challenges that both make valuation more difficult and increase the uncertainties around those valuations. In addition, there is a wide perception that mark-to-market accounting in circumstances of widespread illiquidity deviates from underlying fundamental values. There are questions about whether fair-value accounting approaches have increased the severity of the market stress relative to other possible alternatives and, if so, whether this reflects a fundamental feature of such approaches or weaknesses in the current state of their implementation. In light of the magnitudes of the writedowns and their systemic impact, it is essential that these broadly encountered questions be addressed.
74. A critical subset of issues revolves around whether mark-to-market exacerbates the overall degree of risk aversion in the marketplace and thereby contributes in a procyclical manner to the continuation and possible worsening of market stress. The effect of these issues in the context of a fair-value accounting regime that covers a much wider scope of instruments than ever before has created the potential for confusion and even for possible misreading by investors. In circumstances where doubts about products and underlying credit quality undermine valuations inducing extensive margin calls, there is the danger of a precipitous and destructive downward spiral, which reinforces the procyclical impact.
75. For these reasons, the Committee believes that broad thinking is needed on how to address such consequences, whether through means to switch to modified valuation techniques in thin markets, or ways to implement some form of “circuit breaker” in the process that could cut short damaging feedback effects while remaining consistent with the basics of fair-value accounting. And, while there is no desire to move away from the fundamentals of fair-value accounting, the Committee feels that it is nonetheless essential to consider promptly whether there are viable sound proposals that could limit the destabilizing downward spiral of forced liquidations, writedowns and higher risk and liquidity premia. The Committee is developing specific proposals for consideration in a timely fashion.
76. The Committee recognizes that these are not new issues, but believes that the interactions observed between market liquidity and announced or anticipated writedowns are concerning and provide evidence of potentially destabilizing feedback effects. The Committee’s discussions on this topic have also noted the arguments that forbearance in assessing the scale of losses may prolong a crisis and worsen its ultimate impact. Moreover, the Committee stresses that any “circuit breaker” would be intended to address situations where the market fails substantially to provide inputs for valuations reasonably in line with underlying values; such a “circuit breaker” would not affect recognition of actual losses. Use of any “circuit breaker” would have to be subject to clear disclosures and would include provisions to prevent arbitrage or other abuse.
4/8/2008: Sabaziotatos on Minyanville's discussion of mark-to-market accounting
In a recent blog entry on Minyanville, John Mauldin discusses mark-to-market accounting and the SEC's recent "Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)." John argues that the phrase "unless those prices are the result of a forced liquidation or distress sale" in the SEC letter constitutes a change in accounting rules:
Be that as it may, John's misinterpretation of the phrase in the SEC's letter is beside the point. What is more interesting is the fact that John goes on to argue that the supposed "change in accounting rules" causes a lack of transparency:
In my opinion, what has created a lack of transparency is not the LACK of mark-to-market accounting, but mark-to-market accounting itself.
As Plantin, Sapra, and Shin in their paper "Marking-to-Market: Panacea or Pandora's Box?" write:
- "Thus it should not come as a surprise to you, gentle reader, that the rules have been changed in much the same way as in 1980."
- "A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale)."
Be that as it may, John's misinterpretation of the phrase in the SEC's letter is beside the point. What is more interesting is the fact that John goes on to argue that the supposed "change in accounting rules" causes a lack of transparency:
- "[The change of rules] clearly creates a lack of transparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company."
In my opinion, what has created a lack of transparency is not the LACK of mark-to-market accounting, but mark-to-market accounting itself.
As Plantin, Sapra, and Shin in their paper "Marking-to-Market: Panacea or Pandora's Box?" write:
- "A bad outcome for the asset [for example, an increase in the default rate for mortgages backing an RMBS] will depress fundamental values somewhat, but the more pernicious effect comes from the negative externalities generated by other firms selling. When others sell, observed transaction prices are depressed more than is justified by the fundamentals, and exerts a negative effect on all others, but especially on those who have chosen to hold on to the asset. Anticipating this negative outcome, a short-horizon firm will be tempted to preempt the fall in price by selling the asset itself. However, such preemptive action will merely serve to amplify the price fall. In this way, the mark-to-market regime generates endogenous volatility of prices that impede the resource allocation role of prices."
- "[C]an a forced liquidation or distress sale be from a margin call? Obviously the answer is yes. But as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then it found out that the investment bank is valuing them differently on its books than the price at which it was forced to sell, there will be some very upset managers and investors. Cue the lawyers."
- "The problem is that [fair value accounting] assumes markets have good information from inputs such as financial reports and credit ratings. But there is a circularity built in: if credit raters and investors get their information from accounting numbers, which are themselves based on prices inflated by a market bubble, the accounting numbers support the bubble. So instead of informing markets through prudent valuation and controlling management excess, "fair" values feed the prices back to the market."
4/7/2008: Bank of Scotland chief warns fair value could lead to recession
Excerpt from Bank of Scotland chief warns fair value could lead to recession
By Katherine Griffiths
Former Bank of Scotland CE Sir Peter Burt has called on the Bank of England to relax rules on how banks account for their assets on the balance sheet, in the face of mark-to-market or fair value accounting rules which could see these booked below their value, amidst a volatile market.
Sir Peter is the latest senior figure to add his voice to the growing revolt against mark-to-market pricing, warning over the weekend that the credit market freeze is so serious that Britain could slump into recession, the Sunday Telegraph reported.
'To the proverbial visitor from Mars, the problem and its solution might seem clear. In the past week, I have been told by senior bankers and customers of having mark[ed] down assets of undoubted value. No bank will lend or invest if, by doing so, they have to take an immediate write down as a result of being required to mark the asset to an unrealistic market price,' Sir Peter said.
By Katherine Griffiths
Former Bank of Scotland CE Sir Peter Burt has called on the Bank of England to relax rules on how banks account for their assets on the balance sheet, in the face of mark-to-market or fair value accounting rules which could see these booked below their value, amidst a volatile market.
Sir Peter is the latest senior figure to add his voice to the growing revolt against mark-to-market pricing, warning over the weekend that the credit market freeze is so serious that Britain could slump into recession, the Sunday Telegraph reported.
'To the proverbial visitor from Mars, the problem and its solution might seem clear. In the past week, I have been told by senior bankers and customers of having mark[ed] down assets of undoubted value. No bank will lend or invest if, by doing so, they have to take an immediate write down as a result of being required to mark the asset to an unrealistic market price,' Sir Peter said.
4/2/2008: EU advisers back fair value change
Excerpt from EU advisers back fair value change
Letter opposing mark-to-market accounting in the Financial Times from Carsten Zielke, Michael Starkie and Thomas Seeberg, members of the EFRAG TEG, which advises the European Commission on accountancy matters
Because risk aversion has increased so sharply that there are no longer liquid markets for the assets the banks hold, a representative index, such as the ABX Index, which tracks mortgage-backed securities, is used to measure the values of these assets. However, in these market conditions, this index does not reflect the fair or true value - the practice of marking assets to market prices that has led to billions in writedowns - since realistically, the risk of default is much lower than the index level implies.
Announcements of writedowns cause this index to fall further, which in turn means that other players need to make writedowns. Their share prices continue to fall, and they continue to find it difficult to access the regulated financial markets. There is actually no end in sight to this downward spiral.
Out of necessity, the banks plug the holes by raising fresh capital from the rich sovereign wealth funds. These sovereign wealth funds originate from countries most of which are not democratic, that do not practise fair value accounting and are therefore able to rush to the aid of the banks in question. Only once the shot in the arm has been received, are we suddenly concerned about these investors' intentions and anxious to impose corporate governance demands on them.
Are our current problems self-inflicted? Our view is that if assets are measured at fair value as at the reporting date, even if the requirements for a liquid and orderly financial market are no longer met, then this measurement reflects an erratic market price and not fair value.
This erratic market price is damaging the economy. In order to escape from this vicious circle, and to remain fundamentally self-sufficient in terms of its financial position, Europe must move away from reporting date-based measurement of the market price and start measuring the average market price over a period.
See also, the Financial Times' story on this letter.
Letter opposing mark-to-market accounting in the Financial Times from Carsten Zielke, Michael Starkie and Thomas Seeberg, members of the EFRAG TEG, which advises the European Commission on accountancy matters
Because risk aversion has increased so sharply that there are no longer liquid markets for the assets the banks hold, a representative index, such as the ABX Index, which tracks mortgage-backed securities, is used to measure the values of these assets. However, in these market conditions, this index does not reflect the fair or true value - the practice of marking assets to market prices that has led to billions in writedowns - since realistically, the risk of default is much lower than the index level implies.
Announcements of writedowns cause this index to fall further, which in turn means that other players need to make writedowns. Their share prices continue to fall, and they continue to find it difficult to access the regulated financial markets. There is actually no end in sight to this downward spiral.
Out of necessity, the banks plug the holes by raising fresh capital from the rich sovereign wealth funds. These sovereign wealth funds originate from countries most of which are not democratic, that do not practise fair value accounting and are therefore able to rush to the aid of the banks in question. Only once the shot in the arm has been received, are we suddenly concerned about these investors' intentions and anxious to impose corporate governance demands on them.
Are our current problems self-inflicted? Our view is that if assets are measured at fair value as at the reporting date, even if the requirements for a liquid and orderly financial market are no longer met, then this measurement reflects an erratic market price and not fair value.
This erratic market price is damaging the economy. In order to escape from this vicious circle, and to remain fundamentally self-sufficient in terms of its financial position, Europe must move away from reporting date-based measurement of the market price and start measuring the average market price over a period.
See also, the Financial Times' story on this letter.
4/1/2008: Charlie McCreevy on fair value/mark-to-market accounting
Excerpt from testimony of Charlie McCreevy, European Commissioner for Internal Market and Services, before European Parliament's Committee on Economic and Monetary Affairs on Latest developments on policy response to financial turmoil
There is a growing debate on whether fair value and mark to market measurements may have aggravated the crisis by bringing pro-cyclicality in financial statements. I want to make it clear that I believe that there are some real accounting issues and anomalies to examine, including the interface with the Capital Requirements Directive, such as the consolidation of special purpose entities or the measurement and information disclosed on risk exposures. Clearly, these and other issues – such as the impact of mark to market valuation when markets generally become illiquid and irrational – must be thoroughly analysed.
There is a growing debate on whether fair value and mark to market measurements may have aggravated the crisis by bringing pro-cyclicality in financial statements. I want to make it clear that I believe that there are some real accounting issues and anomalies to examine, including the interface with the Capital Requirements Directive, such as the consolidation of special purpose entities or the measurement and information disclosed on risk exposures. Clearly, these and other issues – such as the impact of mark to market valuation when markets generally become illiquid and irrational – must be thoroughly analysed.
3/31/2008: RMA Group to Study Fair-Value Model
Excerpt from RMA Group to Study Fair-Value Model
By Todd Davenport
The Risk Management Association said it is establishing a working group on fair-value accounting that will offer "solutions for the accounting profession."
Kevin Blakely, the trade group's chief executive, wrote in a letter Friday to its large-bank members that the accounting process has played "no small part" in the market's inability to find a price floor for the assets at the center of the subprime mortgage crisis — which so far has resulted in over $150 billion of writedowns.
By Todd Davenport
The Risk Management Association said it is establishing a working group on fair-value accounting that will offer "solutions for the accounting profession."
Kevin Blakely, the trade group's chief executive, wrote in a letter Friday to its large-bank members that the accounting process has played "no small part" in the market's inability to find a price floor for the assets at the center of the subprime mortgage crisis — which so far has resulted in over $150 billion of writedowns.
3/31/2008: Sabaziotatos calls for SEC to investigate "gaming" of ABX
The SEC should investigate the possibility that the ABX and CMBX (and other mark-to-market indices) have been gamed by the same kind of “wash trades” that plagued the energy industry several years ago.
The ABX and the CMBX have come to be used as external, observable inputs in arriving at fair values of banking assets. For example, in the recent "Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)," the SEC instructed banks to include the following information in their MD&A:
For example, a profitable investment strategy might have been:
The SEC should investigate the possibility that the ABX and CMBX have been gamed by “wash trades.”
The ABX and the CMBX have come to be used as external, observable inputs in arriving at fair values of banking assets. For example, in the recent "Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)," the SEC instructed banks to include the following information in their MD&A:
- “To the extent material, a discussion of the extent to which, and how, you used or considered relevant market indices, for example ABX or CMBX, in applying the techniques or models you used to value your material assets or liabilities. Consider describing any material adjustments you made during the reporting period to the fair value of your assets or liabilities based on market indices and your reasons for making those adjustments.”
For example, a profitable investment strategy might have been:
- 1.) short the common stock of banks that are required to mark their assets to market based on the ABX and CMBX indices, and
2.) engage in offsetting "wash trades" of RMBS's or CDO's in an illiquid market at depressed prices, thereby driving down the ABX and CMBX indices.
- "The Federal Energy Regulatory Commission broadened its investigation today into the possible manipulation of energy prices, ordering traders to provide information on whether they engaged in fake trades and whether those transactions affected published electricity prices.
The commission ordered energy traders to disclose whether they had engaged in so-called wash trades, also known as round-trip trades, in which they sell the same amount of power back and forth at the same price. Such sales do not incur profits or losses but allow traders to claim inflated revenue and volumes, potentially misleading investors about the size and liquidity of the market.
In addition, regulators want to know whether traders reported wash trades to publications [similar to the ABX and CMBX] that publish prices for electricity sold around the nation. The published numbers are often used to set prices for financial instruments whose value is determined by the reported prices for the underlying energy commodity."
The SEC should investigate the possibility that the ABX and CMBX have been gamed by “wash trades.”
3/31/2008: Dick Bove on Wachovia and ABX.HE
Excerpt from Being Watchful of Wachovia
By Dick Bove
The indexes that are used as comparables for valuing securities and loans on financial company balance sheets are plunging once again. Some have declined by 22% in March alone. This suggests that banks, in general, and Wachovia, in specific, are going to have lower earnings than we thought just two weeks ago.
One must stop and think as to whether this adjustment makes sense. Let's take a few of the ABX indices for example. The ABX-HE-AAA 07-2 (home equity loans) is now valued at 51.93. It is just about six months old, so it is down 48.1% from Sept. 1, 2007. The ABX-HE-AA 07-2 index is now 21.32. This index has fallen 78.68%.
What else are the indices indicating? On Sept. 1, the loans in the securities of the ABX-HE-AAA 07-2 were being valued at 95%. Presumably, this meant that the index reflected a potential loss of 5% on these loans. Since Sept. 1, interest rates have declined. In theory, then, the value of the index should have risen. Any decline in the value of index given this event would reflect expected losses on the underlying loans.
What is that assumption? Well, for the AAA index it is now expected that approximately 48% of the loans will go bad. For the AA index, the assumption is that about 79% of the loans will go bad. Is this plausible?
Each quarter, the Federal Deposit Insurance Corporation publishes the actual loan quality experience of the nation's 8,223 banks and thrifts. In the fourth quarter of 2007 (ancient history by today's standards) the percent of home equity loans in these banks' portfolios that were 30 to 89 days past due was 1.14%. The percent of the loans that were noncurrent was 0.86%. The actual charge-offs in this quarter for banks over $1 billion in size (only data available) was 0.88%. The annualized rate would be 3.52%.
Make no mistake; this is a very bad number. It is the highest since the data were first collected in 1991. It is up more than fourfold from the year-earlier results and it is likely to get worse. However, this number would have to jump 12-fold to reach the assumed write-off in the AAA index and it would have to jump more than 22-fold to reach the assumption in the AA index.
Does this make sense? (No.) Has it ever happened before? (No.)
By Dick Bove
The indexes that are used as comparables for valuing securities and loans on financial company balance sheets are plunging once again. Some have declined by 22% in March alone. This suggests that banks, in general, and Wachovia, in specific, are going to have lower earnings than we thought just two weeks ago.
One must stop and think as to whether this adjustment makes sense. Let's take a few of the ABX indices for example. The ABX-HE-AAA 07-2 (home equity loans) is now valued at 51.93. It is just about six months old, so it is down 48.1% from Sept. 1, 2007. The ABX-HE-AA 07-2 index is now 21.32. This index has fallen 78.68%.
What else are the indices indicating? On Sept. 1, the loans in the securities of the ABX-HE-AAA 07-2 were being valued at 95%. Presumably, this meant that the index reflected a potential loss of 5% on these loans. Since Sept. 1, interest rates have declined. In theory, then, the value of the index should have risen. Any decline in the value of index given this event would reflect expected losses on the underlying loans.
What is that assumption? Well, for the AAA index it is now expected that approximately 48% of the loans will go bad. For the AA index, the assumption is that about 79% of the loans will go bad. Is this plausible?
Each quarter, the Federal Deposit Insurance Corporation publishes the actual loan quality experience of the nation's 8,223 banks and thrifts. In the fourth quarter of 2007 (ancient history by today's standards) the percent of home equity loans in these banks' portfolios that were 30 to 89 days past due was 1.14%. The percent of the loans that were noncurrent was 0.86%. The actual charge-offs in this quarter for banks over $1 billion in size (only data available) was 0.88%. The annualized rate would be 3.52%.
Make no mistake; this is a very bad number. It is the highest since the data were first collected in 1991. It is up more than fourfold from the year-earlier results and it is likely to get worse. However, this number would have to jump 12-fold to reach the assumed write-off in the AAA index and it would have to jump more than 22-fold to reach the assumption in the AA index.
Does this make sense? (No.) Has it ever happened before? (No.)
3/28/2008: SEC gives guidance on mark-to-market/fair-value accounting
Excerpts from Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)
Additional context/background
Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157.
...
[C]onsider providing the following additional information in your MD&A:
...
To the extent material, a discussion of the extent to which, and how, you used or considered relevant market indices, for example ABX or CMBX, in applying the techniques or models you used to value your material assets or liabilities. Consider describing any material adjustments you made during the reporting period to the fair value of your assets or liabilities based on market indices and your reasons for making those adjustments.
Additional context/background
Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157.
...
[C]onsider providing the following additional information in your MD&A:
...
To the extent material, a discussion of the extent to which, and how, you used or considered relevant market indices, for example ABX or CMBX, in applying the techniques or models you used to value your material assets or liabilities. Consider describing any material adjustments you made during the reporting period to the fair value of your assets or liabilities based on market indices and your reasons for making those adjustments.
3/28/2008: CEO of ABA offers comments on fair value accounting
Excerpt from Viewpoint: Accounting Rules Making Things Worse?
by Edward L. Yingling, Chief Executive Officer of the American Bankers Association
There are certainly many factors causing the freeze-up in our financial markets. However, it is time to debate whether accounting policies are making the problem worse than it should be.
Are they adding fuel to the fire, rather than accurately measuring its heat? Are they, in fact, helping to build a feedback loop that causes a downward spiral?
Assets are being marked to market, but what is the right definition of the market, particularly when it is clearly dysfunctional? Many people believe that in some cases the assets behind the securities — mortgages, for example — are worth more than the mark-to-market valuations of the securities.
by Edward L. Yingling, Chief Executive Officer of the American Bankers Association
There are certainly many factors causing the freeze-up in our financial markets. However, it is time to debate whether accounting policies are making the problem worse than it should be.
Are they adding fuel to the fire, rather than accurately measuring its heat? Are they, in fact, helping to build a feedback loop that causes a downward spiral?
Assets are being marked to market, but what is the right definition of the market, particularly when it is clearly dysfunctional? Many people believe that in some cases the assets behind the securities — mortgages, for example — are worth more than the mark-to-market valuations of the securities.
3/27/2008: Four largest US banks' outlooks slashed-Oppenheimer
Excerpt from Four largest US banks' outlooks slashed-Oppenheimer
By Jonathan Stempel
[Meredith Whitney wrote]: "Despite cutting estimates for financials by over 30 times since November, we are confident this will not be our last reduction in 2008. As key mark-to-market indices trend lower, the housing market worsens, and the U.S. consumer comes under increasing pressure, we anticipate further downside to both estimates and stock prices."
Sabaziotatos says:
I find Meredith’s naïveté stunning. She genuinely does not seem to understand the events she is caught up in.
Meredith would have us believe that she is an analyst offering independent, objective observations on the financial condition of banks. There are two problems with this view.
First of all, her analysis is derivative, being to a significant extent merely a reflection of the movements of “key mark-to-market indices” (Markit.com’s ABX and CMBX, for example). As these mark-to-market indices have trended lower over Q108, Meredith has changed her estimates to agree with them. How, then, can Meredith’s estimates be viewed as an independent data point or as adding any independent analytical insight at all? Meredith is simply telling us that Mr. Market is in a panic. As if we didn't know that already! What she is NOT telling us is whether Mr. Market is right and, if not, how one should calculate the fundamental value of the banks.
Secondly, Meredith does not seem to realize that she herself has become an important actor in the events she is seeking to describe (George Soros’ “reflexivity”). This was unavoidable given the almost rock-star-like status she has achieved through her correct call on Citigroup late in 2007 and the kind of vicious cycle the market is in due to mark-to-market accounting. Here are the steps in this vicious cycle:
The most remarkable thing about Meredith’s predictions over the last 6 months is that she has been so consistently wrong. At first, she said that C could drop as low as $26 a share; then she changed her mind and said that C could drop as low as $16 a share; now she is changing her mind again and saying she anticipates "further downside to both estimates and stock prices." Doesn’t Meredith wonder why she has had to cut “estimates for financials by over 30 times since November” and is “confident this will not be our last reduction in 2008.” What could be the cause?
In my opinion, the cause is obvious: the market is caught in a self-reinforcing, pro-cycyclical, feedback loop caused by mark-to-market accounting. And Meredith doesn’t even seem to realize she is part of that loop.
By Jonathan Stempel
[Meredith Whitney wrote]: "Despite cutting estimates for financials by over 30 times since November, we are confident this will not be our last reduction in 2008. As key mark-to-market indices trend lower, the housing market worsens, and the U.S. consumer comes under increasing pressure, we anticipate further downside to both estimates and stock prices."
Sabaziotatos says:
I find Meredith’s naïveté stunning. She genuinely does not seem to understand the events she is caught up in.
Meredith would have us believe that she is an analyst offering independent, objective observations on the financial condition of banks. There are two problems with this view.
First of all, her analysis is derivative, being to a significant extent merely a reflection of the movements of “key mark-to-market indices” (Markit.com’s ABX and CMBX, for example). As these mark-to-market indices have trended lower over Q108, Meredith has changed her estimates to agree with them. How, then, can Meredith’s estimates be viewed as an independent data point or as adding any independent analytical insight at all? Meredith is simply telling us that Mr. Market is in a panic. As if we didn't know that already! What she is NOT telling us is whether Mr. Market is right and, if not, how one should calculate the fundamental value of the banks.
Secondly, Meredith does not seem to realize that she herself has become an important actor in the events she is seeking to describe (George Soros’ “reflexivity”). This was unavoidable given the almost rock-star-like status she has achieved through her correct call on Citigroup late in 2007 and the kind of vicious cycle the market is in due to mark-to-market accounting. Here are the steps in this vicious cycle:
1) The mark-to-market indices fall.
2) Meredith predicts writedowns based on the mark-to-market indices.
3) The banks mark down their assets against the mark-to-market indices.
4) Bank writedowns induce more panic.
5) Go to step 1).
The most remarkable thing about Meredith’s predictions over the last 6 months is that she has been so consistently wrong. At first, she said that C could drop as low as $26 a share; then she changed her mind and said that C could drop as low as $16 a share; now she is changing her mind again and saying she anticipates "further downside to both estimates and stock prices." Doesn’t Meredith wonder why she has had to cut “estimates for financials by over 30 times since November” and is “confident this will not be our last reduction in 2008.” What could be the cause?
In my opinion, the cause is obvious: the market is caught in a self-reinforcing, pro-cycyclical, feedback loop caused by mark-to-market accounting. And Meredith doesn’t even seem to realize she is part of that loop.
3/20/2008: Barney Frank: Create a "Risk" Post
Excerpt from Barney Frank: Create a "Risk" Post
by Alan Rappeport
Invoking the Heisenberg uncertainty principle, a concept from quantum physics that shows how the act of measuring something can change its position, Frank also contended that strict "mark to market" valuations were pushing the market down. "A rigid interpretation could be dangerous," he said.
by Alan Rappeport
Invoking the Heisenberg uncertainty principle, a concept from quantum physics that shows how the act of measuring something can change its position, Frank also contended that strict "mark to market" valuations were pushing the market down. "A rigid interpretation could be dangerous," he said.
3/19/2008: Act now to stop the markets' vicious circle
Excerpts from Act now to stop the markets' vicious circle
By Paul De Grauwe, Professor of Economics at the University of Leuven
This perverse co-ordination by the market (some will call it a vicious circle) is made worse by "marking to market" (valuing assets at market rates). The practice forces banks to take a loss on their balance sheets on assets that are caught by the liquidity-solvency spiral. They are forced to do so even if these assets are sound. Thus marking to market today accelerates the downward spiral. Marking to market, which was generalised as an accounting procedure in the 1990s, was influenced by the idea that financial markets are efficient. In this view markets provide the best method to put a correct value on financial assets. Markets are wiser than the judgment of individual bankers or accountants, it was said. That is right under normal circumstances, but not today, when markets are clearly driving towards a bad equilibrium. Markets are not always right.
Today the accounting rule of marking to market is driving us at high speed into the abyss. A speed limit must be imposed. It can be achieved only by temporarily allowing financial institutions not to mark to market. This will make it possible to keep the assets on their books for a while at their previous values (or historic costs). If this is done, the spiral will be slowed down. Prices of many financial assets will recover because they are fundamentally sound. Their value is artificially pulled down by the liquidity-solvency spiral.
By Paul De Grauwe, Professor of Economics at the University of Leuven
This perverse co-ordination by the market (some will call it a vicious circle) is made worse by "marking to market" (valuing assets at market rates). The practice forces banks to take a loss on their balance sheets on assets that are caught by the liquidity-solvency spiral. They are forced to do so even if these assets are sound. Thus marking to market today accelerates the downward spiral. Marking to market, which was generalised as an accounting procedure in the 1990s, was influenced by the idea that financial markets are efficient. In this view markets provide the best method to put a correct value on financial assets. Markets are wiser than the judgment of individual bankers or accountants, it was said. That is right under normal circumstances, but not today, when markets are clearly driving towards a bad equilibrium. Markets are not always right.
Today the accounting rule of marking to market is driving us at high speed into the abyss. A speed limit must be imposed. It can be achieved only by temporarily allowing financial institutions not to mark to market. This will make it possible to keep the assets on their books for a while at their previous values (or historic costs). If this is done, the spiral will be slowed down. Prices of many financial assets will recover because they are fundamentally sound. Their value is artificially pulled down by the liquidity-solvency spiral.
3/18/2008: Governors of Bank of Canada comment on fair-value accounting
Excerpts from The mark to market fiasco
By Terence Corcoran
Including comments by a current and a form Governor of Bank of Canada
In a speech last week … Bank of Canada Governor Mark Carney raised the issue:
"The combination of the relative novelty of fair-value accounting and extremely volatile markets has made this interpretation [of financial institution information] more difficult. Some have questioned the utility of requiring mark-to-market valuations of all assets and liabilities on a corporate balance sheet. The point can be made that, in the current circumstances, existing accounting rules provide a degree of precision that is not warranted."
A similar red flag was waved over fair-value accounting by former governor David Dodge in a 2004 speech:
"Does compliance with some of our accounting rules lead to large swings in reported earnings that do not reflect the true economic state of a firm? If we are to use fair value accounting, how do we ensure that both assets and liabilities are correctly and equally marked to market? And we need to understand how particular elements of accounting rules can affect the risk-taking behaviour of financial institutions and investors."
By Terence Corcoran
Including comments by a current and a form Governor of Bank of Canada
In a speech last week … Bank of Canada Governor Mark Carney raised the issue:
"The combination of the relative novelty of fair-value accounting and extremely volatile markets has made this interpretation [of financial institution information] more difficult. Some have questioned the utility of requiring mark-to-market valuations of all assets and liabilities on a corporate balance sheet. The point can be made that, in the current circumstances, existing accounting rules provide a degree of precision that is not warranted."
A similar red flag was waved over fair-value accounting by former governor David Dodge in a 2004 speech:
"Does compliance with some of our accounting rules lead to large swings in reported earnings that do not reflect the true economic state of a firm? If we are to use fair value accounting, how do we ensure that both assets and liabilities are correctly and equally marked to market? And we need to understand how particular elements of accounting rules can affect the risk-taking behaviour of financial institutions and investors."
3/17/2008: “CFA Says Fair Value Used As a Scapegoat
Excerpt from CFA Institute Centre for Financial Market Integrity Says Fair Value Being Used As a Scapegoat for Bad Decisions, Lack of Compliance
The CFA Institute Centre for Financial Market Integrity today reaffirmed its support for fair value as the most transparent measurement for investors to analyze financial statements. The CFA Institute Centre also said that fair value is being used as a scapegoat by corporations who have made poor decisions or were not in compliance with accounting standards.“Putting the blame on fair value for current market conditions is misguided,” said Georgene Palacky, director of the CFA Institute Centre’s financial reporting group. “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors. Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition.”
The CFA Institute Centre for Financial Market Integrity today reaffirmed its support for fair value as the most transparent measurement for investors to analyze financial statements. The CFA Institute Centre also said that fair value is being used as a scapegoat by corporations who have made poor decisions or were not in compliance with accounting standards.“Putting the blame on fair value for current market conditions is misguided,” said Georgene Palacky, director of the CFA Institute Centre’s financial reporting group. “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors. Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition.”
3/15/2008: Richard Kovacevich, Chairman of Wells Fargo, on mark-to-market accounting
Richard Kovacevich, Chairman of Wells Fargo says on Bloomberg’s “On the Record” (unfortunately no link to the video, which I recorded on my DVR):
If you mark to market the LDC debt back in the 80’s relative to the capital that was in the banks at that time, many banks would have been bankrupt. That is not the case today. They’re marking to market their problems, and the problems are in the same area of magnitude as the LDC debt and they still have substantial capital, much better than was the case back in the 80’s and 90’s. The difference is they weren’t forced to mark to market their problems. They are forced to today. And I would point out that it is likely because of the situation that exists when there is a bubble that the debt could well be being marked at a lower value than its underlying economics because they’re looking at a screen and no one wants to buy this at the moment and they’re forced to mark it down to whatever the screen says. And the screen is unlikely to be right.
If you mark to market the LDC debt back in the 80’s relative to the capital that was in the banks at that time, many banks would have been bankrupt. That is not the case today. They’re marking to market their problems, and the problems are in the same area of magnitude as the LDC debt and they still have substantial capital, much better than was the case back in the 80’s and 90’s. The difference is they weren’t forced to mark to market their problems. They are forced to today. And I would point out that it is likely because of the situation that exists when there is a bubble that the debt could well be being marked at a lower value than its underlying economics because they’re looking at a screen and no one wants to buy this at the moment and they’re forced to mark it down to whatever the screen says. And the screen is unlikely to be right.
3/13/2008: An unforgiving eye: Bankers cry foul over fair value accounting rules
Excerpt from An unforgiving eye: Bankers cry foul over fair value accounting rules
By Jennifer Hughes and Gillian Tett
Accounting rules rarely top senior executives' agendas. But when Axa, the mighty French insurance firm, recently unveiled its results, its bosses were unusually outspoken in voicing their criticism of bean-counters.
"If you are in the medical business, you want to be sure that the thermometer is the right one for benchmarking things properly," said Henri de Castries, chief executive of Axa (pictured below). "The accounting systems in the economy are the thermometer, and I'm not sure their measurement scale is the right one."
It is a sentiment now being echoed with increasing vigour by financiers, particularly given the impending round of results from Wall Street brokers. As the credit turbulence has spread this winter, financial companies have unveiled a staggering swath of losses on instruments such as mortgage bonds. Axa itself, for example, recently revealed some €600m (£460m, $940m) of writedowns; meanwhile, western investment banks have reported hits of more than $181bn (£89bn, €116bn).
Many observers expect this tide of red ink to swell further in the next two weeks, when US brokers such as Bear Stearns (NYSE:BSC) announce results for the December to February period. The price of mortgage securities, as measured by indices such as the ABX, is continuing to fall, and there is pressure on banks to make large writedowns for corporate leveraged loans as well ... .
As the losses rise, anxiety is growing over the way these hits are being measured. At present, accounting is dominated by a concept of "fair value": companies are expected to report the value of their holdings in as "current" a manner as possible, which in practice means marking to market prices.
However, there is mounting concern that this approach creates distortions when markets are as dysfunctional as they are now. Indeed, some bankers fear that the system is actually making the crisis worse. Far from offering a reassuring yardstick, it is forcing banks and hedge funds to sell assets in a manner that is stoking investor panic - or so the criticism of men such as Mr de Castries goes.
More coverage of mark-to-market/fair-value accounting from the Financial Times.
By Jennifer Hughes and Gillian Tett
Accounting rules rarely top senior executives' agendas. But when Axa, the mighty French insurance firm, recently unveiled its results, its bosses were unusually outspoken in voicing their criticism of bean-counters.
"If you are in the medical business, you want to be sure that the thermometer is the right one for benchmarking things properly," said Henri de Castries, chief executive of Axa (pictured below). "The accounting systems in the economy are the thermometer, and I'm not sure their measurement scale is the right one."
It is a sentiment now being echoed with increasing vigour by financiers, particularly given the impending round of results from Wall Street brokers. As the credit turbulence has spread this winter, financial companies have unveiled a staggering swath of losses on instruments such as mortgage bonds. Axa itself, for example, recently revealed some €600m (£460m, $940m) of writedowns; meanwhile, western investment banks have reported hits of more than $181bn (£89bn, €116bn).
Many observers expect this tide of red ink to swell further in the next two weeks, when US brokers such as Bear Stearns (NYSE:BSC) announce results for the December to February period. The price of mortgage securities, as measured by indices such as the ABX, is continuing to fall, and there is pressure on banks to make large writedowns for corporate leveraged loans as well ... .
As the losses rise, anxiety is growing over the way these hits are being measured. At present, accounting is dominated by a concept of "fair value": companies are expected to report the value of their holdings in as "current" a manner as possible, which in practice means marking to market prices.
However, there is mounting concern that this approach creates distortions when markets are as dysfunctional as they are now. Indeed, some bankers fear that the system is actually making the crisis worse. Far from offering a reassuring yardstick, it is forcing banks and hedge funds to sell assets in a manner that is stoking investor panic - or so the criticism of men such as Mr de Castries goes.
More coverage of mark-to-market/fair-value accounting from the Financial Times.
3/13/2008: AIG urges rethink on 'fair value' accounting
Excerpt from AIG urges rethink on 'fair value' accounting
By Francesco Guerrera and Jennifer Hughes
American International Group (NYSE:AIG) is urging regulators to change controversial accounting rules on asset valuations to stem the tide of writedowns that have wreaked havoc on Wall Street. The US insurer, which this month recorded a record quarterly loss after an $11bn mortgage-related writedown, is the first company publicly to air a proposal to move away from "fair value" accounting. … Martin Sullivan, AIG's chief executive, told the Financial Times that "mark-to-market" rules forced companies to recognise losses even when they had no intention of selling assets at the current prices. He said the practice created a vicious circle whereby companies recorded huge losses, lost investors' confidence and were then forced to raise funds at unfavourable prices. "This is not a criticism of fair value accounting. I just think it has had unintended consequences in these uncharted waters," he said.
Sabaziotatos says:
For context, see AIG's press release from 2/28/2008, in which AIG reports that $11B of “market valuation losses” on their credit default swap portfolio are “unrealized” and will reverse over the remaining life of the portfolio:
By Francesco Guerrera and Jennifer Hughes
American International Group (NYSE:AIG) is urging regulators to change controversial accounting rules on asset valuations to stem the tide of writedowns that have wreaked havoc on Wall Street. The US insurer, which this month recorded a record quarterly loss after an $11bn mortgage-related writedown, is the first company publicly to air a proposal to move away from "fair value" accounting. … Martin Sullivan, AIG's chief executive, told the Financial Times that "mark-to-market" rules forced companies to recognise losses even when they had no intention of selling assets at the current prices. He said the practice created a vicious circle whereby companies recorded huge losses, lost investors' confidence and were then forced to raise funds at unfavourable prices. "This is not a criticism of fair value accounting. I just think it has had unintended consequences in these uncharted waters," he said.
Sabaziotatos says:
For context, see AIG's press release from 2/28/2008, in which AIG reports that $11B of “market valuation losses” on their credit default swap portfolio are “unrealized” and will reverse over the remaining life of the portfolio:
- “AIG continues to believe that the unrealized market valuation losses on this super senior credit default swap portfolio are not indicative of the losses AIGFP may realize over time. Under the terms of these credit derivatives, losses to AIG would result from the credit impairment of any bonds AIG would acquire in satisfying its swap obligations. Based upon its most current analyses, AIG believes that any credit impairment losses realized over time by AIGFP will not be material to AIG’s consolidated financial condition, although it is possible that realized losses could be material to AIG’s consolidated results of operations for an individual reporting period. Except to the extent of any such realized credit impairment losses, AIG expects AIGFP’s unrealized market valuation losses to reverse over the remaining life of the super senior credit default swap portfolio.”
3/13/2008: Former Fed Chairman Paul Volcker on fair-value accounting
Comments by Former Fed Chairman Paul Volcker on 3/13/2008 before the Advisory Committee on Auditing Profession (about 42:45 minutes into the webcast of the Morning Session )
It is known to some people around this room that I have a certain amount of problems with fair value accounting. It seems to me that this [i.e., fair value accounting] has been seized upon as a summum bonum [highest good] of accounting, of general field theory, that was going to solve all problems. But, I think it's evident that it doesn't solve all problems. In fact, it may create a few. In fact, [unintelligible] along the lines of some of our financial engineers, who keep running into 100 year possibilities every 2 years. There is a real question of how to blend the real insights of mark-to-market accounting in markets where there's no market. Or, in fact, the accounting practice may lead to exaggerated movements in markets, which is the opposite of what we want to happen. And I don't say there is any easy solution to this.
Other comments by Paul Volcker on fair value and mark-to-market accounting.
It is known to some people around this room that I have a certain amount of problems with fair value accounting. It seems to me that this [i.e., fair value accounting] has been seized upon as a summum bonum [highest good] of accounting, of general field theory, that was going to solve all problems. But, I think it's evident that it doesn't solve all problems. In fact, it may create a few. In fact, [unintelligible] along the lines of some of our financial engineers, who keep running into 100 year possibilities every 2 years. There is a real question of how to blend the real insights of mark-to-market accounting in markets where there's no market. Or, in fact, the accounting practice may lead to exaggerated movements in markets, which is the opposite of what we want to happen. And I don't say there is any easy solution to this.
Other comments by Paul Volcker on fair value and mark-to-market accounting.
3/11/2008: Don't Mark to Markit: The king of credit indices casts doubt on its own products
Excerpt from Don't Mark to Markit: The king of credit indices casts doubt on its own products
by Economist Staff
Intriguingly, Markit agrees with the sceptics, up to a point. The firm is working on a report that will highlight the limitations of the ABX and champion other inputs, such as new issuance and recent trades in similar securities, that can help value credit instruments, "Two years ago we had to tout [the ABX's] virtues. Now people consider it to be more relevant than it should be. They are panicking, over-reacting," says Ben Logan, Markit's head of structured finance. He hears frequent complaints from banks on both sides of the Atlantic saying that their auditors want to see entire portfolios marked to Markit indices.”
by Economist Staff
Intriguingly, Markit agrees with the sceptics, up to a point. The firm is working on a report that will highlight the limitations of the ABX and champion other inputs, such as new issuance and recent trades in similar securities, that can help value credit instruments, "Two years ago we had to tout [the ABX's] virtues. Now people consider it to be more relevant than it should be. They are panicking, over-reacting," says Ben Logan, Markit's head of structured finance. He hears frequent complaints from banks on both sides of the Atlantic saying that their auditors want to see entire portfolios marked to Markit indices.”
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