Fair Value for Financial Instruments: It's Now or Never

I don't watch TV very much, except for sports – lots of sports. I nonetheless tore myself away from ESPN for thirty minutes last week when a friend strongly suggested that I watch an interview of Paul Volcker (former Fed Chairman) and William Isaac (former FDIC Chairman) on the Kudlow Report. Among other things, these gentlemen were supposed to explain why they were staunchly opposed to mark-to-market accounting for bank loans.

As expected, I didn't learn anything new from watching a superficial discussion amongst voices singing in unison. However, I did come away with a new appreciation for how much public pressure is being brought to bear on the three FASB members who boldly voted to issue proposed revisions to financial instruments accounting.  If finalized, they would require reporting nearly all financial instruments at their fair values, so it's a safe bet that the ultimate disposition of this proposal will be a watershed event in the history of U.S. accounting standards; not just for what it says about the future of fair value accounting, but for what it portends for adoption of IFRS in the U.S. This one is for all the marbles.

There are, to be sure, many aspects of the FASB's proposal to debate, but the flashpoint is whether any version of mark-to-market (MTM) accounting is appropriate for bank loans. The conventional hue and cry is that market-based valuations induce "procyclical" behavior with the ultimate effect of blunting or even defeating other economic policies. The story goes like this:

1. The market value of a bank's loan portfolio must decline during an economic downturn, even if there are no specifically identifiable problems with any individual loan. This is because the market will assign a higher probability to future bad news and impound it in the price.
2. If the decline in market value is recognized on the bank's financial statements, then regulators, whose policy it is to utilize balance sheet ratios for determining the capital adequacy of banks, will require those banks either: (a) to raise new equity capital (not an attractive option in down times), or; (b) to cut back on their lending—the more likely outcome, since equity values would be depressed.
3. If the banks were to cut back on their lending, the economic downturn would become worse.

In other words, the cornerstone argument of the anti-fair value camp goes thus: truth hurts; therefore, we must repress it.

Volcker and Issac recommend a head-buried-in-the-sand accounting standard, which allows management to disregard any possibility that a loan will not be repaid in full unless and until direct evidence to the contrary bites them in the rear end.  And, when reality can be ignored no longer, we should prefer estimates of uncollectibility produced by self-interested management (under the watchful eye of their "independent" auditor), and ignore the collective opinion of disinterested market participants.  

Here's just two of many reasons for casting one's lot with the markets.

Reason #1: Current GAAP is Procyclical, Too

One can argue just as forcefully as the MTM naysayers that the existing accounting standards are also procyclical, and that it was the flaws in the existing standards that brought us the S&L failures of twenty years ago, not just the bank failures of two years ago:

1. During periods of economic expansion, accounting rules that permit delayed recognition of loan losses encourage bankers to make inappropriately risky loans. It doesn't help that auditors are prone to accept management's head-in-the-sand versions of loan loss allowances.
2. When economic expansion ceases, banks will continue to lend to inappropriately risky candidates, and perhaps, to even riskier candidates in a desperate attempt to meet unreasonable earnings expectations. Bankers can do this with apparent impunity, because they are permitted to ignore market valuations of their existing loan portfolio.
3. When bank financing is needed to reverse the economic downturn, it won't be available, in large part because the banks have dug themselves a hole, jumped in, and can't climb out.

In other words, it is also bad economic policy to base measures of capital adequacy on fictional loan portfolio valuations, especially when that fiction is the cause of underfunding government-sponsored deposit insurance programs.

I would regularly tell my students that sound banking policy means that you only lend money to people who don't actually need it. Everybody else must seek to issue equity, thank you very much. Similarly, it may be unrealistic for policy makers to expect even healthy banks (never mind the ones in that aforementioned hole) to increase their lending during a downturn. Lacking sufficient appetite for risk on the part of potential equity investors, that leaves only the government to take up the stimulus mantle. (Yes, dear reader, I'm a Keynesian).

Current GAAP has clearly encouraged banks to make loans they shouldn't have made, and if that's not exactly what Bob Herz, FASB chair said in his testimony to Congress, it's pretty darn close:

"The fact that fair value measures have been difficult to determine for some illiquid instruments is not a cause of current problems but rather a symptom of the many problems that have contributed to the global crisis—including lax and fraudulent lending, excess leverage, the creation of complex and risky investments through securitization and derivatives, the global distribution of such investments across rapidly growing unregulated and opaque markets lacking a proper infrastructure for clearing mechanisms and price discovery, faulty ratings, and the absence of appropriate risk management and valuation processes at many financial institutions." [italics supplied]

Reason #2: Fair Value Doesn't Have to Be Procyclical

If an economic policy can be defeated by putting a truth on the balance sheet, then there is something fundamentally wrong with that economic policy. Bob Herz, FASB chair, is now calling for severing the linkages between financial reporting and bank regulations, and I've also made that suggestion here. I don't want to sound like a broken record, but there must be a better way to regulate banks than to rely on made-up balance sheet numbers.

Getting back to TV and sports, while lying sleepless and jetlagged in a Chicago hotel room a couple of days after the Volcker and Isaac show, I woke to Jimmy Kimmel's monologue. What I think happened is that I dozed off during the stupefying game seven of the NBA finals, and Kimmel followed. Here, as I paraphrase it, is perhaps as close to an accounting joke as Jimmy may ever get:

"It seems like every week, the estimate of the amount of oil spewing into the ocean from that underwater well doubles. We have to stop these estimators: they're destroying the Gulf"

Get it?

Comments

[Dane Morrison]

Typical financial institutions try to produce a partial hedge on their interest rate risk by carefully balancing the repricing terms of the liabilities and the assets. Revaluing only the asset side to the market will distort the balance sheet, particularly when interst rates become volatile.

Until both sides can be marked to market, it is better to shore up the existing methods of accounting for credit risk (e.g. use of environmental factors) rather than setting only half the balance sheet ot fair value.

Credit risk is the concern today, but interest rate risk will be back again some day. If we are going to fix the balance sheet, fix both sides!

[Edward Beale]

Mark to market of financial instruments is in principle the right approach for minority of companies that are financial institutions, where in the main those financial instruments are their "working capital".

However, the accounting standards also apply to the vast majority of companies that are not financial institutions and where the financial instruments are mainly investments or financing (outside of treasury operations where they are "working capital").

The problem with the debate on accounting standards for financial instruments is that it is totally driven by the needs of financial institutions, overlooking all the other companies that are affected.

We really need two sets of financial instruments standards, one mark to market for shorter term working capital items and one for more long term investments (where fair value is a guess unless the investment is publicly traded) and financing (where the timing of gross cash flows is key).

Alternatively financial institutions should have their own separate standards.

[Howard Lothrop]

Even if interest rate hedging occurs organically through matching the repricing of assets and liabilities, the full interest rate risk component of the loan will still represent a counterbalancing offset to the cyclical credit shift.

For example, in the above-mentioned economic downturn, as credit factors act to depress loan prices, lowered interest rate will act to increase (fixed rate) loan values. Similarly, in an expansion as credit spreads narrow (loan values increase), interest rate increases will act to limit this gain. So, the impact is not without some offset.

Finally, even if the mark-to-market component is somewhat volatile, regulatory capital need not (nor is it now) equal accounting capital, so bank regulators have tools to allow some slack here.