Fair value accounting is not fair!

Mark-to-market accounting, a rule which forced US banks to carry more securities at market value, owes its origins to the US savings and loan crisis when losses on loans had been hidden by the use of “historic cost” accounting. In the midst of the current credit-induced global stock market meltdown, the impact of the mark-to-market accounting has assumed greater significance.

ICICI Bank and its overseas banking subsidiaries reportedly have an aggregate exposure of $2.2 billion in credit derivatives, of which around $500 million is in the books of its overseas subsidiaries.

Till markets are in turmoil, banks will have to make provisions on such exposures. For the March 31 quarter, ICICI Bank will have to make an additional provision of around $74 million, after having already provided $189 million in the previous quarters. The provisioning accounts for the bank’s and its subsidiaries’ investments in derivatives such as credit-linked notes and CDSs (Credit Default Swaps) as well as fixed-income instruments such as bonds.

Just like ICICI, various PSU banks such as State Bank of India, Bank of India and Bank of Baroda, also have a combined exposure of about $1.5 billion, which may translate into a mark-to-market loss of over $200 million.

However, one must note that the banks state that they have no material direct or indirect exposure to the US sub-prime credit. These are only mark-to-market losses and as the money comes back, the losses will get recouped over a four-year period.

The widening of credit spreads in the international markets has resulted in a negative mark-to-market impact on its credit derivatives and fixed-income investment portfolios of the bank and its overseas banking subsidiaries. At the same time, there has been no significant deterioration in actual credit quality of the underlying investments.

CDS spreads for Indian players have widened significantly in the past few months. For example, the CDS spreads of Reliance Industries are currently at 200 basis points above LIBOR as against 95 basis points around three months ago. Similarly, the CDS spreads of Tata Motors is 475 as against 280 three months ago.

The problems of the write-downs as a fallout of the sub-prime crisis started this year with Merrill Lynch’s $15 billion (Rs 58,500 crore) write-down of mortgage-related securities in January 2008. And then came AIG Insurance’s large write-down of sub-prime paper to the extent of upwards of $11 billion. Its chief, however, predicted these “unrealised” losses would eventually correct themselves.

It may be noted that in 2005, both GM and Ford had slashed their 2005 earnings forecasts. At that time, S&P rated GM and its financing arm, GMAC, at triple-B-minus. S&P on account of Ford’s downward revision, changed its outlook for Ford to negative.

Moody’s separated the two auto majors and cut GM one notch to Baa3, and lowered GMAC one notch to Baa2. Moody’s, which was then rating Ford Baa1 and Ford Motor Credit A3, reacted to the lowered earnings forecast by placing both on watch for possible further downgrade.

Another cut by the ratings companies, and two of the largest issuers of corporate debt would have fallen to non-investment grade, or junk. Should they have fallen to junk, GM and Ford, together with their finance arms, would account for about 14 per cent of the high-yield market — far more than fund managers typically allocate to any one company or sector.

As markets were rife with speculation regarding possible downgrade of both GM and Ford to junk status, the credit spread on GM’s benchmark bond maturing in July 2033 reached 5.36 per cent — much larger than that of the average junk bond. The 30-year GM bond, which was paying an 8.375 per cent coupon, fell 1.058, or $12.44 for each $1000 invested, to yield 10.096 per cent. Ironically, just when these downgrades were taking place, GM was sitting on $19.8 billion in cash and could have tapped into roughly another $10 billion in a trust and other credit facilities. And the company’s highly profitable financing arm, GMAC, had its own cash of $22.7 billion.

At this very time, many Indian banks were holding securities of both GM and Ford because of the high returns they were yielding. Yet, because of the mark-to-market provisions of accounting, as the yields on these securities had shot up and the prices of these securities had come down, the Indian banks holding instruments in these companies had to book mark-to-market losses which had to be subsequently reversed, as money started coming from these companies and mark-to-market losses started getting converted into mark-to-market gains, ultimately resulting in a zero-sum game.

Typically, banks have incentives to buy more when prices are high, and are forced to sell when they are low. The expansion and contraction of balance-sheets amplifies, rather than counteracts, the credit cycle. Capital standards and mark-to-market rules add to euphoria in good times and despair in bad times. In other words, fair-value accounting “could even further increase the euphoria in a financial bubble or the panic in the markets in a time of crisis”.

In their paper entitled Liquidity and leverage, Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin of Princeton University, have produced work about this kind of “pro-cyclicality” in finance and the economy.

The paper ‘Liquidity and leverage’ examines the links between asset prices and the value of banks’ capital bases when mark-to-market accounting is used. It postulates that banks are driven to lend more and grow their balance-sheets as the value of their capital rises. This is because they target a more or less constant leverage multiple on their balance-sheets.

The same paper concludes that it was inevitable that an industry buoyed by rising asset prices would pursue increasingly aggressive lending growth. This pushed credit upon even more risky clients and loan structures, when then fed into asset price growth. This, in turn, created “positive feedback loops”. Vivid description of the Enron debacle in the movie The Smartest Guys in the Room by filmmaker, Alex Gibney, brings to mind how Enron’s mark-to-market method of accounting sowed the seeds of the tragicomedy that was Enron. Outlandish predictions about future profits on such business schemes as trading weather derivatives, booked as if they were current earnings, sowed the seeds of its demise.

The most disturbing inference is that this system should behave in exactly the same way in reverse, creating “negative feedback loops” with a destructive impact on all kinds of asset values — from structured finance to house prices and equities. This is exactly what is happening to Indian banks with no direct exposure to the US sub-prime crisis but falling a prey to the mark-to-market system of accounting.

The world accounting bodies including the FASB (Financial Accounting Standards Board) of the US have recently agreed to converge to IFRS (International Financial Reporting Standards) which tend to bend towards the “fair-value system of accounting”. They need to come up with some solutions quickly, like temporary halt to the mark-to-market system of accounting. The reason being that exaggerated write-downs in the current credit crisis are rapidly eating away the banking system’s capital cushion.

If this is not immediately rectified, banks will be forced to dump assets at fire-sale prices, leading to more write-downs and more fire-sales. This could drastically impact the CARs (Capital Adequacy Ratios) of even the most solvent banks, and hinder smooth adoption of the Basel II norms. At best, banks will have to keep selling cheap equity to foreign sovereign wealth funds to keep themselves afloat.

In other words, the problem is that as fair value gets extended beyond assets with clear and liquid markets, what exactly constitutes market price is less clear. The US recently delayed plans to extend FAS 157, its fair value standard, beyond the realm of financial instruments after being warned that many had no idea how it would work in practice.

FAS 157 is based on a single definition — exit price, or the price at which you could sell the asset or liability. There is, of course, a buyer’s view, or entry price and, in some cases, the two can produce very different numbers. IFRS has elements of both.

The sub-prime credit problems which started with the accounting mark-to-market system of accounting and its concomitant pitfalls, may, after all, find its saviour also in the annals of accounting principles. It may be time to revert back to the historical method of accounting to tide over the current crisis marked-to-market.