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Was fair value accounting to blame for credit crunch?

Every bull market that turns into a bubble has similar characteristics; the same have been discovered, experienced and endured in the ongoing credit crisis. The phase before the start of turmoil and mayhem corresponded to a vivid and promising futuristic perception. The soaring profits of the banking industry and sky peaking financial markets signified a steady augmentation of the economy. The residential foreclosure crisis that swept US and progressively the world and dominated the headlines in 2007 has ultimately caused turbulence and instability in the world economy. Intuition of the turbulent financial epoch was first felt in early 2007 over the duration of Subprime Mortgage Crisis in US. Interest rates were relatively very low in the first part of the decade. The low and attractive interest rates spurred increase in mortgage financing and substantial increases in house prices which encouraged investors such as pension funds, hedge funds and investment banks to seek instruments that offer yield enhancement. Using long term mortgages to pay for home was considered as a good idea but with few important caveats. There is no doubt that the US real estate market is at the epicentre of the crisis and is pivotal for its course which has rammed the major European and Asian economies in a dilemma ever since the Great Depression.

In this light it seems important to understand the cause of amplification mechanism, which explains why the mortgage crisis caused such large dislocations and turmoil in the financial markets. Numerous bankers, legislators, borrowers and regulators have expressed their views about the cause of the credit crunch. The desire of investors to make some extra yield plus a lack of understanding of the risks assumed by investing in those securities definitely compounded the situation (Michel G. Crouhy, Robert A. Jarrow and Stuart M. Turnbull). The ongoing financial meltdown is the consequence of several trends that have developed over several decades and then converged to create a powerful and unexpected storm. The most elemental and robust financial institutions including Bear Stearns, Lehman Brothers and Merill Lynch realised that they held enormous quantities of securities in their books. These securities while rated AAA by reliable rating agencies started to show serious default rates as individual borrowers were either unwilling or unable to keep up to date on the mortgage payments. The losses cascaded through the system very quickly and the subprime crisis has thus turned into one of the biggest financial meltdowns of the history. The credit havoc is a major test for all valuation frameworks. It originated from the uncertainty about the valuation of complex structured credit products, concerns about the reliability of ratings, opacity of actual risk exposures and the robustness of risk assessment. The excessive reliance on ratings for structured products, an over optimistic assessment of liquidity risk, an insufficiently broad range of valuation tools, the use of outdated market data inputs and volatility estimates are among the most significant problems revealed by the turmoil (Noyer, Financial Stability Review 2008).

As the untimely turmoil struck the UK economy stalwartly the International Accounting Standards Board (IASB) has been put in the dock being accused of having intensified the effects of the financial crisis. The banks, businesses and politicians remarked the International Financial Reporting Standards (IFRS) of not being effective during the period of the crisis alternatively precipitated the fall of some major financial institutions. Criticised and destabilised fair value accounting has been considered one of the key factors of the crisis. The financial Institutions and politicians including Gordon Brown have criticised Fair value accounting, stating that the reported losses are misleading because they are temporary and will reverse as markets will recover. As a result the reported losses have adversely affected market prices yielding further losses and hence exacerbating the crisis. Despite its almost universal adoption by accounting standard setters, the persisting merits of fair value accounting continue to generate intense and passionate debates among the regulators and the investors.

Emergence of Fair Value Accounting

The technique of Historical (Prudence) accounting was exercised since many years and was adapted universally. During the application of Historical accounting the businesses, academics and regulators took a dangerous leap of faith and agreed to the myth that certain future events such as price fluctuations, volatility, correlation between markets could be characterized using past behaviour and by considering past series within a chosen probability the range of market movements can be predicted. However, over the years the well-known swindles and the market crashes demonstrated that future risk is a consequence of future price fluctuations which cannot reliably be predicted. The regulators and rating agencies supported Prudence accounting completely as it illustrated a promising view to the investors. Going in favour of the businesses it represented steadier markets as less risky. The companies displayed the original cost of the asset on the balance sheet and current market values in the footnotes or in parentheses, avoiding reporting gains and losses from changes in the market price of securities unless and until they were actually sold. As a consequence more money was injected in these markets, price bubbles grew and returns increased. When finally the bubbles burst the financial institutions were faced with a catastrophic (Black Swan) event that was never forecasted by the prudence technique (Amzalla et al, 2009). In the end the financial institutions and other industries faced vastly larger losses than they estimated and remained profoundly uncertain as to where and how far these uncharted currents will drive the economy. Therefore the turbulence raised many fingers against the Accounting Standards and Regulating Bodies about the prudence method and a need and requirement was been felt to revise the technique.

In November 2005 International Accounting Standards Board along with the US Financial Accounting Standards Board (FASB) and the European Commission and the other major accounting bodies did hold round table meeting called as the ‘Conceptual Framework Project’, with a rationale of developing high quality, common accounting standards for use in the world capital markets. The decision of adapting Fair Value Accounting (FVA) technique was emphasised by IASB mainly to codify, clarify and simplify the accounting methods to judge the level of transparency and disclosures with respect to the interest of the industries and the investors (Invitation to Comment and relevant IFRS guidance 2nd April 2007). IFRS has defined FVA in IAS 39 (International Accounting Standard) as ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in arm’s length transaction’ (Andre et al 2008). The move of adapting Fair Value Accounting was mainly to support improved transparency and enhanced financial disclosures which promote market discipline and provide useful information to the decision makers. But at the same time the researchers warned the accounting industry to be careful before moving towards a more comprehensive fair value approach, where all financial assets and liabilities are recorded on the balance sheet as per the mark to market changes and these changes are recorded in the earnings whether realised or not.

Alfred M.King (January 2009) states that the business community has had a single definition for fair value accounting since 120 years affirming ‘’Fair Market value is defined as the price for which property would exchange between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither under compulsion to buy or sell and with equity to both’’. Richard (2004) points out that considering the market value has been a part of the French trade since 19th century, the courts have used the term to mean a price at which buyer and seller both receives an appropriate benefit from a transaction. The goal of this technique is for firms to estimate as best as possible the prices at which the positions currently hold would change hands in orderly transactions based on current information and conditions. To achieve this goal firms must fully incorporate current information about future cash flows and current risk adjust discount rates into their fair value adjustments. The underlying principle for this requirement is market prices should reflect all publicly available information about future cash flows including investor’s private information that is revealed through trading as well as current risk adjusted discount rates. According to the IFRS Standards implemented in England and European Union legislation when the fair values are estimated using unadjusted or adjusted market prices they are referred to as mark to market values and with respect to some financial instruments if market prices for the same or similar positions are not available then firms must estimate fair values using valuation models termed as mark to model values. The IASB proclaimed that fair value accounting would be the best possible measurement attribute for inducing firm’s managements to make voluntary disclosures and to make the investors aware and cautious of the critical questions to ask managements. When firms report profits or losses their managements are motivated to explain in the Management Analysis and Announcements about what went wrong or right during the period and the nature of any fair value measurement issues. If the management is unable to adequately explain their unrealised gains and losses then the fair value numbers at least indicate the correct position of the company valuation and its future prospects (Stephen G.Ryan July 2008). The method of Fair value was always described as a controversial policy but did come under strict scrutiny in the middle of the crisis. As the real estate prices kept going lower the companies reported losses due to the decline in the mark to market values and hence eroding the net worth of the companies. As the net worth kept declining the Companies were in a fear to test bankruptcy and were under tremendous pressure to sell the worthless securities and obtain new capital. However as per the law of demand the fraternity perceived more sellers and almost no buyers in that demoralized phase of the markets Alfred M.King (January 2009). Therefore not only finance but different industries like housing and real estate, automobiles have appeal for a major change in the accounting techniques. The industries have justified the appeal by explaining that if fair value method were repealed then mark to market would be easier to meet as the valuations would now be much higher from the rock bottom levels.

Literature Review

Burkhardt and Strausz (July 2006) support the wide spread view that fair value accounting increases disclosure and reduces the degree of asymmetric information. But they don’t agree that the change in the accounting policy would improve the informational position of capital markets and regulators. In actual fact reduction in the degree of asymmetric information between the capital markets and the banks may actually intensify the bank’s risk shifting behaviour and therefore increases the need for regulation. The argument exemplified by Burkhardt and Strausz is based on the theory of risk shifting behaviour of debt by Jensen and Meckling (1976). The argument elucidates that if a move towards fair value accounting improves the informational position of the market, then it reduces the asymmetry of information between the bank and the market. The contraction in asymmetric information increases the liquidity of the assets and thereby enlarges the bank’s investment opportunities; this behaviour leads to a higher probability of default and a reduction in the bank’s overall value. Therefore even if fair value lives up to its deal of achieving full transparency at zero costs it increases rather than decreases tensions between regulators and banks in contrast, historical value technique offers an in transparent situation in which the bank retains some private information.

The piece of evidence, fair value accounting leads to a higher liquidity of the banks’ assets can be correlated to the Akerlof’s (1970) theory of lemon problem. As the car dealers possesses good and bad information about the cars in the same way under book value accounting the bank possesses private information about the quality of its assets and the market can therefore not distinguish between the good and bad assets. Hence under the prudence technique the bank is willing to pay at most an average price which effectively results into a discount for good assets and a premium for the bad ones. The discount prevents banks from selling high quality assets and decreases the liquidity of these assets at the same time fair value accounting reduces the asymmetric information between the bank and the market and increases the liquidity of high quality assets.

The financial institutions had been at the forefront all throughout the debate on the controversial shift in the international standards from prudence accounting to fair value accounting. During the progress of the Conceptual Framework Plantin, Sapra and Shin (September 2005) suggest that when there are imperfections in the market the superiority of a mark to market regime is no longer so immediate. Put in plain words the presumption by Plantin et al states when there is more than one imperfection in a competitive economy, removing just one of these imperfections need not be welfare improving. The key dimension to the research work is the extent to which mark to market accounting injects excessive volatility into financial markets. They put across market prices as playing a double edged role as they are a reflection of the underlying fundamentals at the same time they also affect the market outcome through their influence on the actions of market participants. For instance due to agency problems or other market imperfections there is a possibility of a feedback loop where anticipation of short term price movements will induce market participants to act in such a way as to amplify these price movements. In these situations the firm’s decisions are based on the second guessing of others decisions rather than on the basis of the perceived fundamentals, giving scope to an additional, endogenous source of volatility. The volatility formed in the share prices is purely a consequence of the accounting norm rather than any underlying fundamentals. Therefore Plantin et al bring the shortcomings of fair value to attention by clarifying that simply moving to a mark to market regime without addressing the other imperfections in the financial system need not guarantee a welfare improvement. Demonstrating a different perspective on volatility Barth (2006) supports FVA firmly by clarifying that if financial statement amounts are based more on fair values, the amounts will change more from period to period as compared to in historical cost accounting. Fair values summarize the stream of expected cash flows, and scrutinises the recognised amounts such as net income and equity book value as well as individual line items in the balance sheet and income statement. The values recognised as per the FVA technique alter from period to period leading to increased volatility conversely in prudence accounting the recognised value and the volatility factor hardly show any variations. Advocating FVA Barth indicates that historical cost based amounts may be less volatile but that is the result of masking underlying economic volatility and not the result of superior financial reporting.

Michel Magnan (January 2009) does focuses on the question ‘Did FAV play a role in the current financial crisis’ and the criticisms raised against FAV directing that the accounting judgment is based on unreliable assumptions or hypotheses and provides management with too much discretion into the preparation of financial statements. Magnan disagrees to these criticisms and proposes that the theoretical and empirical premises of FVA are relatively solid, being one of the few accounting standard that can be traced back directly to accounting based scientific research. The empirical evidence over the past 20 years explicates that a firm’s stock price is more closely associated with the market value of its underlying financial or real assets than with their historical cost therefore the superior relevance of market derived values is even more obvious in the case of financial derivatives which historical cost is often close to zero but which market value can fluctuate widely. Adding to the value relevance of the method, FVA affects the role of accountants in the preparation of financial statements as prudence accounting technique are squarely under the control of the accountants whereas FVA derived assets and liabilities often require the expertise of other professionals such as actuaries, valuation experts with accountants being more likely to play a secondary role. As a result the mark to market values have been found to be more relevant indicators of firm value than traditional historical cost based figures. From a different perspective Magnan suggest that FVA can not only be a messenger but also a contributor as the information provided is highly volatile and unstable. For example, during the crisis the mark to market figures have shown a fluctuation of 5-10% in the stock market based assets hence according to the values a firm may be solvent one day assuming a large stock market gain, insolvent the next two days responding the stock market losses and solvent again on the fourth day. For that reason the reliance on FVA based information may have two opposite implications regarding the length and the severity of the current crisis. Keeping all the criticisms and charges against FVA Matherat (2008) contributes his view explaining that in the course of the last few years as long as the market was in its bullish phase no one was too shocked by fair value accounting be they politicians or the management. Market to market technique started to stigmatised when the market began to decline, because neither regulators nor banks welcomed the reflection of the market downturns in the bank’s balance sheets. Matherat blames credit institutions for granting loans on poor quality criteria and the loans been used in complex operations that were poorly securitised.

Aubin and Gil (2003) demonstrate a biased view towards FVA underlining that the application of fair value to the banking sector leads to a great heterogeneity in the content of the balance sheets of banking groups and the computation of their results. They highlight the fact that accounting rules do not translate the reality of bank’s management of assets and liabilities which is aimed at protecting themselves from variations in rates and not at netting off the variations in value of the financial instruments concerned.

Monitoring the current situation and the haphazard measures been proposed by the politicians all over the world Gavin Hinks and David Jetuah (October 2008) suggest that having a knee-jerk reaction to try and change the accounting rules seems like an inappropriate way to treat something that has taken years to establish (fair value reforms). The irrational comments issued about suspending FVA by European leaders such as the French President Nicholas Sarkozy and Gordon Brown indicates that politicians know even less about accounting than the rest of the world. Hinks et al explain further that FVA accounting works perfectly fine when the assets are not so risky or when the risk are mitigated by hedging. The majority of accountants working in a blue chip treasury department where all the risk are calculated and mitigated are dumbfounded by the suggestion of suspending fair value accounting.

Scrutinizing the ongoing crisis the two worst hit industries in this turmoil have been banking real estate. Danbolt and Rees (July 2008) have experimented on the British real estate and investment fund industries to compare the two diverse methods of accounting. Both the industries have majority of their assets marked to market and hence the difference between the two accounting systems should be profound. The main factors to distinguish between the two methods are relevance, bias and reliability. The results signify FVA is considerably more value relevant than prudence accounting. Furthermore, FVA for real estate sample is considerably less value relevant as compared to the investment companies hence confirming that fair values are highly relevant and largely unbiased where the values are unambiguous. Extending the analysis further if the valuations are ambiguous as they were in the current crisis value relevance will be lower and biased accounting may be revealed.

The current crisis exposed weakness in the application of accounting standards and gaps associated in the regulatory system. Caruna and Pazarbasioglu, 2008 illustrate that during the upturn the revaluation of assets build up of booking unrealised gains and obscured risk exposures taken by financial institutions. But as the cycle has turned downwards the uncertainties in the value of assets may lead to negative dynamics that may exaggerate the trough of the cycle. The concern raised by the investors is does mark to market provides the necessary objective representation or contributes to mispricing of risk during upturns and injecting artificial risk during downturns. They further suggest that changing the accounting standards at the height of the crisis would risk adversely impacting investor confidence. FVA is the directions that need to be followed but there is a need to revisit the implications of accounting standards. Allen and Carletti (October 2008) do favour mark to market accounting but have different perspective about the accounting methods. They have the same opinion as Caruna and Pazarbasioglu, 2008 that market prices provide the best estimate of value available but the circumstances where in market prices do reflect future earning power and those where market imperfections imply they do not stand to be fair. Mark to market works well and reflects the true underlying situation most of the time however in crisis times when there is a shortage of liquidity, mark to market values do not reflect future earning power and cannot be used to assess the solvency of financial institutions. For example the current crisis the market prices are driven by liquidity provision incentives and not fundamental values. In such circumstances historic cost accounting can provide a better indication of true value. Therefore Allen et al propose that during the times of crisis and meltdowns when model based valuations based on plausible assumptions differ by more than 5% (for example) both types of accounting methods should be implemented as it will signal to the users of information that they need to be careful to identify what is going on in the markets. They finally recommend that the proposed technique may not be a perfect system but it is practical and can be an improvement over the current one.

Historical versus Fair Value Accounting

Historical cost accounting measures financial assets and liabilities at their cost or origination value. This leads to inefficiencies as adjustments are not made for subsequent changes in the market value. For example the value of an asset throughout the business cycle, during the upturn the historical cost valuation may lead to an undervaluation of an asset conversely during the downturn the asset may be overvalued (Caruna and Pazarbasioglu, 2008).

Similarly considering the value of an asset throughout the business cycle under the fair value accounting technique, marking to market assumes the financial markets are efficient and provide with the accurate valuations from period to period. Under normal circumstances FVA should meet its objective of providing information about a bank’s true risk profile and promote market discipline. Nevertheless markets are subject to uncertainties and cyclical changes that overshoot the underlying value of an asset bith during upturns and downturns (Caruna and Pazarbasioglu, 2008). With the help of graphic representation it can be illustrated that in the upturn, asset price bubbles may be started by excess liquidity in the markets which may lead to procyclical and self enforcing write ups hence increasing the bank profits.

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