realitybase - Journal

This report about Royal Bank of Scotland, which was permitted by a change in international accounting rules not to write down certain assets to market value, suggests those who would do business with RBS know the problems are still there no matter what the financial statements say.

Under US and international accounting rules, financial institutions are required to consider writing up or writing down the values of certain assets to reflect changes in market value. This is "fair value" or "mark-to-market" accounting. As the current credit crisis began to develop, markets for certain assets (e.g., mortgage backed securities, collateralized debt obligations, and credit default swaps) essentially disappeared as there were no buyers at all or buyers only at fire-sale prices of a few cents on the dollar. It is widely suspected that many financial institutions would be insolvent if they aggressively marked down assets to values for which they could actually be sold. This led to calls for mark-to-market accounting to be "suspended" and, naturally, the question of what valuation rules would apply during the suspension.

The International Accounting Standards Board issued a ruling that allowed RBS not to mark to market declines in value occurring after July 1, 2008. Apparently, this is done by reclassifying assets from tradable securities to "hold to maturity" status and then applying some different, but unexplained, valuation method. At least that's what RBS did. Apparently, there is some inhibition on selling hold-to-maturity securities when prices recover.

Is the alternative valuation method cost, face value, an estimate based on modeling, or perhaps just a SWAG? Presumably, that's explained in the footnotes to RBS's financial statements, but I don't care enough to dig into that, and maybe others don't either. It's just easier to make the judgment that the markets seem to have made—we're still worried about RBS's financial condition, so let's do business elsewhere.

Update on Monday, January 12, 2009 at 10:53PM by

Skeptic

Robert Waldman thinks a big use of credit default swaps ("CDSs") was not to transfer risk in a real and good faith way but to create plausible bases for not marking low quality assets to market. Such CDSs were issued by special purpose entities (remember Enron?) that would not be able to pay, but were substantial enough to satisfy the auditors.

I think a lot of this was done, that is, a lot of CDSs were totally fake CDSs which everyone knew wouldn't pay as promised if the insured instruments defaulted. I strongly suspect that a lot of CDSs were really MRSs, that is, a swap of mark to market risk, where one agent buys insurance against changes in the perceived probability of default on an instrument which hasn't defaulted yet, but not against actual default.

Update on Friday, March 13, 2009 at 08:47AM by

Skeptic

Floyd Norris reports that the mark-to-market rule was around a long time before FASB Rule 157 imposed some limits on management discretion about how to do it.

It is true, as the bankers argue, that valuing illiquid instruments is tricky. And it is true that markets can overshoot. Some of these securities may well be undervalued now. But the solution is not to go to what Robert H. Herz, the chairman of the Financial Accounting Standards Board, calls “mark-to-management” accounting.

I call it “Alice in Wonderland” accounting, after Humpty Dumpty’s claim in that book that “When I use a word, it means just what I choose it to mean, neither more nor less.” After Alice protests, he replies, “The question is, which is to be master — that’s all.”

Although you would not know it from the angry complaints, the accounting board’s Statement 157 did not require mark-to-market accounting. That was already required under earlier rules. What it did do was clarify how such values should be determined. That stopped banks from defining “market value” as meaning whatever they chose it to mean.

Conrad Hewitt, who was chief accountant at the Securities and Exchange Commission when it conducted a Congressionally mandated review of the issue late last year, said at a recent Pace University accounting forum that he asked all the complainers if they had a better way to determine market value than the one prescribed by Statement 157. None did.

Update on Tuesday, March 31, 2009 at 10:06AM by

Skeptic

Accounting statements are not just used by buyers—they are used perhaps even more by lenders. If a lender takes securities as collateral, which is common or even essential in this business, the only thing the lender wants to know about that collateral is its quick liquidation value. MTM shows approximately that, and hold-to-maturity value definitely is not that. Thanks to Richard Beales for the insight.