financial crisis and fair value accounting

7/30/2019 Financial Crisis and Fair Value Accounting

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Dr. Georgios Georgakopoulos, [email protected]

Financial Crisis and Fair Value Accounting

International Financial Reporting Standards

(IFRS)



Financial Instruments (II)

Financial crisis

Origins: performance of subprime mortgages in the US

Results:

Liquidity virtually disappeared from important markets Stock markets plunged

Triggered a wave of bailouts

Many economies slipped into recession

September 2007, total write-offs – $760 billion

October 2008, total loss prediction by IMF – $1.4 trillion




Current financial crisis in figures

Total volume of non-prime mortgage-backed securities – $1.1 trillion Almost as much as total assets of Allianz SE

About 2.5% of total private wealth in the US

Total losses due to mortgage-backed securities – $500 billion Savings and loans crisis 1980ies estimated losses – $600-800 billion

Collapse of the internet bubble – NASDAQ declined from $5.2 trillion in 1999to $3.6 trillion in 2000 (=$1,600 trillion)

Why did the subprime-mortgage crisis bring down the whole financialsystem and economy?

What explains the difference? Fair value accounting?




Fair value accounting to blame?




...or not to blame?




Benefits of fair value accounting or

who could be against “fair value”?

Investors are concerned with value, not costs

With the passage of time historic costs are irrelevant

Fair values report economic substance

Fair value is market based: Not affected by firm specific factors

Unbiased not reliant on accounting subjectivity

Consistent from period to period Obviously more ‘relevant’ and necessary for efficient markets!

A basis for management compensation

Increased verifiability for auditors and regulators




Fair value accounting aims to improve financial

reporting

Best suits conceptual framework (Barth 2007)

Relevant and transparent accounting numbers

Landsman (2007, 20) “…disclosed and recognized fair values areinformative to investors”

Mitigate the use of accounting-motivated transaction structuring andearnings management (Landsman 2007)

Aboody et al. (1999) predictive ability for future changes in profitabilityand cash from operations

Decision making: timely information is beneficial in corporategovernance and can trigger prompt corrective actions (Ball/Shivakumar 2005)




Timeliness of financial reporting: Case of S&L

crisis

Savings and loans crisis in the US

Estimated losses – $600-800 billion

In the 1980-81 about 2/3 of savings and loans institutions weretechnically insolvent

Assets: mortgages to homeowners provided in the 1960ies, maturities~40 years, fixed rates ~6%.

Liabilities: deposits, interest 10%

Historical cost accounting – the full extent of the problem was notrecognized

The “cleanup” in the late 1980ies – when the problems becameapparent – was very costly




Example: A “Zombie” bank from 1985

Historical cost If fair value accounting is applied

Balance sheet Balance sheet

Mortgageassets (6%)

1,000 Equity 75 Mortgageassets (6%)

784 Equity -166

Liabilities:deposits (10%)

925 Liabilities:deposits (10%)

950

Income statement Income statement

Interest income 60 Interest income 60

Interest expense 95 Interest expense 95

Net income -25 Revaluation of financial assets

216

Net income -241

Problems are

visible only in theincomestatement

Revaluationhighlights thetrue extent of theproblems




Case analysis (I)

Under historical cost accounting problems hit only income

Under fair value accounting mortgages are revalued

downwards to reflect current market rates (say, 12%) Equity shows that the bank is insolvent, and that business

model is not “sound”

Timely reporting using fair values would have triggered

intervention much earlier




Case analysis (II)

Could fair value accounting during the current crisis revealthe true extend of the problems?

If all companies would report risk exposure on a timelybasis, could we avoid mistrust between banks?

But: The opponents suggest that timeliness workeddifferently during current financial crisis




Disadvantages of fair value accounting

Fair value hierarchy

Active quoted liquid market prices (m-2-market) Quoted or observable available to the public Either HC, buying prices, exit prices (IASB 2006)

If no active market (m-2-market/model) Similar transactions, derived from above prices

Other measurement techniques (or m-2-model) Present value of future cash flows (earnings) Multiples of variables (P/E, BV/E, etc. etc.) Option pricing models




Problems with mark-to-market accounting

May lead to increased noise in accounting numbers

defer attention from firm ‘core’ earnings and reduce the ability touncover long-run performance (O'Hanlon/Pope 1999; Stark 1997)

bring bubble prices into financial statements, and fail to serve as an‘anchor’ of firm performance (Penman 2003)

introduce ‘excess’ volatility into financial statements (Penman 2007;Plantin et al. 2008)

mix measurement systems and different income components (e.g.,mixing capital increments and operating income components)

(Cooper 2007; Goncharov/Hodgson 2008)




Accounting as anchor of firm performance

Long Run Return on Historic Cost Equity (ROE) = NetIncome/ Shareholders’ equity

On average over long periods = 11-13%

Long run return on the stock market = 12%

But do returns (and rewards) in booms behave badly?




Prices and Fundamentals

UK 90-2005UK PRICE, EARNINGS, DIVIDENDS, CASH FLOW

0

0,5

1

1,5

2

2,5

3

3,5

INDEX

EARNINGS

DIVIDENDS

CASH FLOW

This boom was notsupported by the

earnings, cash flow anddividend fundamentals

for the UK. The marketrose 300% and thefundamentals 100%




UK 1965-1970

65-70 UK

0

0.5

1

1.5

2

2.5

3

INDEX

EARNINGS

This is not new. Manyother instances are

obvious in the last 40years – for example the

late sixties in the UK.

What is this?




Accounting in boom periods

Fair value accounting can incorporate bubble prices into financialstatements

Lead to inefficient actions (e.g., paying out excessive compensation)

Accounting fails to serve as an anchor and reveal existence of thebubble

What if markets are overly pessimistic?

Current crisis:

The estimates of $450-500 billion of losses on $1.1 trillion of outstanding mortgage-backed securities correspond to average lossrates of 40-45% (Hellwig 2008)

The actual average decline of US residential real-estate prices in2008 was 19%




‘Excess’ volatility

Fair values accounting forces to quickly acknowledge adverse developmentsand to take corrective actions without undue delay (Hellwig 2008)

Necessary to exert “market discipline” to correct

Appropriate if the bank wants to hold to maturity? Write-offs will force a bank to take corrective actions

As write-offs decrease equity, corrective actions are likely to involve somedeleveraging, i.e. some sale of assets to reduce leverage

If the assets in question are the very assets for which markets are notfunctioning, the book losses turn into real losses

These losses would have not been there under historical cost model

Corrective actions themselves will feed back into the financial system

Selling leads to further selling etc etc etc




Additional concerns with mark-to-model

The reliability criterion prevents fair value accounting fromproviding relevant information for non-quoted assets (Hitz2007; Ramanna/Watts 2008)

“Mark-to-myth” (Buffett 2003)

Loss of informativeness

Hide true problems during the crisis?




Neutral

Previous slides implicitly assume that measurement issues (e.g.,reliance on fair value accounting) affect economic behaviour

Is it so?

Scant empirical evidence: only several studies were able todocument an effect (Beatty 2007) Little evidence: Not interesting? Or no results to publish?

Fair value accounting merely reflects real problems (Veron 2008)

The markets react positive to write-downs (UBS: write-down - $19bil.; share price increased by 15%)

Blaming it on fair value accounting is akin to killing the messenger




SEC 2008 findings

SEC examined the role of fair value accounting during financial crisis

Fair value measurements were used

to measure a minority of the

assets (45%) and liabilities(15%)

Percentage of assets for which changes in fair value affected incomewas significantly less (25%)

Fair value measurements did significantly affect financial institutions’reported income




But.....

Fair value and mark-to-market accounting do not appear to be the“cause” of bank and other financial institution failures

Rather than a crisis precipitated by fair value accounting, the crisis

was a “run on the bank” Interesting they looked at impairments as a cause of the bubble

bursting....not the initial write ups!

Recommendation:

General-purpose financial reporting should not be revised to meetthe needs of other parties if doing so would compromise the needsof investors

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financial crisis and fair value accounting

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