04 06 08 Credit Crisis Accounting
You've probably read quite a bit of ink on how accounting rules have had a large effect on the size and timing of losses at many financial firms this year, in many cases forcing these same firms to raise new capital at generally unfavorable rates. In the past, most firms owning bonds or other financial instruments with the intent to hold a significant period of time, generally until maturity, have been able to 'value' these assets at their original historical cost - regardless of the current market price. However, the accountancy boards have recently shifted gears and deem this as no longer acceptable, in particular for impaired assets, and now suggest firms use mark to market valuation.On the face of it, mark to market valuation sounds like a reasonable approach to present fairly to investors and regulators the balance sheets of companies holding financial assets. Why should bonds bought at par but now trading at 90 be kept on the books at 100? What of certain asset backed and other more exotic securities which might now only be worth 10 or 20 cents to the dollar - according to available market prices? Conversely, if the intent is to hold to maturity, short of bankruptcy or default, the asset will return its full expected value, so why bother reporting gains and losses which will ultimately wash? And how does one accurately value securities which may have little or no secondary market trading? In some cases products are so specifically tailored for the buyer that there may be no other 'identical' security to look to for pricing guidance.
And these problems have acted as accelerant on the credit crisis. Dealers and other investors, fearing the worst, stopped bidding for CMOs and other hybrid securities which resulted in a price vacuum. Ultimately prices were quoted with extremely low bids while offers from sellers were significantly higher. Some were so low as to all but imply impending default. But what about those holding securities in inventory or investment accounts? What should they use to mark to market their holdings? The accountants say you must still use what ever market price is available, however unrealistic that price may be. The subsequent unrealized losses were huge - tens of billions of dollars in some cases and some firms felt pressed to raise more capital either for immediate liquidity needs or to satisfy regulators or rating agencies. This was a decidedly poor outcome of mark to market accounting and exposed to to be just as imperfect as historical cost basis when trying to value illiquid securities.
A battle is going on right now between those who wish to keep the mark to market method and those who wish to go back to the historical cost approach. Of course, there is posturing by those who benefit most from each method (either directly or through damage to a competitor). We would like to propose a better way which attempts to strike a balance between the two methods: amortizing the gains/losses from mark to market valuation over the expected holding period of the underlying assets. Should the securities be sold prior to this date, all remaining gain or loss must be realized immediately. Footnotes can be added to financial statements showing expected amortization schedules to provide investors a complete picture of the firms portfolio risk while avoiding the crash and burn of the current system. Losses would be more manageable as they are realized gradually over a period of time and the need to raise capital could be reduced or even eliminated. Also eliminated would be the negative feedback loop of firesales of portfolio holdings to raise cash and/or eliminate risk. Certainly this is a better approach than naive mark to market or historical cost accounting?
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