Monday, March 10, 2008

Mark-to-Market Accounting

The Globe and Mail, Tara Perkins, 10 March 2008

An international committee is considering the need for a major review of accounting standards and hopes to quickly make recommendations that will help financial institutions put more accurate values on their massive portfolios of subprime-related investments.

While there's no shortage of areas that need to be reviewed in the wake of the credit crunch - from risk management to ratings to compensation - the most important issue to be dealt with in the short run is how financial institutions value their portfolios, namely marking them to market, said Rick Waugh, the chief executive officer of Bank of Nova Scotia. Mr. Waugh is also co-chairing the Institute of International Finance's committee on market best practices.

The IIF is an association of more than 375 financial institutions, and Mr. Waugh's committee is preparing a report laying out suggestions for the sector in the wake of the turmoil that erupted in August.

Accounting rules require banks and other financial firms to regularly place a value on portfolios of complicated investments, including collateralized debt obligations and other structured securities.

Increasingly, the investments are valued by marking them to market - regularly establishing what their value would be in the market, and marking them up or down accordingly.

It's very different from the days when banks were contending with portfolios of assets such as real estate that were relatively easy to put a price on, Mr. Waugh noted in an interview this weekend.

"We've moved into an era of mark-to-market on balance sheets," he said. "That works, as long as there's good liquidity."

But liquidity has dried up since August and many of these complex securities are not actively traded. With few investors buying them, their market prices are difficult to establish. And the price that they might fetch in the market now could be dramatically different from what they might fetch when liquidity returns.

The fear is that the prices banks are marking their portfolios at don't reflect their actual values. "They're obligated to put a price on, but the fair value may be much different than the market value," Mr. Waugh said.

The continuing revaluation of portfolios has become "quite worrisome," he said, adding that he doesn't see the end in sight yet.

It's no small issue, considering that global banks have already written down more than $150-billion in subprime-related holdings and bad debt.

Royal Bank of Canada [RY-T] chief executive officer Gordon Nixon blames recent mark-to-market accounting rules for much of the volatility in bank earnings these days.

"One of the challenges with the accounting rules - and it's been compounded by the mark-to-market rules that have come into place over the last year or so - is that some of this volatility is a result of mark-to-market, as opposed to as a result of a permanent impairment, which is more traditional from a banking perspective," he said.

"If we lend money to a company, and that company is downgraded, the value of our loan goes down, but there's no mark-to-market writedown on that loan because the assumption is that, ultimately, you get that money back. And if there's ever permanent impairment, then you take a writedown."

But the mark-to-market rules mean that many of the complicated debt securities that have been created in the past decade are being written down long before it's clear how much they will ultimately be worth to the bank. "Even on what are potentially good long-term assets, the mark-to-market rules do create balance sheet and income statement volatility," Mr. Nixon said. "And I think that's compounding the problem."

Globally, the paper value of hundreds of billions of dollars worth of holdings are in question.

One possibility is that some of the securities that banks have been writing down will turn out to be worth more than the value they've been given, resulting in gains in coming quarters.

But many could also turn out to be worth less, adding to the long string of continual writedowns that has been troubling the markets.

Royal Bank's earnings, for instance, were hit by $430-million of writedowns in its most recent quarter. Asked whether those had come to an end, Mr. Nixon said "it could go higher, it could go the other way."

Mr. Waugh has just returned from the IIF's conference in Rio de Janeiro, where its chairman Josef Ackerman (who also heads Deutsche Bank) said banks need a stronger framework around valuation processes. Mr. Waugh's committee is "looking at the possible need for a broad review of accounting standards at the highest levels," Mr. Ackerman said.