One of the feats of modern finance has been to turn hard assets, such as real estate, into financial ones. This would have been impossible without the use of complex modelling. However, the whole concept is now under pressure, and not just because of the mistakes made in securitizing mortgage loan pools and resecuritizing residential mortgage-backed securities into collateralized debt obligations.
Part of the beauty of this system was that because these securities were afforded high credit ratings, they were tradable and therefore relatively liquid. But the models and ratings were wrong, liquidity has disappeared and prices on assets that were once easily marked are now opaque.
This is now contributing to problems in marking credit books. Investment banks should provide regular marks on the risks they have on their balance sheets. But how can this be done in a way that does not do an injustice to shareholders?
Marking everything that is complex down to zero, because markets are illiquid, does not seem to be a particularly equitable or sensible way of going about things. And that’s before you even consider the way the marking malaise is contributing to systemic risk.
The financial system is always prone to periods of market stress and panic. The extent to which one accounting system or regulatory regime makes things better or worse is hard to gauge fully without the benefit of hindsight. But it seems clear that the present system is contributing to the speed – if not the scale – of write-downs.
After Enron and Parmalat, no one can comfortably argue for reduced disclosure of financial institutions’ assets and liabilities. Nevertheless what is happening at present is giving the accounting process a bad name.
What happens when two-way flows for credit return? Windfall gains for those in charge – and those shareholders brave enough to have stayed the course, or who bought their stakes at rock bottom prices – it seems.
Had the new accounting rules come a year or so earlier, it might have been different (see Understanding the mark-to-market meltdown). There would have been greater investor and analyst understanding and, most important, settled markets during which bank CFOs and auditors would have edged towards a consensual format of reporting. There would have been recognition of those pursuing best practice and the climate of fear that now surrounds financial institutions might not exist.
There is an understandable tension between having a reliable, simple model that is easily understood – whereby senior management and the users of financial statements can get a straightforward view on the implications of credit decisions – and having the ability to get a true understanding of the economics of complex structures.
The dislocation in the financial markets is a function of price opacity and the regulatory/accounting regime. It is impossible to get away from price opacity – exploiting such arbitrages is how investment banking operates. Calls for greater transparency are understandable but miss the key point – what is really needed is more understanding.
A lot of the problems that have emerged recently are a function of reduced trust between auditors and their clients, hedge funds and their prime brokers, and between shareholders and their companies.
Regulators such as Iosco have called for greater involvement of third parties for valuing hedge fund credit portfolios. Third parties could have a role to play in verifying valuations of banks and insurance companies too.
Sometimes a modelled price – one that is independently verified – is a better, and more accurate one than the market’s. It might seem cute, or convenient, to propose that in stressed markets financial statements based on real cashflows should have greater relevance than profit-and-loss numbers. Furthermore, such measures would increase the detail in accounts. And yet it should be possible for modern accounting and banking practice to ensure that there is clarity over the prices of complex securities.