Understanding the mark-to-market meltdown

The accounting farce that’s gone beyond a joke

INSURANCE GROUP AIG, UK mortgage lender Bradford & Bingley, and wealth manager and investment bank Credit Suisse would at first glance have little in common except that they fall under the broad bracket of ‘financial institutions’.

But in the space of a few days in February, the firms found themselves in similar – and uncomfortable – situations.

First, Bradford & Bingley’s management – already fending off speculation that it would be the next UK lender to fail after Northern Rock – announced write-downs of more than £250 million ($500 million) on a range of SIVs, CDOs and hedging instruments. It made it clear that it did not agree with the accounting treatment of these securities insisted upon by its auditor.

Then AIG raised estimated losses on mortgage-related instruments from $1 billion to $5 billion. PricewaterhouseCoopers claimed that there was a "material weakness" in the way that the insurer valued its exposure. Euromoney understands that the auditors forced AIG to mark to market at valuations provided by a US investment bank. AIG fought back, saying that the firm did not expect to realize many of the losses.

A week later, Credit Suisse was in the hugely embarrassing position of having to call an emergency press conference to reveal a $1 billion hit to its first-quarter profits, just a few days after telling investors at its full-year 2007 results presentation that the bank had survived the credit crunch largely unscathed. Chief executive Brady Dougan said that the value of mortgage-backed bond investments had been inflated by $2.85 billion. It was not yet clear whether the mis-marking had been a genuine mistake or a result of manipulation by traders.

Transparency clouds the issues

All three incidents – and many more before them, as well as the many more certainly to come – show that the present crisis in financial markets is not just about actual credit losses. Financial institutions and their accountants are having to learn the full impact of new accounting regulations in the midst of the biggest market dislocation in a generation. So far, they are not coping well. Attempts to improve transparency often leave investors even more baffled (see "There must be a better way than this", Euromoney, February 2008, page 14). For many firms with exposure to the credit markets, mark to market is becoming almost as unpopular a term as sub-prime.

Marking to market when no real market exists can seem nonsensical, especially when the asset is performing. Far from helping to make markets more efficient, it amplifies problems.

Even if detailed disclosure of assets and liabilities is appropriate for complex financial institutions, it seems that the present framework for doing so brings much financial reporting into disrepute. Until the current regime, auditors were able to use their discretion and accept far greater flexibility.

A lack of consistency, where some banks appear able to take different approaches to marking to market, doesn’t help. It might require another system, where reporters temporarily ignore profit and loss – or at least their auditors issue heavy caveats – to stop the cycle of destruction.

Instead of investors gaining comfort from banks unveiling huge market-to-market losses, they expect more around the corner. Yet many of these reported losses and write-downs are mostly not yet actual, realized losses. They are just a set of numbers thrown up by a set of audit rules that insist on valuing assets at any market levels, even in the absence of normal market conditions.

The calls made last summer for transparency on the scale of sub-prime losses issued by central bankers and politicians are increasingly being met, but there are few signs that it is doing anybody any good. In any case, the policymakers were wasting their breath – transparency was on its way, most pertinently in the form of Financial Accounting Standard 157, otherwise termed fair value measurements. It might sound like dull, dry accounting terminology, best left to those with a penchant for scouring banks’ balance sheets, but this innocuous-sounding rule has inadvertently wreaked havoc.

Hundreds of billions of dollars have been written off. How much is because of the new regulations is not yet clear. Because of their intricate nature and the backdrop of extreme volatility, it is even more difficult, nigh-on impossible, to compare one institution against another – even if they are both governed under US GAAP. As for trying to meaningfully compare a FAS157 user with other institutions that report using International Financial Reporting Standards, forget it. Although for several years, European IFRS users have had the equivalent to FAS157 in the form of International Accounting Standard 39, it doesn’t have the same prescriptive approach.

Aside from difficulties surrounding peer group comparison, the most worrying development has been the emerging downward spiral that starts with falling valuations, leading to write-downs and emergency capital raisings, and is followed by wider credit spreads – which of course forms the basis for lower valuations. Market participants expect that mark-to-market losses will, as night follows day, be followed by yet more losses.

"The size and speed of write-downs is materially different from previous situations where we have seen deterioration in the financial markets," says Tom Garside, global head of finance and head of risk at consultants Oliver Wyman. "The big debate is over the degree that it is truly helpful or actually amplifies the [downward] cycle. I don’t think there is a clear answer on that."

And what exactly is being measured? In truth, these are projections of future losses derived from prices made in illiquid, poorly functioning markets. It has led to some managements vainly insisting that things are not as bad as made out by the numbers laid out in their books.