Facts are the enemy of the truth

August 20, 2009

The quote above from Cervantes is eerily accurate when it comes to this op-ed piece from FT. Merton a Noble prize winning economist, a director at LTCM writes

Banks and other financial institutions are lobbying against fair-value accountingfor their asset holdings. They claim many of their assets are not impaired, that they intend to hold them to maturity anyway and that recent transaction prices reflect distressed sales into an illiquid market, not what the assets are actually worth.


A bank typically argues that a mortgage loan for which it continues to receive regular monthly payments is not impaired and does not need to be written down. A potential purchaser of the loan, however, is unlikely to value it at its origination value. The purchaser calculates a loan-to-value ratio using the current, much lower value of the house. After calculating the likelihood of default, the potential buyer works out a price balancing the risk of default and amount that might be lost – a price well below the carrying value on the bank’s books.

But this is true for any business. There are two types of assets in any business, current assests and Fixed assets. Fixed assets are used for generating income while current assets are what the business buys and sells in it’s day-to-day operations. Obviously in the case of FIs the line blurs between Fixed Assets and Trading Inventory but as long as the management and auditors are scruplous about keeping the two sets separate and report it in their accounts clearly ther should not be any issues. This is simply Acounting 101.

The fetish for mark-to-market accounting is simply idiotic. Most of the people pushing it seem to be economists who do not seem to understand that simply reflecting asset values on a particular day when books are closed is not necessarily a more truthful account of the affairs of a business. Let’s assume I have a business making widgets and I have a widget maker which I bought for $100. Obviously if I tried to go out and sell the widget maker I wouldn’t get $100 dollars for it. I might only get $50 for it, that doesn’t mean that I write down the value in my books to $50. What I have is a Depreciation schedule which says how many years I expect to use the Asset there are usually standard rules on marking down the value, sometimes dictated by Revenue Authorities, sometimes by industry practice. Which is why companies reports EBIDTA, so the investors get a sense of operating capability of the company.

Accounts are drawn up on a Ongoing Business basis and not on the basis that everything would be liquidated on that day. Values like that may be factually accurate but they are not anywhere close being true. An auditors job is to ensure that accounts are true and fair and not just factually correct.  As the authors note

Obtaining fair-value estimates for complex pools of asset-backed securities, of course, is not trivial.

No number of external experts can validate complex assest values. The right thing to do is to not let banks speculate and if they are speculating to clearly lay it out in the accounts, that this is speculation income, just like it is done in the case of businesses which have windfalls from Forex or Assest sales. It should not be reported as part of operating income of a bank. It’s as simple as that.


Mark-to-Market for Assets – Normal & Financial

March 14, 2009

John Gapper FT’s Business Editor writes

However, just as an exercise, imagine what it would be like if all homeowners were forced to mark to market the value of their homes, and post cash collateral in cases of negative equity.


Of course, households are not banks and do not have shareholders and bondholders, so there is probably no good reason for them to mark to market their assets. Still, it makes you think.

What is wrong with this is that it doesn’t matter if households have shareholder or not, actually they very much do have at the least stakeholders, people who are part of the household.

The key determinant of marking an asset to current prices or cost which ever is lower, is whether the asset is used as a trading asset or is it a holding asset. Businesses do not mark to market their plant & machinery, furniture or office buildings as long as they are not trading in these things. If a business buys and sells houses then they would mark-to-market if the house prices fall, else they would simply keep it at cost at which it took to acquire the inventory.

The obvious problem with Financial Assets is that their cost price especially for complex options, derivatives etc is essentially a combination of market prices and the model used for valuation. This gives unrealised gains and losses for these assets which can be huge.

The key to solving this is to go back to basics, look at the point of time when the asset was created and simply treat that as the cost of the asset, banks should not be allowed to take profits if prices move up unless they actually sell the asset, but they should have to write-down the value if the prices fall.

This will create a natural disincentive to creating complex products where the financial institutions cannot realise the gains without actually selling the asset, but would take losses if prices fall.

Mark-to-Market Accounting and Investors Due Diligence

February 11, 2009

There is a rant in today’s FT by Willem Buiter on Barclay’s Annual Results reported in FT and he picks up a specific quote

“The bank confirmed it had written down its exposures to complex debt instruments by £8bn in 2008, though the impact was reduced by a £1.66bn gain it booked from the reduced value of its own debt.”

He writes

With very few exceptions, banks now use every means at their disposal to hide financial embarrassments on of off the balance sheet for as long as possible.  Rigorous mark-to-market valuation without managerial discretion as to whether to shift assets from one valuation bucket to another is a partial solution.  Unfortunately, the IASB lost first its nerve and then the plot in response to pressure from those exposed to toxic and dodgy assets.  Banks can now drive a coach and horses through fair value principles and release what information they want when they want it.

This approach seems to be a classic case of shooting the messenger. MTM is not to blame for the losses the shareholders are making. The gains being counted are perfectly legitimate for accounting and tax regulatory reasons.

The Annual Report clearly states that there is a gain of 1.66 billion from reduced value of own debt. They have not tried to hide it. All businesses have areas where a gain or loss happens not because of business operations but rather because of a change in external environment. Like Airlines losing due to sudden spike in Oil prices, Indian Exporters gaining from weakening of the Rupee Vs. the dollar.

The responsibility of the business and the auditor is to clearly highlight that there have been extraordinary gains or losses made from events outside the normal scope of business operations.

Of course in case of FI whose profits are primarily based on proprietary trading sorting out ordinary from extra-ordinary events becomes difficult, but again it’s the responsibility of the investor to appropriately discount the profits. Instead of having a P/E ratio of 30 he may decide to forgo investing in such risky investments.

As they say caveat emptor!