International Financial Reporting Standards (IFRS)

Financial Crisis and Fair Value Accounting

Dr. Georgios Georgakopoulos, M1.05 g.georgakopoulos@uva.nl

Financial crisis
Origins: performance of subprime mortgages in the US Results:
Liquidity virtually disappeared from important markets Stock markets plunged Triggered a wave of bailouts Many economies slipped into recession September 2007, total write-offs $760 billion October 2008, total loss prediction by IMF $1.4 trillion

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Current financial crisis in figures

Total volume of non-prime mortgage-backed securities $1.1 trillion
Almost as much as total assets of Allianz SE About 2.5% of total private wealth in the US

Total losses due to mortgage-backed securities $500 billion

Savings and loans crisis 1980ies estimated losses $600-800 billion Collapse of the internet bubble NASDAQ declined from $5.2 trillion in 1999 to $3.6 trillion in 2000 (=$1,600 trillion)

Why did the subprime-mortgage crisis bring down the whole financial system and economy? What explains the difference? Fair value accounting?
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Fair value accounting to blame?

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...or not to blame?

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Benefits of fair value accounting or who could be against fair value?

Investors are concerned with value, not costs With the passage of time historic costs are irrelevant Fair values report economic substance Fair value is market based:
Not affected by firm specific factors Unbiased not reliant on accounting subjectivity Consistent from period to period Obviously more relevant and necessary for efficient markets! A basis for management compensation Increased verifiability for auditors and regulators
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Fair value accounting aims to improve financial reporting

Best suits conceptual framework (Barth 2007) Relevant and transparent accounting numbers Landsman (2007, 20) disclosed and recognized fair values are informative to investors Mitigate the use of accounting-motivated transaction structuring and earnings management (Landsman 2007) Aboody et al. (1999) predictive ability for future changes in profitability and cash from operations Decision making: timely information is beneficial in corporate governance and can trigger prompt corrective actions (Ball/Shivakumar 2005)

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Timeliness of financial reporting: Case of S&L crisis

Savings and loans crisis in the US Estimated losses $600-800 billion In the 1980-81 about 2/3 of savings and loans institutions were technically insolvent Assets: mortgages to homeowners provided in the 1960ies, maturities ~40 years, fixed rates ~6%. Liabilities: deposits, interest 10% Historical cost accounting the full extent of the problem was not recognized The cleanup in the late 1980ies when the problems became apparent was very costly
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Example: A Zombie bank from 1985

Historical cost Balance sheet Mortgage assets (6%) 1,000 Equity Liabilities: deposits (10%) 75 925 Balance sheet Mortgage assets (6%) 784

Revaluation highlights the true extent of the problems

If fair value accounting is applied

Equity Liabilities: deposits (10%)

-166 950

Income statement Interest income Interest expense Net income 60 95 -25

Problems are visible only in the income statement

Income statement Interest income Interest expense Revaluation of financial assets Net income 60 95 216 -241
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Case analysis (I)

Under historical cost accounting problems hit only income Under fair value accounting mortgages are revalued downwards to reflect current market rates (say, 12%) Equity shows that the bank is insolvent, and that business model is not sound Timely reporting using fair values would have triggered intervention much earlier

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Case analysis (II)

Could fair value accounting during the current crisis reveal the true extend of the problems? If all companies would report risk exposure on a timely basis, could we avoid mistrust between banks?

But: The opponents suggest that timeliness worked differently during current financial crisis

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Disadvantages of fair value accounting Fair value hierarchy

Active quoted liquid market prices (m-2-market) Quoted or observable available to the public Either HC, buying prices, exit prices (IASB 2006) If no active market (m-2-market/model) Similar transactions, derived from above prices Other measurement techniques (or m-2-model) Present value of future cash flows (earnings) Multiples of variables (P/E, BV/E, etc. etc.) Option pricing models
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Problems with mark-to-market accounting

May lead to increased noise in accounting numbers defer attention from firm core earnings and reduce the ability to uncover long-run performance (O'Hanlon/Pope 1999; Stark 1997) bring bubble prices into financial statements, and fail to serve as an anchor of firm performance (Penman 2003) introduce excess volatility into financial statements (Penman 2007; Plantin et al. 2008) mix measurement systems and different income components (e.g., mixing capital increments and operating income components) (Cooper 2007; Goncharov/Hodgson 2008)

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Accounting as anchor of firm performance

Long Run Return on Historic Cost Equity (ROE) = Net Income/ Shareholders equity On average over long periods = 11-13% Long run return on the stock market = 12% But do returns (and rewards) in booms behave badly?

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Prices and Fundamentals UK 90-2005

UK PRICE, EARNINGS, DIVIDENDS, CASH FLOW
3,5

This boom was not supported by the earnings, cash flow and dividend fundamentals for the UK. The market rose 300% and the fundamentals 100%

2,5

INDEX EARNINGS DIVIDENDS

1,5

CASH FLOW

0,5

0 1 22 43 64 85 106 127 148 169 190 211 232 253 274 295 316 337 358 379 400 421 442 463 484 505 526 547 568 589 610 631 652 673 694 715

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UK 1965-1970
65-70 UK
3

This is not new. Many other instances are obvious in the last 40 years for example the late sixties in the UK.

2.5

What is this?
2

INDEX 1.5 EARNINGS

0.5

0 1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121 129 137 145 153 161 169 177 185 193 201 209 217 225 233 241 249 257 265 273 281

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Accounting in boom periods

Fair value accounting can incorporate bubble prices into financial statements Lead to inefficient actions (e.g., paying out excessive compensation) Accounting fails to serve as an anchor and reveal existence of the bubble What if markets are overly pessimistic? Current crisis: The estimates of $450-500 billion of losses on $1.1 trillion of outstanding mortgage-backed securities correspond to average loss rates of 40-45% (Hellwig 2008) The actual average decline of US residential real-estate prices in 2008 was 19%
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Excess volatility
Fair values accounting forces to quickly acknowledge adverse developments and to take corrective actions without undue delay (Hellwig 2008) Necessary to exert market discipline to correct Appropriate if the bank wants to hold to maturity? Write-offs will force a bank to take corrective actions As write-offs decrease equity, corrective actions are likely to involve some deleveraging, i.e. some sale of assets to reduce leverage If the assets in question are the very assets for which markets are not functioning, the book losses turn into real losses These losses would have not been there under historical cost model Corrective actions themselves will feed back into the financial system Selling leads to further selling etc etc etc

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Additional concerns with mark-to-model

The reliability criterion prevents fair value accounting from providing relevant information for non-quoted assets (Hitz 2007; Ramanna/Watts 2008) Mark-to-myth (Buffett 2003) Loss of informativeness Hide true problems during the crisis?

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Neutral
Previous slides implicitly assume that measurement issues (e.g., reliance on fair value accounting) affect economic behaviour Is it so? Scant empirical evidence: only several studies were able to document an effect (Beatty 2007) Little evidence: Not interesting? Or no results to publish? Fair value accounting merely reflects real problems (Veron 2008) The markets react positive to write-downs (UBS: write-down - $19 bil.; share price increased by 15%) Blaming it on fair value accounting is akin to killing the messenger
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SEC 2008 findings

SEC examined the role of fair value accounting during financial crisis Fair value measurements were used to measure a minority of the assets (45%) and liabilities(15%)

Percentage of assets for which changes in fair value affected income was significantly less (25%) Fair value measurements did significantly affect financial institutions reported income
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But.....
Fair value and mark-to-market accounting do not appear to be the cause of bank and other financial institution failures Rather than a crisis precipitated by fair value accounting, the crisis was a run on the bank Interesting they looked at impairments as a cause of the bubble bursting....not the initial write ups! Recommendation: General-purpose financial reporting should not be revised to meet the needs of other parties if doing so would compromise the needs of investors

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