Mark-to-market accounting exacerbates the crisis
5 – Wealth – 1
THE enduring crisis in financial markets has brought to everyday use words such as “sub-prime”, “toxic assets”, “securitisation” and “wholesale funding”.
“Mark-to-market accounting” will soon join this list. Mark-to-market accounting did not cause the credit crisis — which reflects excessive lending and the earlier neglect of risk — but it has exacerbated it. And changes to this accounting standard are likely to play a small role in easing the grip from tight credit.
In mark-to-market accounting, a wide range of assets (and some liabilities) are valued at their current market prices.
Where the market prices of loans or securities decline, the value of these assets in the accounts of financial institutions, managed funds and hedge funds has to be written down — reducing profits and shrinking their capital bases.
In normal times, mark-to-market accounting operates reasonably well. During a financial crisis, however, the market prices for some loans and securities — even those with little risk on their interest payments or repayments of principal — can plunge because of a few transactions in an illiquid market.
In turn, the value of quality securities, including corporate debt or mortgage securities that carry AAA-ratings, has to be written down in the balance sheets of the financial institutions and funds that hold them — even though there is little risk of loss when the loans or securities mature. The Bank for International Settlements — often called the central bank for central banks — has suggested that the existing accounting standard could be overstating the expected losses on AAA-rated sub-prime mortgage securities by as more than 50 per cent.
The Bridgewater group, a US fund manager, warns that “ending the credit crisis will be highly unlikely without some type of accounting accommodation”.
“Because mark-to-market accounting on existing assets threatens bank capital today, it increases solvency concerns today, which raises funding costs and accelerates the need to sell assets today, this depresses the prices of those assets, which threatens capital and raises funding costs.”
As part of its recent package of measures to address the credit crisis, the US Congress has insisted on an early review of mark-to-market accounting.
Of course, the main action to alleviate the credit crisis will still have to come from the huge rescue package announced recently in the US, from further moves by European authorities to support strained banks, and from other central banks making bold cuts to their interest rates — as the Reserve Bank did last week.
But a change in accounting standards that avoided the shortcomings of mark-to-market but that still preserved the integrity of financial accounts would present a less magnified dimension to the woes facing investment markets — and make some contribution towards reviving credit flows, which are disastrously constrained.
An understanding of how the accounting standards require loans and securities to be valued in the balance sheets of banks and other financiers also helps in any assessment of how much, in the end, the recently announced bailout of US banks and other lenders will cost the US taxpayer.
The US Treasury, which can borrow at interest rates of 2 per cent on medium-dated securities, is likely to be able to buy distressed assets at prices above the levels at which they are currently recorded on the books of banks and other financial institutions and earn a reasonable return on them — and even show a small profit — as the loans mature.
Nearer to home, there’s an effect from mark-to-market accounting that applies to many Australian investors. A number of managed funds that invest in corporate bonds and other interest-bearing securities, and which are soundly managed, have had to reduce their unit prices for two reasons.
One is that the market prices have dropped for some of their quality, but illiquid, investments, particularly when the funds were selling investments to finance withdrawals.
Also, market prices declined on their holdings of quality non-government securities as interest rates on these securities rose relative to those paid on government securities.
Bonds and mortgages on which there is no default must eventually rise back to their pre-determined values.
As Warren Bird of Colonial First State Global Asset Management likes to put it, a bond that falls in value from say 100 cents in the dollar to 95c hasn’t permanently lost 5c; anyone who holds, or invests in, that bond after it has fallen in price to 95c will eventually see that 5c gain as part of their total return. (In technical language, they will receive the coupon interest payments as scheduled plus the amortisation of the bond to its termination value.)
Investors can expect a recovery in the return on managed funds that hold quality corporate bonds and mortgage-backed securities, as these assets close in on their maturity dates. Mark-to-market accounting might at times be viewed as arcane, but it’s important in several ways that matter.
Dr Stammer chairs and the Investment Committee of INGIM’s Portfolio Solution Group. The views are his alone.