Fair value of financial investments is a matter of debate in financial media, with opinions suggesting that reflecting it in accounting has worsened the credit crunch.
Providing investors with total transparency is essential for global capital markets to save turbulences and prevent future bubbles and economic disturbances.
At the heat of low interest rates numerous non-banking companies’ divisions arose in the business of high-risk mortgages, as General Electric, H&R Block and banking as British HSBC. At the same time traditional credit packagers as Fannie Mae, Freddie Mac and FHA (Federal Housing Administration) joined investment banks as Sear Steams and Merrill Lynch. In this way high-risk mortgages came to represent almost 40% of total mortgages in US by 2006 and the volume of new debt in this segment grew to 640 billion dollars, up from 150,000 in 2000, representing 12.7% of the entire residential mortgages market in the country.
With the rise of interest rates delinquencies in these mortgages reached maximums of four years and foreclosures increased to unprecedented levels by 2007. Specialized lenders as New Century Financial –the largest specialized entity- stopped trading at New York, called for bankruptcy protection and closed its credit unit, selling most of assets. The non-payment of the original mortgages caused need to created provisions in the balance of institutions with “packaged” debt to cover the loss of value, not only from defaults but also in higher credit rating segments, causing new market prices adjustments and provisions to cover foreseeable additional losses. Citigroup had to provision 22.1 billion dollars in related collaterals and other deteriorated assets, UBS 18.4 billion and HSBC 10.7. Result: these assets ceased to have a market, preventing liquidation and exit from balance sheets.
Then banks stopped lending each other for fear of hidden losses or difficulties with loans. This was followed by bankruptcy of investment bank Sear Stems, where the crisis was originated in several of its hedge funds.
CFA Institute considers that only reasonable valuation facilitates looking beyond volatility at difficult times.
During these turbulences, opinions emerged relative to the application of new international accounting standards, which requires financial investments accounted at fair value, thus worsening the intensity of the crisis. However, CFA Institute believes that fair value is not guilty and that transparent and honest communication -that only reasonable valuation can provide- increases the ability to look beyond volatility at difficult times.
Despite the crisis, financial statements must be measured at reasonable values. In a survey among CFA members Institute Around the world (2,006 replies) 79% considered that fair value requirements improve transparency and contribute to investors understanding of risk of financial institutions. In addition 74% considered that these requirements improve the integrity of the market. They also accept they can aggravate the crisis by forcing financial institutions to recognize the reality of their business (volatility, bad decisions, wrong risk determination and others) rather than showing stable results.
Georgene Palacky, CFA Institute Centre for Financial Market Integrity financial information director indicates: “Pointing to fair value as culprit is an attempt to distract attention from real causes of the high-risk mortgage-related financial crisis” For Palacky “providing investors with total transparency is essential for global capital markets to survive the turbulence and prevent corresponding bubbles and economic disturbances”. At the same time, he does not agree with those who demand a diluted version of fair value: “This mindset will not restore investor confidence. Only when fair value is used extensively can investors assess risk “. For Kurt Schacht, CFA Institute Centre For Financial Market Integrity managing director, fair value makes it easier for companies to understand their own risk and knowledge profiles on time for investors and capital suppliers: “Intervention of any kind would be an attack to the independence process of creating international standards and undermine a system designed to protect against political interference and other interests.” In addition, he considers that “the development of fair value standards has been subject of an intensive and rigorous process and changing them only softens potholes or camouflage the reality of market conditions, an irresponsible way of managing risks”.
To fair value it is often opposed that it introduces in estimates financial statements, inaccuracies and subjectivity, reducing reliability and usefulness for investors and other users. However, CFA Institute believes that such an argument is naive and exhibits lack of understanding of what financial statements should be. All accounting figures are estimates. The only alternative is historical cost, but only reflects fair value at the transaction date. Many historical costs are subject to arbitrary amortization plans and deterioration estimates that reflect directors ‘ criteria rather than economic data.
Rebecca Mcenally considers that “as the decisions of directors regarding acquisitions and disinvestments, investors decisions to buy, sell or maintain are based on reasonable values and their changes, not historical costs. By definition, fair value measures are more current with respect to quantity, timing and risk of future cash flows attributable to an asset or liability”. In fact, the international financial reporting standards of the Accounting Standards Board and FASB in U.S. require companies to realize fair value in balance sheets and profit and loss statements, rather than historical cost.
José Maria Serrano-Pubul, CFA.
