Valuation within illiquid markets - Is ‘Fair Value’ measurement still an appropriate approach?

Table of Content

1. Introduction

2. Overview: ‘Financial Crisis’
2.1 'Special purpose entities' and 'mortgage-backed securities'
2.2 Reasons for setting up SPEs and issuing MBSs
2.3 Developing of the sub-prime crisis

3. Accounting for ‘Financial Instruments’ within the financial crisis
3.1 Recent accounting for financial instruments – IAS 39
3.1.1 Categorisation of financial instruments
3.1.2 Fair value and measurement under different market conditions
3.1.3 Overview ‘mark-to-model’ techniques in illiquid markets
3.2 Problems with IAS 39
3.2.1 General problems related to IAS 39
3.2.2 Criticism related to IAS 39 especially during the financial crisis

4. IASB’s response to the problems of IAS 39
4.1 IASB addressing complexity of IAS 39
4.2 Amendment of IAS 39
4.2.1 IASB’s reasons for amending IAS 39
4.2.2 Criticism regarding the amendments of IAS 39

5. Conclusion

Appendix

References

1. Introduction

Banks always played a superior role in business and especially in our today’s internationalised environment their position has become more crucial than ever before. Though, since summer 2007 these financially strong giants have been unhinged by their self-developed ‘financial crisis’ that originated from the US sub-prime market. Due to the instance that the today’s capital markets are interlinked worldwide, it was just a matter of months that the effects of this ‘banking crisis’ unbalanced the entire global economy. Actually large banks became illiquid and the governments had to shore them up, so that the whole financial network did not go to pieces.

Among others, the reason for this disaster was a lack of trust between market participants, caused by enormous amounts of ‘toxic debts’, hidden in the balance sheets of almost every bank that cannot be reliably valued or seem to be worthless. For that reason the professional world and the accounting body IASB came under fire. Especially banks and politicians accused them of having provided inadequate and in-transparent accounting standards, which led to this disaster and amplified the downturn in the world economy. Hence, not only the accounting standard for financial instruments IAS 39 is in the centre of this discussion, especially the IASB's eminently respectable 'fair value' approach has been criticised of being useless in times when markets are absent.

This paper will try finding answers if better accounting standards for financial instruments would have prevented us from this downturn in economy by analysing the origin of the financial crisis and showing the arisen problems. After highlighting its development, the central IFRS standards IAS 39 and the fair value approach will be analysed and evaluated with focus on banks. Finally the IASB’s attempts to manage the arisen problems within the credit crisis will be shown and annotated.

2. Overview: ‘Financial Crisis’

To understand the impact and the arisen implications regarding standard setting, it is important to track the origin of this sub-prime crisis. Sir David Tweedy, chairman of the International Accounting Standards Board (IASB), stated: “[...] it is evident that at the heart of the crisis were bad lending practices” (IASB, 2008a). Although it is a very simplifying statement it hits the mark and the reasons will be examined in the following.

2.1 'Special purpose entities' and 'mortgage-backed securities'

To boost their profitability, banks sold huge amounts of their hazardous ‘subprime mortgages’ into the capital markets. 'Sub-prime' means, that these credits were granted to debtors with very weak credit scores and where no verification of income or assets took place. Banks thought that this higher risk derived from impending non-payments would be over-compensated by rising real estate prices and so even people of very low solvency were enabled getting mortgages so easily (Kiff & Mills, 2007). Because the loan default risk was however heightened, compared to mortgages granted to more solvent clienteles, this circumstance made these types of mortgages very unattractive for lenders and banks wanted to divest themselves of these assets.

This took place with the collaboration of extra set up 'special purpose entities' (SPE), which have been founded by banks for just that purpose (Baetge et al., 2008). The credit risk of these ‘sub-prime mortgages’ can be transferred from a bank (the 'originator') to a SPE, in two ways: One possibility is a 'synthetic transaction', where only the credit risk is transferred with help of a 'credit default swap' (CDS), the second one is a 'true-sale transaction', where the obligations are effectively transferred to the SPE (Struffert, 2006) (Lützow & Abel, 2007).

Looking at the latter possibility the SPE buys these sub-prime mortgages from banks. To finance this purchase the SPE issues 'mortgage-backed securities' (MBS) into the capital market, which were formed by a process called ‘securitization’ (Appendix: figure 1).

Hereby bundles of sub-prime mortgages were located in many different 'tranches' and these ones were then put in a consecutive ranking order of repayment. The SPE can achieve a different credit rating for every single tranche of sub-prime mortgages depended on the timing and certainty of repayment of a single tranche. Each tranche is repaid through the cash flows generated by the redemptions of the primary debtors. The first tranche ('senior' tranche) has the highest rating (e.g. A-rating), whereas the rating of the last bundle of mortgages ('junior' tranche) has the worst one (e.g. C-rating). Each tranche is sold at a different level at risk and the interest that has to be paid to investors rises with decreasing rating. The risk of default rises because it becomes more and more uncertain that sufficient debtors are able to repay the following tranches and investors in MBSs will get their investment back. This management of ratings is known as the so-called 'waterfall principle' (Appendix: figure 2). (Barth & Klein, 2002)

At this the SPEs are conducting 'term transformation', too. They finance long-term obligations like MBSs by repetitively issuing short-term securities so-called 'notes' (Weber, 2008). So the SPE is continuously forced finding new investors in the short-term (Baetge et al., 2008).

2.2 Reasons for setting up SPEs and issuing MBSs

The main reason why banks set up SPEs and sold their mortgages to them was the possibility to reduce their financial risk exposure. These transactions enabled them advancing their capital backing and financial performance figures (e.g. RAROC), what resulted in an improvement of their rating and boosted their profitability (Barth & Klein, 2002). Especially before the background of BASEL II an improved rating became more and more crucial for financial institutions, because this influences their lending policy and has a decisive impact towards their earnings. All this was possible because these SPEs were developed in form of a 'trust' or as a 'joint-stock company', with one or more trusts as partners. Therefore the originator has (apparently) no control over the SPE and it has not to be consolidated in the bank’s group accounts (Ernst & Young, 2007) a classical case of ‘off-balance-sheet finance’.

Secondly banks used MBSs as an alternative instrument of funding by transforming quite non-liquid, individual mortgages into liquid and tradable financial market instruments. This is the reason, why they were very interested in high-rated MBSs that were issued by the SPEs. An investor will buy a MBS only if he will receive an adequate risk adjusted rate of return; this means that an investor in a junior tranche will receive a much more higher interest as the one who invested in a more secure senior tranche; in turn the SPE/banks has to pay a lower interest the less riskier a tranche is and funding becomes cheaper.

2.3 Developing of the sub-prime crisis

After wrapping these mortgages into MBSs and issuing them in the worldwide capital markets, the economic situation in America changed. The US economy in 2007 was characterised by high debt ratios of private households due to excessive lending practices, a beginning downturn in the domestic economy and rising interest rates. All this together resulted in a growing number of loan defaults, especially in private housing credits or more precisely among the sub-prime mortgages.

Nevertheless it is important to mention that these non-payments by itself would not have caused this crisis. These sub-prime mortgages were securitised, passed on to other investors, which again diced and distributed the MBSs. This reselling leveraged the overall effect of loan losses. (Becker, 2008)

Because more and more defaults occurred, investors in MBS were forced to reassess their risk-exposure, what resulted in a buying resistance to the point of an almost complete market disruption for securities of this kind. As mentioned above, the SPEs' purchases of long-term MBS were just refinanced in the short-term, so that they got into trouble very quickly finding new investors and so the liability side of their balance sheets got under pressure. Because the originators were bound by commitments towards their SPEs, they had to provide liquidity to the SPVs and to transfer the MBS back on their own balance sheets. (Baetge et al., 2008)

Up to this point there was no duty presenting neither SPEs nor these commitments on the banks’ financial statements because a company is only obliged doing such a passivation under IFRSs, when it is certain that these commitments will be claimed. No one knew up to what extend banks have disguised such liabilities from their accounts and this was disclosed only bit by bit. Interestingly not even the originators knew by oneself the scope of toxic debts that were hidden in their accounts. (Hoffmann & Lüdenbach, 2007)

Johns Smith, board member of the IASB, highlighted that a “[…] major part of the problem [regarding the financial crisis] is that markets are unsure where these bad loans have ended up and consequently have marked down any instrument suspect of containing them” (Bruce, 2008, 1).

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