Thursday, September 18, 2008
Did Enron beget AIG?
There are more knowledgeable people than me arguing that post-Enron accounting "reforms" drove the collapse of AIG and probably influenced the crises at several other big American financial institutions. Since many of those smarter people read and write this blog, let's get a discussion going.
Contrary to popular belief, good accounting rules properly applied do not reveal the "truth" about a company's financial performance or position. They reveal a truth. This is for many reasons, but particularly because assets and liabilities can be measured in different and equally legitimate ways.
Warning: The following is technically inaccurate and riddled with gross generalities, but it is directionally true.
Consider the case of a simple mortgage, or even a security backed by five hundred mortgages, recorded as an asset on the books of a financial institution. How do you value it? Before Enron, you might have looked at the expected cash flows on that instrument, discounted them back to a present value, and recorded that number. That is, you were making a judgment about the likelihood of being repaid, over a period of years, in accordance with the terms of the security or the underlying loans. A mortage-backed security valued this way would not change rapidly in value because most of the underlying mortgages will be repaid in accordance with their terms.
Unfortunately, valuing assets this way requires judgments that can be manipulated to inflate values artificially. Post-Enron accounting reforms addressed that risk by requiring that most assets be "marked to market." You no longer measured financial assets according to discounted cash flows, but rather according to their market value on the date of measurement. Normally and theoretically, the result should not be that different -- an efficient market will yield roughly the net present value of the asset's expected cash flows on its sale. But the market value of an asset will not equal the NPV of its cash flows if the market's liquidity is insufficient to absorb far more selling than is customary. If this seems strange to you, think of houses instead of financial assets. The houses in your neighborhood might be "worth" around $200,000 each in a normal market, but if they all went up for sale at the same time (for reasons unrelated to the local economy) they could not be sold at even a fraction of that price.
So this invites the question, what is the "fair market value" of an asset on the books of a financial institution? In abnormal times, the ultimate value of those assets is probably far in excess of the result driven by post-Enron accounting rules. AIG said as much earlier this year when it was recognizing massive losses on its books from having written down suddenly illiquid assets that would nevertheless perform according to their terms.
Now, when a financial institution incurs a loss for accounting reasons it has a substantive impact on its ability to make loans or enter into other transactions that can earn money. This is because the loss diminishes its base of equity capital, and financial businesses must maintain a certain ratio of equity capital to total obligations outstanding. If equity capital shrinks suddenly (as can happen when assets are marked to market) the financial institution will rapidly default on its obligations to other institutions. That will in turn affect the market value of the assets on the books of those institutions, and, well, we are seeing what happens.
In other words, accounting not only reflects the financial condition of the business, it also affects it. When we choose a set of accounting rules, we are not only deciding how to look at a company, but what that company will look like. Moreover, the condition of one company can affect many others, all through the interaction of mark-to-market accounting rules.
None of this is to argue that accounting rules are solely or even primarily the cause of the current stresses on financial institutions. Bad loans are bad loans, and there are plenty of them to go around. But post-Enron accounting rules may well have acted as an accelerant, driving the breakneck speed of the collapse of these firms. To the extent that the sheer pace of the change causes trauma that need not to have occurred, we ought to ask ourselves whether we should be so rigid in the standard we require for measuring the fair value of financial assets.
The counterargument, of course, is that less market-driven accounting defers capitalism's necessary creative destruction. See, for instance, the very long time that it took Japan to emerge from its crash in 1989. Perhaps the damage done in today's crisis is preferable to the death by a thousand cuts that we would suffer under a less dynamic system.
Release the hounds.
8 Comments:
By 
Charlottesvillain, at
Thu Sep 18, 12:17:00 PM:
I can't argue with your basis thesis, but that doesn't mean mark to market isn't an appropriate, or the most appropriate, measure of value (and by extension risk of loss) in certain circumstances.
Let's consider a CDO, in which the senior AAA tranche has been guaranteed by AIG. Let's say the CDO's underlying collateral is in distress and subordinate tranches are impaired. Because of the nature of the structure, the senior tranche may not actually experience and Event of Default as long as bond holders continue to receive current interest. Event of Default may not occur until the maturity date, at which point the collateral is deemed insufficient to pay down the senior tranche, and the bond defaults, requiring the insurer to made good on the principle guarantee.
At what point should we assess the risk to the insurer? In this example the risk of a contingent liability being realized can be identified prior to an Event of Default, even if the insured tranche continues to perform pursuent to its indenture. When collateral is hard to value, or even identify, a mark to market would appear to be the best way to quantify the risk of loss to the insurer (although it may vasly overstate it in times of illiquidity).
So, you may be right that Enron brought about rules that have put this pressure on AIG. But what REALLY put the pressure on AIG was its own mispricing of the risks it was insuring. The piper is ultimately paid regardless of accounting methodolgy, although MTM accelerates the recognition of the loss, and might exacerbate it.
From the perspective of the equity holder, I'd probably prefer to defer the loss. From the perspective of the prospective equity investor, I'd like to know what I'm buying and MTM provides a snapshot of potential losses that I can take into account.
That's my take on it anyway.
By 
, at
Thu Sep 18, 02:02:00 PM:
The problem with mark-to-market is that it puts you in technical default of your bond covenants even though your assets are performing. That leads to margin calls that put you out of business even though you were profitable and could afford to pay your obligations in the normal course of business. I don't see how such a state of affairs benefits anybody.
For a different example, could you imagine the chaos in the housing markets if mortgages had mark to market and margin call provisions? People whose houses have dropped in value but are paying their loans as agreed (they have to live somewhere, might as well stay where they are) would have to come up with big chunks of cash to keep their loans at 80% LTV or be thrown out on the street in an unnecessary foreclosure.
By Escort81, at
Thu Sep 18, 02:26:00 PM:
I agree with Charlottesvillain's take on it, particularly his last paragraph distinguishing between current and prospective shareholders. It really gets to a philosophical discussion as to what the point of GAAP statements are -- in a public market, the statements should be for both existing and possible shareholders.
But mark-to-market accounting has been around in one form or another (albeit not for complex financial instruments) for some time. Oil and gas companies have disclosed reserves in the notes to their financial statements in an "SEC10" format, which uses year-end prices and costs, and cash flows discounted at 10% each year. There are some years when December pricing is significantly higher or lower than the average pricing for that year, so the value of the reserves at that moment in time can be somewhat arbitrary and misleading. Perhaps an impairment should have been recorded but wasn't (in the scenario where a set of high December prices made it appear as though a field was economic when true throughout the year pricing would have painted a different picture), or possibly the other way around.
And that's a fairly straightforward business to run!
Start trying to evaluate credit default swaps and their mark-to market value, and of course you have to have some sense of the underlying piece of paper that the derivative relates to, and you are now in an area where very few shareholders or even analysts will tread. One hopes that at least management is on top of it.
It is always sad when one crappy asset class infects other not so bad asset class, but such is the way of the world and the psychology of markets when there are overreactions (in both directions). There are no internal corporate firewalls strong enough to contain a downward spiral in a leveraged and speculative situation. When Salomon Bros. invented the MBS market in the late 70s, it was a boon to liquidity in the mortgage market and to and to homebuilding in the 1980s. The instruments were pretty plain vanilla by today's standards, but it put Solly (since absorbed by Smith Barney and then Citi) on the map. I think it was a net plus for the financial system, although I suppose one could say that it was a third order contributer to the S&L crisis of the 1980s, in the sense that it altered the market and caught S&L managers unprepared to adjust. When the books are written about what caused this current crisis, hopefully by somewhat well-versed in financial and accounting complexities and without a political axe to grind, I think that a lead culprit will obviously be the mortgage origination business. Whether borrowers or lenders are found to be more at fault remains to be seen; I have no firm sense of that proportionality, but my guess (and my bias) is that there were more speculative buyers than predatory lenders, although lenders should know better in any case than to engage in the undercollaterized loans that they have now eaten.
Back to TH's point, when GAAP accounting goes through changes in how standards are applied (after endless FASB discussions), there is bound to be an adjustment period in how investors view the statements. I am not convinced this crisis was directly related to financial statements so much it was as a true liquidity and leverage issue -- a sufficent portion of the mortgages underlying securitized instruments were not being paid (understanding that the instruments had assumptions in their underwriting and issuance with respect to a lower default rate), which in turn caused ripple effects equal to massive tsunamis, once the financial institutions were required to pony up more capital in response to the instruments not being worth what it was originally thought to be worth, the resultant mispricing of default swaps, and the historically high amount of leverage that was present on the Street. Without high leverage, the capital call would not be as severe -- if you are leveraged 3:1 and prices drop 20%, not a huge deal relative to your original equity position, though still painful; if you are leveraged 25:1, your additional equity contribution at the time of a captial call will be a multiple of your original position with a 20% drop. Leverage cuts both ways.
It sucks when you bet the ranch and didn't even realize it at the time.
To Randian's point about mark-to-market in the individual mortgage situation, I know from discussions with former CEOs of mid Atlantic area banks that during the bank and real estate crisis of 1989-91, federal regulators required them to "classify" (indicate as not good) commercial real estate loans that were performing and current on P&I, if, in the opinion of the regulators, the FMV of the asset was less than the oustanding amount of the loan. Not quite the same thing, but it didn't help the capital position of struggling banks.
By , at
Thu Sep 18, 03:37:00 PM:
Has anyone remembered Elliot Spitzer's role in AIG....? As I recall, he (Spitzer) got Greenburg ousted as chairman of AIG because of his endless threat of litigation by State of N.Y....did this change the outcome at AIG? Who can say........
By , at
Thu Sep 18, 04:26:00 PM:
These instruments appear to confirm the rule of unintended consequences. They were supposed to add liquidity to the market, but when the going got tough they did the opposite.
One of the problems of the mark to market rule is that the underlying asset, the home, is in an imperfect market place to begin with. When forced sales are added to the mix they have a cascading effect in that market place that drives the price down more quickly than would be the case in a more perfect marketplace. One of the results is that mark to market became meaningless when no one had a clue what the price should be.
By Nomenklatura, at
Thu Sep 18, 04:47:00 PM:
There's also a basic problem with the newer 'more sophisticated' Basle rules regarding bank reserves.
The idea was to distinguish between different types of bank-held assets based on how risky they were, and require the banks to hold bigger reserves against the more risky assets.
What the regulators missed was that this created enormous financial incentives for banks, credit rating agencies and traders to collude in to dressing up risky assets so they looked like they belonged in a lower risk class. Eventually playing this game became the key to the banks' profitability.
There is really only one word to describe this: 'Duh'.
By , at
Fri Sep 19, 03:51:00 AM:
And thanks to Th and all of you. I start to get a glimmering of what it's all about.
JC
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