Lloyd Blankfein, CEO of Goldman Sachs, wrote an op-ed article in today’s Financial Timesabout seven lessons from this crisis. Amongst his lessons, Mr. Blankfein addresses fair value accounting (a.k.a. mark-to-market accounting). I think his assertions are valid, but it’s important to consider the whole picture – which is often not as simple as an op-ed piece may suggest. I have included the text of the entire article at the bottom of the post if you’re interested in reading it (which I recommend).
Fair value accounting (a.k.a. mark-to-market accounting) says that all assets should be market to their market values (as opposed to acquisition cost, or other methods) on the firms financial statements. The objective here is to make the statements more transparent, and better reflective of the true firm value. For example, consider your personal balance sheet. You have some assets and some liabilities. Amongst those assets may be a home you own, and amongst those liabilities is likely the mortgage. For simplicity’s sake, let’s assume that the home is your only asset and the mortgage your only liability, and the difference between the two is your equity. Note, means that the fundamental accounting equation (assets = liabilities + equity) is satisfied. Now, let’s assume you bought your home for $100K, and took out a mortgage of $80K. A few years later, housing prices fall, and your home is now only worth $60K. Finally, let’s suppose you’re getting married, and your spouse-to-be, like any good investor, is trying to accurately value the asset (you) before buying (saying “yes”). (No, all us finance folks don’t see everything in life through such an economic lens – hopefully the example made you smile though!)
If you were using acquisition cost accounting, the value of the asset on your balance sheet would be $100K, the liability (mortgage) would be $80K (to keep the math simple, I’m assuming you haven’t paid down any of the mortgage yet), and your equity (the net value your spouse-to-be would be getting) would be $20K. You are sufficiently capitalized and all is well. If however you are using mark-to-market accounting, the value of your asset (the home) must be marked down to its market value, and so is set at $60K. Your mortgage hasn’t changed and so your liabilities are still $80K. So, in order for the accounting equation (which, like gravity, is a law you can’t mess with) to be satisfied, your equity must be -$20K. Wow! You’re undercapitalized and your spouse-to-be will likely say no so as to not absorb the $20K hit to her own equity. In fact, you’re effectively insolvent – your liabilities are greater than your assets and you should consider bankruptcy. As Mr. Blankfein points out, and as you can clearly see, the value of fair value accounting is that it shows the actual market value of your firm, not some other number that may not mean much anymore.
So, to understand what this means in terms of lessons learned from the financial crisis and risk management. Mr. Blankfein is saying that if all firms mark their assets to market value every day, then we have a true picture of what the firm’s value is, and we can better understand how fast we are creating or destroying economic value (i.e. if you see the damage certain positions are doing to your portfolio every day, you’re more likely to respond to it by taking defensive measures than if you only look at where you stand one a month). This in turn should lead to better risk management. Sounds good, right? So maybe Mr. Blankfein is right – we all switch to mark-to-market accounting and everything is clear.
Not exactly. There are some issues that make mark-to-market accounting not such a simple choice. Keep in mind, I’m not arguing against it (I don’t personally have a view on it), but I would like to shed some light on why others may argue against it and what challenges it faces.
Firstly, there’s the question of liquidity. In the example I gave earlier, I said the house had depreciated to $60K. But how do we know/assess that? Your house is not like a stock that’s traded on the market every day and a price is well understood. In fact, homes are very illiquid - their price is not well established and they can’t be sold quickly. Who’s to say the value of the house isn’t really $80K or $40K? Similarly when credit froze up in the market late last year many investors refused to buy anything. This lack of liquidity makes it hard to sell, and when assets can’t be sold easily, their prices fall (the basic idea here is that I try to sell something at $100, if no one buys, I go to $95, and so on. I keep dropping until someone buys). This type of price reaction is temporary. Once investors regain some market confidence, they are likely to come in an buy again, driving up asset prices. So, does it make sense in the mean time to value the firm at a temporarily low amount, even if there’s a good chance it’ll rebound in the near future?
Secondly, mark-to-market may not be relevant for assets held to maturity or other generally long term assets. Again, going back to the house example. Suppose the market value is indeed $60K. But if you don’t plan on selling the house for another 25 years (by when the housing market will likely recover), then does it make sense to mark you insolvent today? Does your spouse-to-be care if she knows that you’ll both live in the house a long time and when you do sell you’ll be solvent? Similarly, in mark-to-market accounting, firms would have to mark their assets to lower prices due to the current crisis. But, if their assets are well-rated bonds that they continue to receive interest on, does it make sense? Suppose the firm holds IBM bonds – IBM will continue to pay interest for the remaining 30 years on the bond, and at the end of the period, they’ll likely pay the amount they borrowed back. So then does it make sense to say the bond holder is in a loss position?
Finally, if we use mark-to-market accounting and we mark down the asset prices, and thus the equity of the firms, we create a self-fulfilling prophecy. If we note the firm as “in trouble” by saying the firm has lost a lot of money, or has become insolvent, then creditors of the firm, its customers, and other business partners will likely stop doing business with the firm because it’s “in trouble”. Furthermore the firm’s stock price may also drop, actually reducing the value of its equity (as opposed to any temporary reductions due to fair value accounting). Thus we have taken a firm that may have otherwise been okay if the crisis were given time to play out, and caused them to fail as a result of customers and creditors fleeing, and its stock tanking.
So, is it true that mark-to-market accounting depicts the fair value of the firm and can be used to better manage risk? Sometimes is the answer. Yes, seeing how fast your positions are shrinking on a daily basis does allow you to react faster from a risk management perspective. However, it’s important to understand which assets are being marked down, and what the characteristics of those assets are (duration, likelihood of recovery, etc). There’s not much value added by deflating asset prices and creating a panic even though the assets would like have recovered. In fact, this can have grave consequences because the mark-to-market can sometimes kill off the firm before the assets are given a chance to recover.
Do not destroy the essential catalyst of risk
By Lloyd Blankfein
Published: February 8, 2009, Financial Times
Since the spring, and most acutely this autumn, a global contagion of fear and panic has choked off the arteries of finance, compounding a broader deterioration in the global economy.
Much of the past year has been deeply humbling for our industry. People are understandably angry and our industry has to account for its role in what has transpired.
Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system but we failed to raise enough questions about whether some of the trends and practices that had become commonplace really served the public’s long-term interests.
As policymakers and regulators begin to consider the regulatory actions to be taken to address the failings, I believe it is useful to reflect on some of the lessons from this crisis.
The first is that risk management should not be entirely predicated on historical data. In the past several months, we have heard the phrase “multiple standard deviation events” more than a few times. If events that were calculated to occur once in 20 years in fact occurred much more regularly, it does not take a mathematician to figure out that risk management assumptions did not reflect the distribution of the actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.
Second, too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.
This over-dependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A. It is easy and appropriate to blame the rating agencies for lapses in their credit judgments. But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.
Third, size matters. For example, whether you owned $5bn or $50bn of (supposedly) low-risk super senior debt in a CDO, the likelihood of losses was, proportionally, the same. But the consequences of a miscalculation were obviously much bigger if you had a $50bn exposure.
Fourth, many risk models incorrectly assumed that positions could be fully hedged. After the collapse Long-Term Capital Management and the crisis in emerging markets in 1998, new products such as various basket indices and credit default swaps were created to help offset a number of risks. However, we did not, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.
Fifth, risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles. It seems clear now that managers of companies with large off-balance sheet exposure did not appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business.
Sixth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.
Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.
For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.
As a result of these lessons and others that will emerge from this financial crisis, we should consider important principles for our industry, for policymakers and for regulators. For the industry, we cannot let our ability to innovate exceed our capacity to manage. Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.
Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report to is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts on the trading desks: if there is a question about the value of a position or a disagreement about a risk limit, the risk manager’s view should always prevail.
Understandably, compensation continues to generate a lot of anger and controversy. We recognise that having troubled asset relief programme money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a profit.
More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.
For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.
Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.
The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.
In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.
After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.
Most of the past century was defined by markets and instruments that fund innovation, reward entrepreneurial risk-taking and act as an important catalyst for economic growth. History has shown that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy.
We collectively have a lot to do to regain the public’s trust and help mend our financial system to restore stability and vitality. Goldman Sachs is committed to doing so.