The accounting rules that have turned a crisis into a disaster

Anthony Hilton
24 Sep 2008

When they come to write the history of these times, it will be interesting to see how much blame gets pinned at the door of fair-value accounting.

Amid the wreckage that was once Wall Street, it is a culprit that has so far avoided the blame. But the accounting profession that gave us WorldCom and Enron is again in the dock. There is a powerful argument that this is a crisis which has been turned into a disaster by mark-to-market accounting rules.

Accountants may protest but, as William Isaac pointed out in a recent article in the Wall Street Journal, the problems the world faced a month ago were far less acute in all respects than the problems faced in the banking crisis of the 1980s when such rules did not exist, yet the world managed to cope.

He should know because, although he is now working for a company within the LECG consultancy group, he was in the first half of the 1980s the chairman of the Federal Deposit Insurance Company, and therefore in the eye of the storm that broke about the heads of the world's bankers at that time.

It came after the oil-price shock caused by the Iranian revolution of 1978-9 when most of the world's banks recycled petrodollar surpluses into Third World sovereign debt. They were loaded with it but when Mexico, Argentina and a string of other countries defaulted, it became worth only cents in the dollar.

At the same time, US agriculture was in depression, the rest of the economy in recession, interest rates were at 21%, inflation was roaring away and thousands of the savings and loans banks were heading for insolvency.

America's eighth-largest bank, the Chicago-based Continental Illinois, actually went under. Yet despite the unprecedented economic chaos of the time, Wall Street and the US banking system got through it without the total meltdown we have seen in the past few weeks.

The economy today is nothing like the mess it was in the 1980s. So if this is now the biggest crisis since the 1930s, it is because we have made it so, not because it started out there. And fair-value accounting is blamed as one of the main reasons this crisis has run so wildly out of control.

Isaac points out that at the start of this crisis, there were $1.2 trillion in subprime asset-backed securities, some of which were held by banks and thrifts but the rest spread round the world. Regulators estimated that the likely level of losses was about 20 cents in the dollar, which would have been painful but eminently manageable within the system.

However, it turned out not to be manageable — and Isaac blames the fair-value accounting rules. These say that assets held for sale must be marked to their market price, or the best equivalent of that which is available. But what do we do when the already-thin market freezes up and the few deals that are done take place at fire-sale prices?

The accountants' answer is to write everything else down to the fire-sale level, thereby making sure every other bank is as badly hit as the one forced into the fire sale.

This, says Isaac, runs counter to all the principles of bank regulation, which hold that when an asset is temporarily impaired, the bank and its regulators are allowed to use judgment and assess what is the economic value of the asset, based on its discounted cashflow.

But the application of fair-value accounting means that is just when judgment and restraint are not permitted. If fair value did not exist, he suggests people would have done their sums on the basis of economic value and discounted cashflow — and panicked a great deal less.

Fair value is in effect swings-and-roundabouts accounting — it measures what you gain, then it measures what you lose, and its snapshots take no account of the time horizon of the business.

Trustees of pension schemes and corporate finance directors will be familiar with the vagaries of mark-to-market because the volatility it measures has played its part in sinking the nation's defined benefit pension schemes. But sinking the banking system is a sin of an altogether different magnitude.

In a corner on HBOS?

Gordon Brown's reinvention of himself as the scourge of fat-cat bonuses, the architect of a new financial order and the saviour of HBOS may be enough to get him through this week's Labour Party conference without a challenge to his leadership, but one wonders if it is actually the right strategy for the medium term.

Positioning himself as the person who organised the HBOS rescue looks particularly dubious, given that the way the share price has been performing lately conveys a risk the deal could unravel.

But I suppose were that to happen, Gordon's embarrassment would be the least of our problems.