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Frequently Asked Questions about Mark to Market Accounting (MTM)
Question: Why do bankers want to get rid of MTM?
Answer: Bankers do not want to get rid of MTM. Bankers believe that MTM is appropriate for assets that a bank, because of its business model, trades or sells to maximize its current market value. Where the bank's business model is to hold for the long-term, MTM is not appropriate, as fair value is irrelevant to the amount that will be repaid to the bank.
Question: When interest rates change, doesn't MTM better reflect the actual value of a loan? If interest rates are currently at 4%, a loan with a rate of 5% is worth more than one with a rate of 3%. All other things being equal, why should they both be recorded at 100 on the balance sheet?
Answer: It is true that, all other things being equal, the fair value of the 5% loan will be greater than the 3% loan. Bankers generally agree that, if a bank's business model is such that it manages that loan in order to maximize the fair value of that loan and then trade it, then the loan should be recorded at its market value. However, for loans held for long-term investment, bankers believe that fair values are not reflective of the true value of the loan. Why?
- First and foremost, the amortized cost, which generally represents the amount owed by the borrower, adjusted for net fees with premiums and discounts, is most reflective of the cash that will actually be received. (Of course, this must be supplemented with a robust impairment (loan loss reserve) process).
The bank will not be selling the loan, so a current market price is not indicative of its true value. The fair value is not as relevant[1] as the amortized cost in order to assess the amount, timing, and uncertainty of prospective net cash inflows to the related enterprise[2]. Therefore, while a 5% loan may have a higher current value than the 3% loan, that difference is not going to result in any change to the bank's cash flow. - Because of the business model of most banks, if there are issues in which action must be executed because of changes in the performance of a loan, there is normally no reasonable expectation that the loan would be sold. Commercial bankers do not sell loans when the borrower is experiencing financial deterioration; instead, they work out the loan situation with the borrower. This workout process can take several routes, including assisting the borrower in realigning operations, restructuring the loan, etc. To think that the market has already built the ultimate resolution of modified lending terms into the market price is to strain credulity, considering the flexibility of lending terms derived for most commercial borrowers during a loan modification process.
Selling the loan for its market value is, in the vast majority of cases, not an alternative. So, to reflect a fair value as part of capital is to mislead the financial statement user. This is especially true today when market volatility is significant.
Question: But if I bought the whole bank, isn't that what my bank could sell the loan for?
Answer: Fair value, in concept, is indeed what you could sell the loan for. However, bankers agree with the SEC responsibility to "uphold the interests of long-term investors"[3], and the accounting should reflect the cash flows the bank will collect rather than what the market thinks the loan is worth.
Given that, however, there are practical issues with the concept of fair value that cause great concern to bankers and are sometimes not generally understood by those outside the commercial banking industry.
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With the exception of new conforming residential mortgage loans, most loans, unlike debt securities, have no active market. Market valuations of loans are not as reliable[4]
as amortized cost (with a loan loss reserve). While banks currently disclose market value estimates within footnote disclosures, the unique terms in most commercial loans, with varying payment terms, varying collateral and multi-collateral structures, and varying guarantor arrangements, puts considerable subjectivity into the process, resulting in very large ranges of estimates. While it is complex to estimate loan loss reserves in such situations, determining fair values, especially when an active market has never existed for such loans, is especially challenging.
To illustrate the challenges of fair valuation, the vast majority of the debt securities market (excluding governmental securities) is in residential mortgage-backed securities (RMBS). In fact, the amount of principal outstanding on RMBSs is higher than the amount of principal of residential mortgages held by banks reported in loan form. The RMBS market has largely been influenced by the government-sponsored enterprises and, as a result, has relatively standardized underwriting, collateral, and servicing terms. Though there can be vast issues in estimating fair value based on the difference in securitized (and normally guaranteed) loans and unsecuritized loans, there appears to be some basis to claim a "starting point" market value.
No such starting point exists in most of the commercial loan arena. Relative to the RMBS market, there is a modest commercial mortgage-backed security (CMBS) market (though the majority of commercial real estate debt is in loan form), and there is a small commercial loan secondary market. However, lending for construction and for commercial and industrial loans is primarily executed in whole loan form. So, getting to a "starting point" for many loans is an exercise in speculation. Even in times when the active markets were not frozen, getting to an "exit price" for most loans starts with imagining what pricing there would be for the standardized terms if there were, indeed, an active market for such a loan. Further speculation is then required to price the non-standard terms that are typical in such arrangements. -
The recorded fair value of an individual loan may not be indicative of the worth of the lending relationship to the bank. Not only will bankers often hold various loans to the same borrower (which may not be aggregated for valuation purposes), bankers will normally provide multiple services to borrowers (such as investment, trust, and benefits management) that are leveraged off the initial loan. Practically speaking, selling a loan can result in breaking the customer relationship and cause all business with a customer to be lost. With that in mind, there is much more value to the relationship than can be measured by aggregating the fair value of individual loans.
With this in mind, the fair value of individual loans is not necessarily indicative of the value to the bank and also not indicative of the success or failure of management in attaining its business objectives.
[3] Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission, letter to the Honorable Edward E. Kaufman, September 10, 2009.
[4] Statement of Financial Accounting Concepts (SFAC) No. 2: Qualitative Characteristics of Accounting Information notes that reliability is a primary decision-specific quality.
Question: In 2007, the market value of many mortgage-backed securities dropped, but loan loss reserves did not increase until much later. It turns out the market values were better indicators of credit risk. Shouldn't this be reason enough to require fair values? It sounds like bankers just want to hide their losses.
Answer: Bankers do not argue that market prices of securities can, in certain situations, be a leading indicator of credit losses. Bankers, however, often question the accuracy of many such prices when considering the large liquidity discounts in today's markets, along with the liquidity discounts inherent in the market for commercial loans (a market that is not normally active in the first place). Bankers are incredulous that reliable and comparable market prices can be achieved, given the non-standardized terms with various unique payment schedules, collateral and guarantor arrangements of these loans. Bankers have intimate, confidential knowledge of the operations and capability of individual corporate borrowers that is not well quantified into rating systems available to active market participants. Therefore, even credit spreads can have a wide range.
Discounting all that, however, a large portion of the predictive nature of the market discounts in securities in 2007 is likely due to the procyclical nature of the banking business, the problems with the current "incurred loss" model of loan loss reserve accounting, and how mark to market accounting rules related to "other than temporary impairment" (OTTI) made things worse. See the page "How Bankers Understand Procyclicality" for more information.
In short, OTTI losses banks were required to record prior to March 2009 were largely based on market-based liquidity discounts that did not reflect the actual expected credit losses. In other words, the losses that were recorded were greatly exaggerated. Therefore, the required reductions in capital virtually halted lending, ensuring that businesses could not get needed financing and slowing the economy to a halt. Thus, such market discounts, because of their impact on bank capital, became a self-fulfilling prophecy. MTM did not cause the losses. But MTM exacerbated the situation by effectively cutting off lending and fueling the meltdown.
Another factor regarding loan loss reserves is that rules regarding provisioning for "incurred" losses has limited banks' ability to set up reserves (1) at the top of a business cycle, and (2) when it is not totally clear that an identifiable loss "trigger" has occurred. While there are still specific implementation questions regarding the FASB's proposal to remove the "triggers" and replace the current "incurred loss" model to an "expected loss" model, bankers believe such an approach would have mitigated a portion of the effects of the current financial crisis.
With all this in mind, bankers believe that the toxic combination of MTM rules for securities and restrictions on loss reserving have created the situation where market prices were not the predictor of loan losses, but became the cause of many of the loan losses. Therefore, the answer is not to increase MTM, but to modify the OTTI rules for securities (as was done in April 2009) and modify the loan loss reserving restrictions.
Question: Won't recording the fair values of both financial assets and financial liabilities provide better information on a bank's liquidity management efforts.
Answer: Practicably speaking, no accounting can truly show the real liquidity picture on the balance sheet of a bank, for the simple reason that there are liquidity facilities available to banks that are unavailable to other institutions that can't be recorded. Facilities through the Federal Reserve and Federal Home Loan Bank, for example, are often utilized, though are given no value in the financial statements. Even the FDIC guarantee to depositors provides useful value to banks in their ability to seek funding and balance the timing of their assets and liabilities.
That said, a critical activity of bank operations is to manage liquidity. Nevertheless, use of fair values is precisely why liquidity management would be distorted through the use of fair values. Over 60% of bank assets are held in loans held for long term investment. The liquidity discounts that are inherent even in a relatively active loan market make such an analysis useless, especially considering these loans are not meant to be sold. With this in mind, liquidity-related information (such as expected maturities) can certainly be included in footnote disclosure, but the fair values are not relevant to how banks manage liquidity.
Question: What's the harm in putting both the amortized cost and the fair value on the balance sheet? Different investors and regulators can take what they want from this information.
Answer: Confirming the feedback from banking analysts we've talked to, as well as from investors in the thousands of non-publicly held banks nationwide, a PricewaterhouseCoopers survey indicates a large majority of investors do not want an expansion of MTM[5].
Bankers believe that the requirement to record the fair value of loans on the balance sheet increases costs on banks without any positive benefit in return. Currently, fair value measures are disclosed in the footnotes to the financial statements, and, thus, is mainly determined after the critical earnings call. Extra resources will be required to perform and audit this work if required to be included for earnings calls.
That said, the real issue is not whether to report, but where to report fair values. Although the non-credit fair value changes will run only through "other comprehensive income", and not through net income, it affects bank capital. Unlike entities almost every other industry, banks are managed based on capital. Management focuses on the cost of it. Regulators monitor it for safety and soundness. Investors monitor it for return on equity. Customer/depositors act on it to protect their cash flow.
In no other industry, however, can a customer shut down a business overnight merely because of reduced confidence. Requiring an accounting rule that distorts true value will reduce confidence because it will confuse financial statement users. Heightening the importance of fair values by placing them on the face of the balance sheet implies to investors that they are relevant and reliable, neither of which is the case. Requiring an accounting rule that unnecessarily increases volatility will reduce confidence. Requiring an accounting rule that does not measure how banks operate their businesses will reduce confidence. Banks are not arguing that fair value information should be excluded from the financial statements. However, financial performance and, most importantly, bank capital, should not be measured on fair values and doing so will only serve to confuse users of financial statements and reduce their confidence in them.
[5] The PricewaterhouseCoopers Survey, "What Investment Professionals Say about Financial Instrument Reporting" (June 2010)
Question: Weren't there calls for MTM during the Savings and Loan (S&L) Crisis of the 1980's/90's? In the FASB Exposure Draft, FASB even refers to a GAO report to support the need for fair value information. Why do bankers keep on fighting this?
Answer: MTM was indeed an issue discussed as a result of the S&L Crisis and the discussion largely resulted in the issuance of FASB Statement No. 115, which related to MTM for debt and equity securities. As a result of the S&L Crisis, the GAO issued a report to Congress "Failed Banks: Accounting and Auditing Reforms Urgently Needed."
While the report was certainly relevant at the time, a close reading of the report indicates that the recommendations would not necessarily persuade a contemporary reader who is not already a MTM advocate. For example, when noting that "accounting rules are flawed", the main GAO complaint related not to the lack of MTM, but to GAAP rules on loan loss reserves. Specifically, the GAO expressed concern as to the amount of judgment allowed over whether a loan loss is "probable" (and, thus, a specific reserve – rather than a general reserve – should be maintained), as well as how the fair value of the underlying collateral was determined within the context of an "in-substance foreclosure". Such fair values were used to determine the required loan loss reserves. [1]
As to the amount of judgment required in determining whether a loan loss is "probable", the same situation exists today and bankers generally agree that the requirement to reserve only for "probable" losses is troublesome. It should be pointed out, however, that such banker complaints stem not necessarily from the GAAP rule itself, but how the rule has been applied over the past decade. Bankers historically have managed their businesses on an "expected loss" basis – managing to what the bank is expected to earn over time. However, many generally believe that changes came in 1998. In its zeal to combat "earnings management", the Securities and Exchange Commission (SEC) required SunTrust Banks, Inc. to restate earnings by lowering its loan loss reserves. Since that time, management's instincts on economic cycles and specific borrower performance were often replaced by sole reliance on loss models, as banks and their auditors struggled to utilize only assumptions that could be empirically supported and documented. As a result, reserves as a percentage of loan balances shrank to historic lows just prior to the financial crisis.
While there are, in fact, recommendations in the GAO report toward full MTM (with changes in fair value recorded directly to earnings) for all debt securities (no matter the intent to hold), as well as further study for "comprehensive" MTM implementation, these were evidently minor suggestions, since they are not even included in the report's executive summary. However, one should note two critical things:
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The context of which these recommendations are given: The study was performed inlight of the reserves for the Bank Insurance Fund and the cost to that Fund. Since regulators normally attempt to liquidate failed bank holdings as soon as possible, the emphasis of the GAO is naturally on liquidation value. That is why the sole example used to advocate for full MTM for debt securities is one S&L that held debt securities, primarily consisting of U.S. Treasury securities that contain no credit risk[2]. Those who believe that credit losses will be sustained by long term investors of U.S. Treasury securities are in a distinct minority.
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In recommending MTM for debt securities, the GAO also assumes that market values are readily available. While this assumption is true for securities in most economic environments, the current financial crisis gives pause as to the wisdom of such an assumption. Further, even in a stable economic environment, determining fair values of commercial loans (outside of the current process used for disclosure purposes) is arduous at best, since the vast majority of commercial loans have terms that preclude an active market. That is likely the major reason that GAO acknowledges in the report that there are "conceptual and implementation issues" that would need to be addressed in studying this issue. Indeed, the GAO spoke out against accounting rules that "allow bank management considerable latitude in determining carrying amounts for problem loans". Because frozen securities markets have caused many debt security fair values to be based on internal models requiring a high level of management judgment, we wonder if the same conclusions and recommendations would be attained in the current environment, whether for loans or for debt securities.
[1] GAO noted that fair values used on real estate involved in an in-substance foreclosure were often based on the expectation that the failed bank would hold the collateral and sell it in an improved market. This is in contrast to assuming the collateral would be sold in the current market. This doesn't appear to be an issue in the current environment, as "collateral dependent" loans, as well as the collateral upon foreclosure, are normally valued based on current appraisals.
[2] Bankers agree that if the security will be sold, that it should be maintained at fair value. Long term holdings should be recorded at the amount which approximates the actual cash to be received – amortized cost, less an estimate of any credit losses. Consistent with traditional theories on "going concerns", if there are going concern issues that would make it likely a sale of assets is necessary, the fair value (liquidation value) is appropriate.
Question: OK, but isn't it true that if MTM had been used during the 1980's and 1990's, the S&L Crisis would have been less severe?
Answer: It may have been. However, the widely acknowledged problem in the S&L Crisis was not the accounting method used. The main problem was the result of regulatory forbearance – special accounting that was derived to ensure S&L capital levels were acceptable.[3]
While MTM may have given regulators early warning regarding troubled institutions, existing GAAP accounting data that was included in S&L-submitted Call Reports were already found to be useful in predicting bank failure three years in advance[4]. In fact, in 1985 the average resolved institution had been "insolvent" (per GAAP capital, less goodwill and other intangibles) for 26 months. By 1989, that time period had grown to 42 months[5] – the average institution had been insolvent over three and-a-half years prior to resolution. Given that many believe the latest economic cycle lasted from late 2002 to 2007, it seems that a farther-reaching early warning system may need to transcend more than one economic cycle. Therefore, those who advocate MTM because of its predictive value during the savings and loan crisis should also re-evaluate "how early" an early warning system must be in order to be effective.
[5] An excellent resource on the various issues of the savings and loan crisis is The Savings and Loan Debacle, by James R. Barth, The AEI Press, 1991. Barth was chief economist of the Federal Home Loan Bank Board and the Office of Thrift Supervision from September 1987 to November 1989.
For more information contact: Michael Gullette (202) 663-4986
