IMF, IIF Issue Reports, Recommendations In Response To Market Turmoil

April 11, 2008

FEI Summary

Following are some highlights from reports issued in April, 2008 by the International Monetary Fund (IMF) and the Institute of International Finance (IIF), particularly as relate to accounting issues.

International Monetary Fund (IMF) Report

The International Monetary Fund's (IMF) April 8 report, “Global Financial Stability Report: Containing Systemic Risks and Restoring Financial Soundness,” provides a wide-ranging analysis of the current market turmoil. Key themes noted in the IMF’s Executive Summary include: 

• a collective failure to appreciate the extent of leverage taken on by a wide range of institutions — banks, monoline insurers, government-sponsored entities, hedge funds — and the associated risks of a disorderly unwinding.

• a lag of private sector risk management, disclosure, financial sector supervision and regulation vs. the rapid innovation and shifts in business models, leaving scope for excessive risk-taking, weak underwriting, maturity mismatches and asset price inflation.

• overestimates in amount of risk transferred off bank balance sheets.

• continuing strain in the financial markets — notwithstanding unprecedented intervention

by major central banks — compounded by a more worrisome macroeconomic environment, weakly capitalized institutions and broad-based deleveraging.

Accounting is discussed primarily in Chapter 2 of the IMF report, “Structured Finance: Issues of Valuation and Disclosure.” A subsection entitled, “The Role of Fair Value in a Crisis” explains (simplified here, not quoted, unless quotes are shown) that fair value accounting as currently constructed (in accounting standards) and applied (by companies and auditors) may have contributed to a “downward spiral” by, in some instances, triggering liquidations of securities based on a predetermined drop in fair value, or by triggering margin calls or demands for additional collateral. These sales, in turn, put further downward pressure on valuations. Accounting is but one factor to be considered, in addition to the broad list of other factors outlined by IMF, as noted above.

IMF recommends action in the private sector, as well as by government, to address these issues. For the private sector, IMF suggests:

• Standardization of some components of structured finance products;
• Transparency at origination and subsequently;
• Reform of rating systems; and
• Transparency and disclosure.

 For the "official sector," (aka government) IMF suggests:   

• Pay greater attention to applying fair value accounting results (detailed further below);
• Examine incentives to set up  Structured Investment Vehicles (SIVs) and conduits;
• Reform ratings systems agencies; and
• Tighten oversight of mortgage originators.

Detailing its recommendation regarding fair value accounting, the IMF says: “The prospects of forced sales triggered by fair value below some threshold will need to be examined thoroughly. Ways of guiding firms to review the elements underlying the valuation without being forced to sell would be helpful. The extent to which such fair value “triggers” are either encouraged or mandated in regulation and supervisory guidance would need to be re-evaluated.”

IMF also discusses a potential overreaction by some observers about the implications of reclassifications of some securities from ‘level 2’ to ‘level 3’ (in accordance with the Financial Accounting Standards Board's (FASB) fair value hierarchy established in FAS 157) owing to the lack of liquidity and observable market prices for those securities, such as some subprime backed securities.

“[I]nvestors seem to have a perception contrary to what the standard setters intended because a fi rm risks a negative market reaction with a reclassifi cation of assets from level two to three, as events during the turmoil indicated. (Figure 2.1 denotes the increase of assets in levels two and three in 2007 for selected large U.S. fi nancial institutions). Market analysts may judge, correctly, that such a move refl ects further illiquidity in the market or, incorrectly, that the firm’s recategorization of fair value methodologies represents a deliberate overestimation of the value that the assets would generate in a sale. It is understandable that in times of instability the absence of observable inputs to verify valuations exacerbates market uncertainty… and, therefore, market illiquidity. However, as the reclassifi cation is often based on technical rather than substantive grounds, the market’s reaction may refl ect both a misunderstanding of how the relevant accounting standard (Financial Accounting Standards [FAS] 157)

works and a broader misunderstanding of what fair value represents. The apparent negative response to level three reclassifi cations also included the market’s generalized reaction against securitized products during the crisis.”

Importantly, and of particular interest to those that follow the relevance vs. reliability debate in accounting, (and to those charged with certifying (management), attesting (auditors) and supervising (regulators) the reliability of reported numbers) IMF adds: “It is the role of prudential supervision to judge the reliability of various methods used to establish fair values, especially when a marked-to-model approach is used.”

In a section entitled “Auditors’ Recommendations on Fair Value Calculations,” the IMF report notes “The absence of active markets for complex structured credit products and the observed sales at values below the theoretical value of their underlying cash flows have presented challenges to financial institutions as to the degree to which they could be considered “orderly sales” and hence depended on as a measure of fair value.”

As a result, IMF notes, “The major audit firms have argued collectively that the presence of a price below theoretical valuation does not necessarily represent a distressed sale. In such cases, the auditors require firms to demonstrate why a sale price is not indicative of fair value before accepting a reclassifi cation of an asset to level three.  For example, a sale in a thin market at a heavy discount by a liquidator may qualify as a distressed sale, while a similar sale by a solvent entity may not.” IMF continues: “This approach aims to prevent “cherry picking” of valuation methods to manage losses.”

“External auditors are likely to adopt a cautious approach to minimize the risks of material post-balance-sheet-date writedowns that would leave the auditor open to charges of negligence,” observes IMF. “Hence, the level of additional writedowns in the audited financial statements will likely refl ect the convergence of the entity’s valuation assumptions with those adopted by the auditors.”

However, IMF cautions, “The adoption of the auditors’ approach raises the risk of a negative bias in the valuations.” They add, “Managers of fi rms may even be tempted to overstate the level of the current year writedowns in order to maximize the revaluation gains when the market recovers, thus increasing their future potential bonus pool.” The IMF adds, “However, the risk of a negative valuation bias may be offset by the fact that audit liability is not defi ned by overvaluation of assets but rather by the appropriate exercise of professional judgment.”

Institute of International Finance (IIF) Issues Report

Separately, the Institute of International Finance (IIF), a global association of banks, issued a Policy Letter on April 3, in advance of the release of the Interim Report of IIF’s  Committee on Market Best Practices (CMBP) published on April 9. The IIF’s Policy Letter calls for “multiple and coordinated policy responses” and recommends reforms to industry practices in:

·         Risk management

·         Credit underwriting

·         Liquidity risk management and conduits

·         Valuation (detailed below) Ratings, and

·         Incentives and compensation

Regarding "valuation," IIF calls for: “strengthening internal governance and framework around valuation processes, and considering means of enhancing the effectiveness of fair value accounting in circumstances where market liquidity has dried up.”

Additionally, IIF states: "Over the past decade, fair-value/mark-to-market accounting has proven highly valuable in promoting transparency and market discipline and continues generally to be an effective and reliable accounting method for securities in liquid markets. However, in circumstances where there is no or severely limited liquidity in secondary markets, current valuation methods for certain structured products have the potential to mislead investors and contribute to unintended procyclical consequences which could prolong credit market problems. To help mitigate such risk, there is an urgent need in the present circumstances for refined methodologies or alternative techniques to be considered, obviously in close consultation with accounting standard setters and other public sector bodies in order to preserve the positive features of fair-value accounting while minimizing its unintended negative effects. Moreover, the official community, including the IMFC, should lend its support to the establishment of a high-level commission to examine broader issues relating to the implementation of fair value accounting in today’s financial markets –– while respecting the independent role of the accounting standard setters.”

Prepared April 11, 2008 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not represent FEI opinion unless specifically noted above.