Saturday, February 18, 2012

Reading summary: Laux and Leuz 2010


Did fair-value accounting contribute to the financial crisis?


Useful information extracted from the paper:

Critics argue that fair-value accounting exacerbated the severity of the 2008 financial crisis. The main allegations are that fair value contributes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write downs set off a downward spiral, which in turn leads to contagion.

However, based on Laux and Leuz’s research and analysis, there is little reason to believe that fair-value accounting contributed to U.S. banks’ problems in the financial crisis in a major way.

1.       Fair value play only a limited role for banks’ income statements and regulatory capital ratios except for a few banks with large trading positions. For these banks, investors would have worried about exposures to sub-prime mortgages and made their own judgments even in absence of fair-value accounting.
l  “Trading assets” are reported at their fair value, and fair value changes are recognized in Income Statement. (33% for large investment banks and 12% for large bank holding companies, but very small fraction smaller bank holding companies)
l  In 2007 and 2008 only a negligible fraction of nontrading assets were reported under fair value option provided by FAS 159.
l  For large bank holding companies, about 36 percent of assets are reported at or close to fair value, another 50% are subject to fair value disclosure. For investment banks, the fraction of assets reported at fair value turn to be higher. Among assets recorded at fair value, level 2 inputs comprise the largest category. Level 1 and level 3 play a much smaller role.
l  For investment banks, outside investors would have been concerned about fair value even if the assets had been recorded at historical cost. Banks seemed to overstate the value of their assets. Increasing haircuts in a downturn are sufficient to produce procyclical leverage.
l  For bank holding companies, income statement and regulatory capital are already shielded from many fair-value changes. The biggest position, the held-for-investment loan is not subject to fair-value accounting. For the second biggest category, available for sale, FV changes are in OCI. Temporary changes will not affect regulatory capital. By selling and repurchasing securities, banks can get around historical cost accounting restriction to writing up assets if banks want to increase its leverage.

2.       Various safeguards exist in extant rules, and banks have offered substantial discretion to avoid marking to distorted market prices.
l  FAS 157 explicitly states that prices from a forced liquidation or distress sale should not be used in determining fair value.
l  Banks choose how to classify their securities at the outset (under FAS 115).
l  When markets become inactive and transaction prices are no longer available, banks are not forced to use dealer quotes that are distorted by illiquidity. FAS 157 allows banks to use valuation models to derive fair values.
l  By the first quarter of 2009, for bank holding companies, level 1 inputs decreased from 34% to 19%, level 3 inputs increase from 9% to 13%. For investment banks, level 3 increase from 7 to 14 percent, level 1 decrease from 27 to 22 percent.
l  Mortgage-related assets are rarely Level 1 assets. At the beginning of the crisis, Level 2/3, and many moved to level 3 early in crisis.

3.       Little evidence suggests that prices were severely distorted due to fire sales of assets or that banks were forced to take excessive write-downs during the crisis.
l  Coval, Jurek and Stafford(2009), the repricing of credit risk appears consistent with the decline in the equity market, and increase in its volatility, and a better pricing of the risks embedded in structured product.
l  Longstaff and Myers(2009), bank equity prices and equity tranches from collateralized debt obligations were priced consistently between 2004 and 2009.

Conclusion: the claim that fair-value accounting exacerbated the crisis is largely unfounded.
It may be more appropriate to loosen regulatory capital constraints in a crisis than to modify the accounting standards, as the latter could hurt transparency and market discipline.

Reference: Did fair-value accounting contribute to the financial crisis? Christian Laux and Christian Leuz, Journal of Economic Perspectives, Vol 24, No.1,Winter 2010,P93-118

No comments:

Post a Comment