The recent upheaval in the world’s financial market is giving accounting processes a bad name. Accountants are supposed to be conservative by nature, and it usually takes a lot of effort to get them to adopt new accounting conventions, especially when it comes to the introduction of new financial products. This might have served them well in the past, when the pace of product innovation and financial engineering was slower. However, modern finance has moved fast and so have the risks involved.
One particular aspect of the current financial crises has been the issue of real estate finance and how they have been booked, packaged and sold to the market.
A lot has still to be learned on how one section of a real estate mortgage market — the so-called sub prime — has unraveled and affected other, less risky real estate markets. A primary issue of modern finance has been on how to book tangible asset, especially real estate, into financial assets. Complex financial modeling, involving depreciation, discounted cash flows, net present value and a host of underlying assumptions are used. This serves the accounting world well in evaluating single model assets, but a whole host of new problems arise when such assets are “bundled” together in a homogeneous package and sold as though they all had the same risk and financial modeling characteristics.
This seemed to be the case in what has turned out to be the sub-prime mortgage fiasco. Fundamental mistakes have been made in securitizing mortgage loan pools and then re-securitizing residential mortgage-backed securities into collateralized debt obligations. To add to this illusion of homogeneity of all asset risk classes, such securities were granted a high seal of approval by credit rating agencies. In essence such credit ratings meant that the securities were tradable, and liquid. Which investor would then not look seriously at them, whether such investors were professional bankers or financially unsophisticated municipalities?
The whole model seems to have gone wrong and the underlying ratings were misguided, to put it mildly. Liquidity has vanished and a credit crunch is now in full swing affecting most financial institutions. Assets that seemed to be easily priced and booked are now more opaque in their pricing, and some have no pricing at all, making accounting for such assets a CFO’s nightmare. Investment banks should provide regular and transparent marked to market evaluations on the risks that they carry on their balance sheet, but they are finding it more and more difficult. The result is an unenviable dilemma between credit write offs, resulting in injustice to their shareholders, or continuing to carry sub-prime assets on their balance sheets.
Some have argued that under current market conditions, and to instill a sense of confidence back to the financial system, the affected institutions should mark all these securitized instruments down to zero, because their market is illiquid.
This seems appealing, but such a move might contribute to the speed of even more write downs as other classes of relatively “safe” assets might become affected, leading to a risk of a systematic banking crises.
Throughout modern financial history, there have been swings in accounting systems and the regulatory regimes supervising these. One can only gauge how effective these have been only when they are tested in times of crises. The recent accounting scandals affecting Enron, Arthur Andersen, Parmalat and WorldCom to name but a few, revealed the need for more accounting disclosure, but the pace of change was not urgent enough it seems. At the same time, there will always remain a certain element of a tug-of-war between auditors and their clients in how to value assets.
One can never pin down everything in black and white, and price opacity will remain. This is when investment banks exploit arbitrage opportunities. One way out could be to involve “neutral” third parties in valuing complex portfolios and hedge funds. Sometimes one might have to go to more simple models to evaluate the viability of financial instruments, such as real cash flows, rather than paper profit-and-loss numbers based on marked to market evaluations. Whatever models are adopted, the accounting profession will certainly be re-examining many of their current conventions in view of the market financial failures.
(Dr. Mohamed A. Ramady is visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals)