Home > finance, news, rant > Good for the IASB!

Good for the IASB!

August 31, 2011

There’s an article here in the Financial Times which describes how the International Accounting Standards Board is complaining publicly about how certain financial institutions are lying through their teeth about how much their Greek debt is worth.

It’s a rare stand for them (in fact the article describes it as “unprecedented”), and it highlights just how much a difference in assumptions in your model can make for the end result:

Financial institutions have slashed billions of euros from the value of their Greek government bond holdings following the country’s second bail-out. The extent to which Greek sovereign debt losses were acknowledged has varied, with some banks and insurers writing down their holdings by a half and others by only a fifth.

It all comes down to whether the given institution decided to use a “mark to model” valuation for their Greek debt or a “mark to market” valuation. “Mark to model” valuations are used in accounting when the market is “sufficiently illiquid” that it’s difficult to gauge the market price of a security; however, it’s often used (as IASB is claiming here) as a ruse to be deceptive about true values when you just don’t want to admit the truth.

There’s an amusingly technical description of the mark to model valuation for Greek debt used by BNP Paribas here. I’m no accounting expert but my overall takeaway is that it’s a huge stretch to believe that something as large as a sovereign debt market is illiquid and needs mark to model valuation: true, not many people are trading Greek bonds right now, but that’s because they suck so much and nobody wants to sell them at their true price since then they’d have to mark down their holdings. It’s a cyclical and unacceptable argument.

In any case, it’s nice to see the IASB make a stand. And it’s an example where, although there are two possible assumptions one can make, there really is a better, more reasonable one that should be made.

That reminds me, here’s another example of different assumptions changing the end result by quite a lot. The “trillion dollar mistake” that S&P supposedly made was in fact caused by them making a different assumption than that which the White House was prepared to make:

As it turns out, the sharpshooters were wide of the target. S&P didn’t make an arithmetical error, as Summers would have us believe. Nor did the sovereign-debt analysts show “a stunning lack of knowledge,” as Treasury Secretary Tim Geithner claimed. Rather, they used a different assumption about the growth rate of discretionary spending, something the nonpartisan Congressional Budget Office does regularly in its long-term outlook.

CBO’s “alternative fiscal scenario,” which S&P used for its initial analysis, assumes discretionary spending increases at the same rate as nominal gross domestic product, or about 5 percent a year. CBO’s baseline scenario, which is subject to current law, assumes 2.5 percent annual growth in these outlays, which means less new debt over 10 years.

Is anyone surprised about this? Not me. It also goes under the category of “modeling error”, which is super important for people to know and to internalize: different but reasonable assumptions going into a mathematical model can have absolutely huge effects on the output. Put another way, we won’t be able to infer anything from a model unless we have some estimate of the modeling error, and in this case we see the modeling error involves at least one trillion dollars.

Categories: finance, news, rant
  1. bertie
    September 1, 2011 at 6:54 am

    Yah 4 IASB! …is it just me or does there seem to be quite a bit of unexpected and long-overdue courage being shown in all sorts of funny places lately…


  2. GMHurley
    September 4, 2011 at 3:47 pm

    Thanks for the links – I know a bit about accounting for financial instruments, but hadn’t bothered to look into this.

    One thing that stands out is that BNP have treated 1.7 billion “outside the plan” as not being impaired. If these bonds have trading at a price below par, and the discount is EITHER significant OR prolonged (either, not both) they’re required to mark them down to the most recent transaction price. I don’t see how they could avoid this while complying with IFRS.

    I can see a case for “marking to model” the 2.3 billion bonds “inside the plan” – the argument would be that these are no longer vanilla gov’t bonds, but have certain other contractual rights attached to them under the “Greek assistance plan”. This would be a good argument if the “Greek assistance plan” consisted of legally enforceable agreements with all conditions precedent met. It would be a bad argument if the “Greek assistance plan” consisted of a few speeches by politicians with all the details still to be worked out and passed through EU bodies, national parliaments, etc. As far as I know, it’s nearer to the latter.

    Another point, though, is that what matters to the markets is less what BNP have booked, than whether they’ve given enough information for an outsider to form a different view. It’s not obvious how the total of 4.0 billion they’ve explained reconciles to the 5.0 billion net direct long that the FT points out. But once investors have an explanation for that, they’ve probably got what they need,


  3. FogOfWar
    September 5, 2011 at 10:05 am

    Cathy wanted me to post a quick primer on “mark to make believe”–what is it and why does it exist. Hurley–feel free to expand, apply or correct.

    “mark to make believe” is snarky slang for “mark to model”, also called “Level 3 Assets”. The general point is that these are assets “marked to market” (listed in financials at current price rather than historic cost), but which aren’t based on observable market data. Since there’s no observable market data, firms use a model to derive the value of the asset shown on their books.

    For example, let’s say you and I enter into a contract where you pay me $100, and I agree to pay you $5,000 if there are 3 or more Cat 3 hurricanes this year. I can pull historic weather patterns and model a probability of that happening, but there’s no “market data” (our contract isn’t traded on an open exchange). Let’s say my models indicate an expected value of $95–I’d book $100 cash in, a ($95) mark on the contract and $5 profit.

    Time passes, and a Cat 5 hurricane hits. Under “mark to model” I should update my expected value to the conditional probability of 3 hurricanes this season given that one’s happened (and when, etc). Let’s say my new expected value is $110. I’d mark down my contract by $15, take ($15) to PnL and now would show a current loss on the position. If another month passes with no hurricanes, I might update my conditional probability again and show a gain.

    This is a textbook example of L3 assets, but there are a lot of wrinkles in application. In particular, NOT all assets are under mark to market in any form, so the first question you should ask is “is this asset mark to market”, second question “is it a level 1, 2 or 3 asset”?

    Hope this is helpful.



  4. GMHurley
    September 5, 2011 at 4:42 pm

    FoW: agree entirely with what you say. A couple of comments:

    (Minor) I’m an accountant not a trader, so rather than saying “mark to make-believe” I’d say “getting your profit off a spreadsheet.”

    (More substantive) As you say, there are several ways of accounting for “Level 3” assets. If they’re in the trading book, they’re at “fair value through P&L”, so gains or losses on the revised mark would immediately go to income, as in your example. Assets which are held for liquidity or maturity management (which is what you’d expect for tradeable instruments issued by governments or banks) can be classified as “available for sale”, meaning that they’re liquid and can readily be exchanged for cash, but you’re holding them as long-term investments. To avoid P&L volatility, normal daily gains or losses in market price would go to reserves, but if there’s a “significant or prolonged” fall in price, the losses have to be taken out of reserves and booked to P&L (this is what I was assuming BNP should have been doing). There’s also a category called “held to maturity”, which is not intended for the trading or banking book but primarily for insurance companies, which match long-term liabilities with long-term assets, and won’t sell unless there’s a liquidation or some other kind of restructuring. I’ve no experience with these, and with what it take for these instruments to be regarded as impaired: but if BNP have convinced their auditors that every single Greek bond they hold that is due after 2020 is going to be held to maturity no matter what, then there may be some reason to suspect that their auditors are clowns.


    • FogOfWar
      September 5, 2011 at 5:37 pm

      Love it. Does Cathy know there’s accounting humor planting seeds in her comments section?



  5. human mathematics
    September 8, 2011 at 1:01 am

    What is it in the “economic infrastructure” that allows these banks to round things so far in their favour?

    On p 211 of “The Big Short”, Deutsche Bank has Merrill on the phone and is calling in margin. Merrill’s model says X is worth 90, DB’s says 70. Says the DB trader: “I’ll make you a market. Either buy more at 77, or give me my f****ing money.” Merrill declines *and* declines to pay the $1.2bn margin.

    Seems really absurd, right?!


    • FogOfWar
      September 8, 2011 at 9:21 pm

      That’s a great moment in The Big Short–I’ve actually been in similar conversations in real life, and they’re very interesting and very disquieting at the same time.

      It definitely seemed absurd to the DB (Deustche Bank) trader, and I’m inclined to agree with them (particularly given they were completely right in hindsight).

      It’s also a core problem with complex, input-driven modelling. DB and MER had a contract based on their respective model valuations of a complex instrument, and when their models didn’t agree, it was a big issue. You can sue, but that takes years and millions of dollars. It’s a very critical, very real world concern when drafting contracts, and one which corporate lawyers often don’t fully appreciate.

      Also murking around in the back of my head is “what is the overall cost of complexity itself?” (things along this line and many, many others I’ve seen play out in real life). Very tricky question, very very hard to model…



  1. September 5, 2011 at 9:47 pm
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