Good for the IASB!
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.