Financial instruments: investors are running the ruler over financial statements in the wake of the sub-prime debacle.
Justin Lachal explains the cause and effect.
As the shock waves from the US sub-prime crisis continue to crash on our shores, there has been a resultant increase in disclosure provisions related to the risk management of financial instruments.
However, just how watertight any of the provisions to address this risk are is still an emerging issue. If we are to examine any provisions that are evolving, we first need to look at the cause of the current credit squeeze roller-coaster.
Sharp falls in US interest rates earlier this decade, partly in response to the bursting of the dot.com bubble in the early 2000s and the increased availability of housing finance, resulted in significant increases in US house prices. Mortgage brokers and originators capitalised on this situation by targeting borrowers with sub-standard credit records or, in the worst cases, people with no jobs or assets and who may have had a history of loan defaults.
Many sub-prime loans were granted with 'honeymoon terms' discounted repayment rates for an initial period, which then reset to the prevailing market rate. Aggressive marketing saw the share of sub-prime mortgages in the US increase from 5 per cent (US$35 billion) in 1994 to 20 per cent (US$600 billion) in 2006. At the same time, the risk premium attached to these assets declined typical of boom-and-bust credit cycles.
Unfortunately for the borrowers, market rates began to rise substantially between 2004 and 2006, as the US Federal Reserve lifted its lending rates by 4.25 per cent. Significant repayment increases under adjustable rate mortgages resulted. Default levels soared. US real estate values continued to slide down an average 10 per cent in 2007. The combination of rising defaults and falling values resulted in significant credit losses. Australian house prices remained buoyant during this period, and we felt secure since sub-prime equivalent mortgages represented less than 1 per cent of all Australian mortgages outstanding.
The fallout wave rolled in when the sub-prime crisis moved beyond the loan originators. Securitisation arrangements allowed many mortgage lenders to pass the risks and rewards of sub-prime assets to investors via mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs).
The securitised share of sub-prime mortgages increased from 54 per cent in 2001, to 75 per cent in 2006.
Although the MBSs and CDOs were rated by credit rating agencies, the quality of the underlying assets was difficult to determine. Credit rating agencies have borne the criticism for giving investment-grade ratings to securitisation transactions holding sub-prime mortgages.
The lack of transparency inherent in structured products has resulted in a lack of faith in the market for all structured investments. These investments have been compared to a sausage factory, where 5 per cent of the meat is bad but you cant tell which 5 per cent. Investors stopped buying sausages. The desire for structured investments dried up, even for the safest AAA-rated paper, and the whole system has suffered from lack of trust in the product.
This lack of faith in structured products meant banks faced difficulties in funding their balance sheets. They moved to retain funds, in case securitised vehicles associated with the bank needed to be brought back onto the balance sheet. This was a direct result of the securitisation market effectively closing down, and indirectly, because banks were seen as riskier investments.
There was a global flight to quality. The cost of new or rolled-over wholesale funds increased dramatically. Australian banks raise much of their funding in deeper, offshore capital markets. In effect, funding for all banks, especially long-term funding, has become more difficult to obtain.
A primary banking function is to provide liquidity across the economy, and this has resulted in the increases in interest rates over and above the official RBA increases.
Companies are also finding it more difficult to borrow. Banks are charging more for credit and imposing tighter lending restrictions. This credit tightening is being felt in both domestic and international economies.
A reduction in the market value of investment portfolios has resulted as the value of shares in financial institutions dramatically decreased. Fears of a US recession have exacerbated this.
These are dramatic changes in the external environment, and users of financial statements are now taking an increased interest in the disclosures relating to provisions such as: fair value; current / non-current liabilities; and going concern and impairment calculations. The disclosures required by AASB 7 Financial instruments: disclosures, particularly regarding liquidity and credit policies will also be of interest to users.
The fair value concept has been championed by standard-setters who believe this measurement basis will help financial statements to better reflect economic reality. As a result, fair value measurement has increasingly been introduced into new and revised accounting rules. However, it is a double-edged sword. The market, while possessing vast, collective wisdom, is also driven by sentiment, and therefore subject to price bubbles, periodic blow-ups, unrealistic investor expectations, self-delusion and herding instincts all of which have been represented in the liquidity crisis. The users of financial statements have been less sanguine about fair value accounting, especially since the ensuing volatility can exacerbate unfavourable investor sentiment.
'Fair value' is defined in the accounting standards as the amount at which an asset can be exchanged or a liability settled between knowledgeable, willing parties in an arms-length transaction. The best evidence of fair value is quoted prices in active markets for identical assets or liabilities. In the absence of quoted prices in an active market, fair value is estimated using valuation techniques that require significant management judgement.
In an illiquid market, such as that for MBS and CDO assets, valuation is complicated by the uncertainty over the assets underlying the investment. Holders of existing loans and mortgage-backed securities that are required by AASB 139 Financial instruments: recognition and measurement to be fair valued have experienced sharp declines in their fair value as a result of marking the investment to quotes. These are seen as being excessively conservative, as a result of an abrupt end to a liquid market. The same effect is caused by using valuation techniques, as the valuation inputs are similarly affected.
Fair value is the required basis of measurement for derivatives, available-for-sale financial assets, trading portfolios and financial assets/liabilities designated as being measured at fair value through profit and loss. Fair value also has indirect effects, with loans and receivables, loan commitments and financial guarantees measured for fair value at initial recognition. A comprehensive fair value policy needs to support each entitys use of the measure.
The current credit environment has also highlighted the need for entities to carefully consider whether liabilities should be shown as current or non-current. The key to disclosing a liability as non-current is that an entity must have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date.
That is, an entity can tell the bank to come back again in 12 months time. If this is not possible, then the liability should be classified as current. If, for example, in the current credit environment, lending covenants are close to being broken, then it may be appropriate to provide going-concern disclosures, as well as carefully looking at the current/non-current liability disclosures.
Fair value is not only the primary basis of accounting for trading accounts, but it is also considered for the purposes of measuring impairment for portfolios of available for sale (AFS) financial assets. An AFS investment needs to be marked down as impaired where it is concluded that impairment had occurred.
Impairment triggers recognition of any losses directly in the income statement, rather than deferring in a revaluation account in reserves. An assessment of impairment is a complex exercise.
Specific factors to consider are dependent on whether the underlying asset is a debt instrument or an equity interest. However, in all cases it should be based on observable data.
The disappearance of active markets specifically for equity investments might have made the impairment assessment more challenging, because evidence of impairment requires a significant or prolonged decline in its value.
As part of the implementation of AASB 7, companies are required to increase their disclosure regarding the significance of financial instruments to an entitys financial position and performance, and the nature and extent of risks arising from financial instruments, including how it manages those risks.
Entities must disclose any policies regarding managing credit risk, liquidity risk, market risk, capital management, and any uncertainty regarding going concern. Fair value disclosures must include whether fair values are determined by prices quoted in active markets or are estimated using a valuation technique.
The AASB 7 disclosures should be viewed as an important part of how preparers of financial statements disclose the risks that have been especially highlighted. The governance processes around any of these disclosures should be as watertight as possible at all levels up to and including audit committee oversight. For financial reporting, the work needed for basic governance and disclosure requirements has probably increased across the board.
Justin Lachal is a member of the CPA Australia Financial Reporting and Governance Centre of Excellence.
