When Accounting Departs from Economics
The case for market value accounting, once again
Swaps hedging HTM bonds do not receive the friendly accounting treatment and hence hit the P&L of the bank – but bonds don’t, which creates a massively inconvenient asymmetry and P&L vol that banks hate.
The result is that US banks end up NOT hedging the interest risk on HTM bonds.
I know that the word “accounting” makes your eyes glaze over, but it drives the modern financial world in interesting and important ways.
Some background on “hedge accounting.”
When you have long-term fixed-rate mortgages on your balance sheet, you have assets that can rise and fall in value as market interest rates move. If your mortgages earn 6 percent and the market interest rate on new mortgages is 10 percent, your mortgages have lost a lot of value. That was the Savings and Loan industry in 1980.
Also, mortgages have a prepayment option embedded in them. When rates fall from 6 percent to 4 percent, a lot of your mortgages will go away, as alert borrowers refinance to the new low rate.
To avoid taking financial losses, you use a complicated funding strategy. You issue some ordinary long-term debt, some callable long-term debt, and some short-term debt. You also use options markets to hedge the option risk. If you do this well, the changes in the economic value of your liabilities match the changes in economic value of your assets, and your economic earnings are smooth.
Back in the days of the Savings and Loans, nobody hedged economic earnings. The result, as I wrote here,
Suppose that an S&L had originated $10 million in mortgages at an interest rate of 5 percent. Subsequently, with market rates near 10 percent, those mortgages might have a current market value of $6 million. Thanks to book-value accounting, the S&L maintained the fiction that its mortgages were still worth $10 million, but it needed to avoid having to sell them, and meanwhile its deposits were melting away.
Back to Freddie, which hedged its economic value. When you do that, you also want your accounting earnings to be smooth. So you use something called “hedge accounting.” This became an issue in an odd accounting scandal.
The accounting scandal had many odd aspects to it. For one thing, Freddie was accused of under-stating its earnings. The claim was that it was undertaking steps, such as beefing up loan loss reserves, which would reduce its earnings in the current quarter. Allegedly, the goal of this was to enable Freddie to show steady growth in subsequent quarters. Another charge was that Freddie was using “hedge accounting” for derivatives instead of marking them to market.
This had been approved by Freddie’s previous auditor Arthur Andersen, and subsequently the accounting profession has given its blessing to hedge accounting. But at the time, Arthur Andersen had to be dropped because of its role in the Enron scandal, and Freddie’s new auditor did not approve of hedge accounting.
The result was that top management was forced out in 2003 (I was long gone by then), new management was brought in, and the new management contributed to Freddie’s role in the financial crisis of 2008.
Hedge accounting is now widely accepted, except that it cannot be used for securities classified as “held to maturity.” When Silicon Valley Bank (or any other bank) puts a lot of securities into the “held to maturity” classification, the required accounting treatment militates against hedging the risk. So SVB was unhedged, and we now know how that worked out.
The moral of the story, as I see it, gets back to Mark to Market Sooner, Not Later. Let banks use hedge accounting for banks that hedge their “held to maturity” assets. Or, better yet, get rid of “held to maturity” and stick with market value accounting.
Substack referenced above:
My instinct is that there are better ways than mark-to-market, because M2M will require continual adjustment, complication and volatility. There's a lot to be said for keeping a system simple and straightforward. Minimize the points of failure and you minimize the possibility for mistakes.
Shouldn't a bank be sophisticated enough to do adjust? Sure. Just like a driver should be able to drive in bad weather. But we know that bad weather causes more accidents, even among good drivers.
In this respect, isn't the SVB failure mostly a failure due to the government's policy of inflation? SVB took measures to compensate, and maybe they were too blasé about it, but at a basic level what happened here is that people who got a helicopter drop of money put it in the bank. This blew up the bank and forced them to buy lots of low interest bonds. Then, the depositors started withdrawing money faster than the bank managed its bond portfolio in the face of rising interest rates.
Should a good bank be able to navigate that situation? Probably. But it's obviously a challenging condition for banking. To follow the metaphor, it's a patch of ice that someone was going to hit.
So maybe what we should be thinking about, rather than dramatically changing banking regulations, is changing our policy choices to something more sustainable than "monetize the debt and give away as much money as the federal government possibly can".
Mark-to-market accounting can cause problems for non-financial companies. Suppose I bought $10 million worth of equipment 5 years ago. It might be machine tools or a lithography machine or a fleet of busses or whatever, but it's tangible capital assets that I use to produce goods or services. Suppose I expect the equipment to last 10 years, so I've been sticking $1 million in bonds per year as a sinking fund for the replacement. If interest rates go up enough, mark-to-market accounting reduces the value of my bonds and might make my company seem insolvent, even though the bonds are as good for their purpose as they ever were. I'm fine, because my long-term assets aren't backing short-term liabilities. Actually, my position has improved a bit since the next batches of bonds will be cheaper.
Financial regulators are constantly having to choose between making rules that work for financial institutions and hoping they don't screw up the real economy too much, making rules that work for real companies and hoping they don't screw up the financial system too much, and making two sets of rules and trying to police the borders between the domains.