Mark-To-Market May Affect Defined Benefit Plans
The Organization for Economic Cooperation and Development (OECD), a 32-country (including the United States) organization committed to protecting democracy and the market economy, has pointed to mark-to-market accounting rules as a primary factor in their review of defined benefit pension funding.
The OECD has sought to reform regulations on defined benefit funding, as the tide has increasingly flowed towards defined contribution plans. Juan Yermo, head of the private pensions unit of the OECD’s financial affairs division, and Clara Severinson, a division administrator, suggest in their recent document various reforms such as “reducing the reliance on market values of assets and liabilities in determining contribution levels, limiting sponsoring companies’ ability to tap surpluses or take contribution holidays and setting minimum funding levels.”
While the document agrees that mark-tomarket accounting has helped increase transparency and comparability in corporate financial statements, it “may increasingly dominate over other arguably more fundamental issues … as the biggest driver behind how and in what manner corporations remunerate their employees,” according to Yermo and Severinson.
Mark to Market Changes Could Spur Transactions in the Hotel Industry
At a July conference, members of the Industry Real Estate Finance Advisory expressed their views that proposed accounting changes will result in a boon for hotel investors as lenders become more willing to part with assets.
“If mark-to-market is going to go back into effect, then you’ll see a flush of hotels become available,” said Mark Elliott, a senior managing director with the brokerage firm Hodges Ward Elliot. Jackson Hsieh, real estate vice chairman for UBS, noted that while in 2009 most banks didn’t have the ability to take a write-down on an asset, “this year [they] made a lot of money” and will be able to do so.
Conference moderator Chuck Henry, president of Hotel Capital Advisers, echoed the sentiments by the panelists and said the time is right for investment in the hotel industry. “Absolutely it’s time to invest,” he said.
Mark-to-Market Impact On Munis is Positive
Municipal bond specialist James A. Klotz, has a bright outlook for Muni investors because of mark-to-market.
As a rule, municipal bond buyers are long-term investors. Mark-to-market values are depressed and are driving rates higher. Because investors are rarely forced to sell their bonds, market-to-market is irrelevant and they are enjoying the higher yields. From their view, this is a unique opportunity to purchase high quality assets with a tax equivalent return of over 9.00% for those in the higher tax brackets.
Investors see a “yield to maturity” value in their bond portfolio that is not available in other investments. More and more new buyers are entering the municipal market, attracted by these higher yields, combined with the security that municipal bonds have always represented.
Aflac Sells Greek Sovereign Debt
Aflac Incorporated has announced that it has sold its holdings of Greek sovereign debt and reduced its investment exposure to “hybrid” securities through two separate transactions. Their waning value, when marked to market, led to the decision.
In a press release, the insurance company declared it sold its entire holdings of Greek sovereign debt, which totaled $270 million of par value at March 31, 2010. The company will incur a realized after-tax investment loss of approximately $67 million on a generally accepted accounting basis in its second quarter financial statements as a result of the sale. Aflac also exchanged a perpetual, Upper Tier II security of a European issuer for a higher-rated, fixed maturity, senior debt instrument.
Commenting on the transactions, President and Chief Financial Officer Kriss Cloninger III said, “As a result of extensive credit analysis, we believed it was prudent to trim our exposures to Eurozone sovereign debt. As we’ve done in the past, we also concluded it was in our best interest to take advantage of opportunities to selectively reduce our holdings of perpetual securities.”
Survey Reveals Investors Reject Fair Value Proposals
Findings from a new PricewaterhouseCoopers (PwC) survey indicate that investors do not prefer mark-to-market accounting for long-held financial assets.
After conducting interviews with 60 leading U.S. and international investors, PwC found that amortised cost accounting for loans and deposits is preferred because the information “better reflects an entity’s underlying business and economic reasons for holding an instrument.”
Respondents indicated they considered fair value relevant but said it was “not necessarily the key consideration in their analysis of an entity.” Instead, investors said that when evaluating the value of a bank, for example, they would rather have more emphasis placed on its credit history and return on equity. Maybe regulators and legislators should listen to the actual participants.
New Financial Model Needed
Professor Haresh Sapra of Chicago’s Booth School of Business argues that a new method needs to be developed for valuing long term assets. Mark-to-market is too volatile; book value is often inaccurate and ignores market dynamics.
Instead, Professor Sapra suggests two methods: The first is to dampen the effect by valuing illiquid securities by some kind of average, for instance between fair value and historic cost. The second method is to base managers’ bonus payments on longer-term performance.
His rationale is that fair value effect subverts the efficient market hypothesis. Markets are only efficient with respect to information held by outsiders. However mark-to-marketing accounting changes the behavior of insiders. As a result fundamentals affect prices and prices affect fundamentals. The normal price mechanism is turned upside down.
The solution to this conundrum, Professor Sapra reasons, is to identify a more accurate value through averaging or by leveraging the power of compensation to assure a maximized long-term value.
Marking A Loan Portfolio To Market Will Be Bad For Banking
Founder and Managing Director of Bradway Research LLC, Bill Bradway, when writing for Bank Systems & Technology, takes issue with the Financial Accounting Standards Board’s (FASB) efforts to expand banks’ use of mark-to-market accounting when valuing loans.
Aside from the risk of devaluation of the loans and the impact on capitalization, four questions Mr. Bradway raises are:
- What is the market value if the loan is current and has always been current?
- What loan underwriting variables need to be revalued? The borrower’s capacity to repay? The borrower’s latest credit score or rating? The value of the collateral underlying the loan? Two of the three? All three?
- Where do you start the mark-to-market process for a portfolio of loans?
- What technology applications are available to help value the loans? Compiling Excel spreadsheets would require an extraordinary commitment of time and resources.
Mr. Bradway then observes, “For all this effort, the mark to market portfolio of loans will not produce any more cash income as long as the borrower complies with the terms of the loan.”
This points out the problem with mark-to-market–isn’t a bond a loan? It is a loan, in a security form. Just because it has a cusip, does it deserve different or worse treatment?
Mark to Market Leads to Greater Investment From Overseas
The Financial Times reports that tougher regulation and the push for mark-to-market accounting have caused domestic pension fund managers to shift away from equities and other riskier investments. Because populations are growing older, this migration was inevitable. However it was anticipated to occur at a more moderate pace.
For example, in the UK, domestic pension funds and life assurers have reduced their share of the UK equity market to 25-30 percent. In the U.S. the pool of pension money is so vast, it takes very little diversification by Americans to have a big impact on the securities market.
The question is whether the shift to bonds is significant. Foreign investors are moving into securities as domestic investors leave. There is reason to be concerned when a country becomes heavily dependent on foreign equity flows: Overseas investors tend to be less committed owners than domestic institutions, and foreign investors are more likely to move in a herd. The Financial Times worries, “When they make for the exit, it can be destabilising [sic] for currencies as well as stock markets.”
Regulations have consequences. Let’s keep this in mind as we reconfigure the U.S. markets.
