Tuesday, October 14, 2008

Grey Men in Grey Suits


Quietly contemplating the carnage currently besetting world financial markets, I found myself wondering what role in all this was played by the grey men (and women) behind the wonderful international financial reporting standards which have kept so many accountants so busy over the last few years.

Consider this.  If a financial institution holds $100m of mortgage backed securities it records those securities on its balance sheet at market value.  If market liquidity dries up, and the best price you can find for the securities is $50m, you write them down to that level and take a $50m hit through the P&L.  Simple right?

But what if the underlying mortgages were still reasonably sound?  What if a sensible assessment of the present value of the expected future cashflows was $80m?  The accountants have been so desperate to avoid "profit smoothing" that they've driven the banks to write their investments down to market value where no market exists.  No doubt there'll be a done of work to be done in sorting the mess out.

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