Peeling away financial reporting issues one layer at a time

Marking Loans to Model is Far Easier and Better than Estimating Loan Loss Allowances: It’s Time to Hear from the FASB Members who Changed Their Minds about That


I'm [Osman Sattar,] a relatively new reader to your blog and I understand that you favour market values in accounting. In this article, you say that:

(1) "[B]oth models [the current incurred loss model and the proposed CECL model] are terrible because they both require estimates of future cash flows over a loan term of 5, 10 or even 30 years out".

(2) "How can the value of a loan at its inception be anything different than the net proceeds to the borrower?"

But, in arriving at a market value for loans (which are not generally traded in a market), surely there would be a need to use models, using estimates of future cash flows over the loan terms? And isn't it likely this would result in a value that is different from the net proceeds to the borrower?

Hi, Osman:

Thanks for reading my blog, and I hope that you will become a regular reader and correspondent. I want to take the opportunity of your comment to introduce you and other relatively new readers to my philosophy of financial reporting that leads to the conclusion you have noted.  Specifically, that some form of "market value" – inflation-adjusted "replacement cost" being my strong preference – is the most appropriate basis of measuring assets and liabilities.

Accordingly, here is my plan for the next three posts:

  • I'll respond below to your specific questions about the value of loans at their inception and the use of models for estimating a market value. I'll also have something to say about the FASB members who switched over from market value to the dark side.
  • In a post to follow in a few days (hopefully, by the end of this week), I'll list what I see to be the fundamental topics that standard setters must address; and the principles to which standard setters should hold themselves accountable.
  • The current controversy is over current measurement of loans, and I am going to demonstrate that even low levels of inflation affect bank profitability. I am choosing to raise this issue at the present time because I believe it is much more important than the present back and forth over the formal details of that exercise in futility known as the accounting for loan impairment. (Impairment models in general are exercises in futility.)

Valuing a Loan at Inception

Osman, you ask, "Isn't it likely [that utilization of models to estimate loan market values that are not generally traded in a market] … would result in a value that is different from the net proceeds to the borrower [at the inception of the loan]?

The short answer to your question is "yes." Notwithstanding, it has no effect on my view that the only reasonable method to account for loans that are not generally traded is to have them appraised by an independent appraiser and/or to mark them to model.

To see this, let's assume that the only alternative to current practice or the boards' proposals is to mark to model. I want to step back from loans for a few sentences to consider first the well-established standards of accounting for forward contracts – which also are generally not traded in a market. Notwithstanding the absence of an active market for trading such a contract, both U.S. GAAP and IFRS specify that these derivatives must be marked-to-model at each balance sheet date; and consistent with my position for loan accounting, both sets of standards provide that if no consideration other than future promises to perform are exchanged, the value of the forward contract at its inception should be set to zero. Management will always believe that they negotiated a fair (or perhaps even better than fair) deal for the company, but according to the standards, that, or the output of any model that would support such a contention, may not be taken into account.

Moreover, in assessing the practical consequences of a disconnect between the economic value of a loan at inception and what any particular model has to say about that, we need to remind ourselves that the first point in time when a loan or a derivative must be "marked to model" would be at the first balance sheet date subsequent to the inception of the contract. However, good practice should validate the model being used at the balance sheet date by testing it against the conditions that existed at the date of loan/derivative inception. If the model yields a valuation that is significantly different from the value dictated by standard economic principles, then such a difference should raise questions concerning model choice and/or inputs used at the balance sheet date.

Is Marking to Model a Reason not to Measure Loans at Market Value?

I know that this is not a question you have specifically asked, Osman, but I sense that you believe it is worth asking.

Any expected loss approach will require estimates of future loan losses at every balance sheet date – an exercise which I have already taken pains to point out as being highly subjective, subject to manipulation, and not amenable to being audited. My view is that marking to model would be a lot simpler and more accurate.

But, I am not asking you to take my word for it. For starters, a perfectly good and reasonable methodology for marking loans to model has already been set forth in U.S. GAAP – albeit for disclosure requirements only:

"For certain homogeneous categories of loans, such as some residential mortgages, credit card receivables, and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities." [ASC 825-10-55-3 (originally SFAS 107), bold italics supplied]

Here again, the principle I have cited that the value of a loan at inception must be equal to the net proceeds is germane. The last sentence in the forgoing quotation needs it to form the conceptual basis for measuring the fair value of any loan. Specifically, the contractual cash flows, when discounted by the effective interest rate will yield the net proceeds – equivalently, "entry value" or "replacement cost" – of the loan at inception. Thus, at any subsequent point in time, discounting the remaining cash flows by the rate at which loans would be made to borrowers with similar credit ratings should yield a reasonable measure of that version of market value.

But, if the boards would recoil from my favored approach to market value, replacement cost, they should also consider the views of an FASB member on precisely the question I am pretending you have asked. Before his appointment to the Board, Hal Schroeder authored a comment letter to the FASB wherein he stated:

"… [B]anks have existing systems that can also be used to fair value loans. We know from our own experience that with the right systems, loans can be marked to market every day. In fact, within two hours after the US markets are closed our entire debt and equity portfolios are marked daily."

Mr. Schroeder was not on the FASB when it voted by a 3-2 margin to require fair value measurement for loans. The series of events that redirected the FASB from fair value back to yet another recipe for accounting sausage was an orchestrated comment letter campaign from irate bankers; the sacking of the FASB chairman (a proponent of fair value) by the Board's overseers; and the appointment of three new board members (including Mr. Schroeder), who could be reliably counted on to resoundingly overturn the vote for fair value.

And that, boys and girls, is how the anything-but-fair-value movement at the FASB got its start. If Mr. Schroeder and the other two Board members (Tom Linsmeier and Mark Siegel) who previously supported fair values for loans are continuing to act on their principles, it sure would be nice to know how they now came to sing in close harmony with the bankers on such short order:

  • I see nothing in the current proposals that reflect Mr. Schroeder's views from before he became a board member.
  • In the case of Mr. Linsmeier, I do know something about his background, but I haven't looked at his academic publications; but I can't imagine that the expected loss model looks anything like the views he would have come to independently as an academic. I am also compelled to point out that Mr. Linsmeier changed his vote only a short while before his re-appointment to the Board was announced.

The accounting for loans is important enough so that we should hear all seven board members express their views on all major aspects of the proposal. For starters, Mr. Schroeder should explain why, if fair value accounting for loans is as straightforward as he claims, he continues to align himself with the anything-but-fair-value bloc. Mr. Linsmeier should provide a justification for changing his views in a manner that is consistent with academic standards of intellectual rigor; and as a model for that, I would suggest that he examine the writings, dissents and speeches of Bob Swieringa while he was a board member.

FASB "due process" should not be used as an excuse to duck the hard questions.


1 Comment

  1. Reply Tony Frank October 7, 2012

    Isn’t it time that the rules were market driven rather than industry focused?

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