Goldman Sachs, Mark-To-Market, and Risk Management
In 2006, the Financial Accounting Standards Board issued FASB 157 on Fair Value Measurement which "defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements" (FASB, 2006). In other words, the FASB issued the statement in order to encourage consistency regarding fair value measurements. Presumably, greater consistency will lead to greater comparability between financial statements and generally promote transparency in fair value reporting.
In Note 5 of its 10K, Goldman says that, consistent with FASB 157, the fair value of financial instruments is determined based on an assessment of current bid prices (in the case of assets) and current offer prices (in the case of liabilities). In the absence of such current bids and/or offers, the firm determines prices by assessing bids/offers for comparable instruments, by referencing recent transactions in the instruments, or by reference to its own pricing models (Goldman 2011). GAAP classifies inputs to valuation models as either Level 1 inputs, Level 2 inputs, or Level 3 inputs. Level 1 inputs are those that are derived from observable market prices for the instrument in question, Level 2 inputs are those derived from the assessment of market prices for instruments comparable to the instrument being valued, and Level 3 inputs are those the firm develops based on its own models. Clearly, Level 1 inputs are preferable, as they are based on actual bids and offers for the instruments in question. Level 3 inputs by contrast, are highly susceptible to manipulation by management for the purpose of inflating earnings (Valencia, 2011; Chong, Huang, and Zhang, 2012). Fair value measurement then, is essentially an attempt to determine the market value of an instrument at a specific point in time and report that value on the balance sheet—readers then, can be confident that the information they receive is current.
Fair value measurement is a controversial issue; its proponents say its use contributes to transparency and accuracy in reporting, while its detractors claim it forces firms to understate the value of certain financial instruments and can fuel dangerous bubbles and exacerbate financial crises. When fair value measurements are based on market prices (Level 1 or Level 2 inputs), fair value accounting is also called 'mark-to-market' accounting. Many analysts have argued that mark-to-market accounting contributes to speculation by encouraging the use of excessive leverage in boom times and increases the risk of contagion in times of crisis. In other words, mark-to-market accounting can both inflate asset bubbles and exacerbate the severity of the problem when those bubbles eventually pop.
The logic behind this contention is that when firms are allowed to mark-to-market financial instruments during asset bubbles, balance sheets become inflated, thus justifying the use of more leverage which is in turn used to purchase more assets which are marked-to-market, and on and on, until the music eventually stops. When the music does finally stop, mark-to-market has the opposite effect; that is, instruments are marked to ever-decreasing market values triggering capital shortfalls and credit downgrades in a vicious cycle which, as we have seen, can end in financial ruin.
Research by Khan (2010) indicates that fair value accounting is indeed positively related to contagion risk. Similarly, Forbes (2009) and Magnan (2010) have suggested that fair value accounting contributed to the global financial meltdown that occurred in 2008, although other research (Andre et al. 2009; Laux and Leuz 2010; Sanders and Shaffer 2010; Badertscher, Burks, and Easton 2012) has turned up little evidence to support this contention. In fact, Laux and Luez (2010) note that “even if (stricter) fair-value accounting were to contribute to downward spirals and contagion, these negative effects in times of crisis have to be weighed against the pros of timely loss recognition” (pp. 23)--presumably, recognizing losses when they are incurred encourages firms to correct problems in a timely fashion. Lloyd Blankfein, Goldman’s Chief Executive Officer, has noted that fair value accounting likely did not exacerbate the crisis, rather “if more institutions had been required to recognize their exposures promptly and value them appropriately, they would have been likely to curtail the worst risks” (Financial Crisis Inquiry Commission, 2009).
For Goldman's part, the firm claims to be 'fanatically' dedicated to the mark-to-market approach, even though the accounting method was partially to blame for the fim’s .84 cent per share loss in the third quarter of last year, only its second loss as a public company. According to Reilly (2011), Goldman has repeatedly defended the use of market prices when valuing assets as it “forces firms to face up quickly to losses and potential capital shortfalls...prevent[ing] the long-term malaise that can result from the kick-the-can approach”. In his testimony to the Financial Crisis Inquiry Commission, Blankfein championed the use of fair value (mark-to-market) accounting and suggested that it is an important part of risk management. In his testimony, Blankfein noted that “rigorous fair value for financial instruments is fundamental to prudent management because it facilitates a clear view of risk” (Financial Crisis Inquiry Commission, 2009). Goldman’s Chief Financial Officer David Viniar echoed the notion that mark-to-market accounting is synonymous with effective risk management in his testimony to the Senate Permanent Subcommittee on Investigations, noting that Goldman carries “virtually [its] entire inventory of financial instruments at fair market value, [which] enables [the firm] to make informed decisions in real time about...risk...and respond nimbly to opportunities and threats” (Senate Permanent Subcommittee on Investigations, 2009). Relatedly, Blankfein partially attributes Goldman’s ability to successfully navigate the financial crisis to the use of fair value accounting, noting that “the daily marking of positions to their fair value was a key contributor to our decision to reduce risk relatively early in markets and positions which were deteriorating” (Financial Crisis Inquiry Commission, 2009).
Despite this, the firm (along with rival Morgan Stanley) has recently moved away from fair value accounting regarding the valuation of corporate loan commitments, a move the firm says applies only to “a very small portion of assets” (Moore, 2012). Because commercial banks do not generally mark loans to market, Goldman and Morgan (both investment banks) have found themselves at a disadvantage by accounting for investment-grade relationship loans based on market prices. In order to remedy this problem, both Morgan and Goldman are moving towards historical-cost accounting for corporate relationship loans. The problem of course, is that such a move represents the “first step on a slippery slope...[where] other portions of the balance sheet [are held] at cost if it improves short-term results” (Reilly, 2011). Additionally, the move to historical-cost accounting directly contradicts Lloyd Blankfein’s assertion that “...assets should be valued at their fair market value...not at the frequently irrelevant historical value” (Financial Crisis Inquiry Commission, 2009). Blankfein does however note that “fair value accounting may not make sense for...[institutions] that focus on lending” (Financial Crisis Inquiry Commission, 2009), suggesting that the firm’s move away from fair value regarding corporate relationship loans may be consistent with its views on the matter.
What is peculiar however, is that the impact of marking these loan commitments (the corporate relationship loans) to market is not material to the company's balance sheet. There is an interesting explanation suggested by Dealbreaker as to why Goldman is considering changing its accounting practices regarding corporate relationship loans. These loans are typically either: 1) bridge loans extended to assist the firm's client companies in mergers and acquisitions or 2) revolver commitments. Both types of loans are almost always money-losing enterprises for two reasons: 1) in the case of the bridge loans, the receiving companies are usually downgraded once news of the loan breaks, meaning the loan is essentially worth less than par almost immediately, and 2) in the case of the revolvers, the company signing-up for the revolving line of credit pays the firm a fee for the promise of a large loan (in the event the borrower cannot secure funds from anyone else), a risk the firm hedges by buying Credit Default Swaps (CDS) on theborrowing company—the problem is that the fee the firm must pay for the CDS is more than the spread it receives for taking the risk, meaning that the revolver is a money-loser from the day it is signed.
The firm only makes these loans (bridge loans and revolvers) to entice the borrowers to use its investment banking services—the loans are 'loss leaders.' When the mergers and acquisitions market begins to recover in the wake of the financial crisis and the European debt crisis, Goldman does not want to find itself marking its 'loss leader' loans to market while commercial banks like Citigroup and JP Morgan classify theirs as 'held to maturity' (Levine, 2011).
This suggests that Goldman is only committed to mark-to-market when it is either unavoidable or when it has no material effect on the bottom line because global M&A activity has not yet fully recovered. This is consistent with research by Valencia (2011) and Chong, Huang, and Zhang (2012) which indicates that financial institutions manipulate fair-value measurements (specifically by their use of Level 3 inputs) to positively impact earnings.
It has also been suggested that Goldman may have encouraged the adoption of mark-to-market just prior to the financial crisis in order to profit from the resulting write downs. Forbes contributor Todd Ganos (2012) suggests that Goldman lobbied Congress in 2006 to mandate the switch to mark-to-market for all mortgage portfolio lenders, causing E-Trade Bank to sell its mortgage portfolio for 35 cents on the dollar which in turn triggered massive paper losses at AIG. This worked out well for Goldman, as the firm had previously bet against AIG’s positions. If true, this represents another instance of the firm using mark-to-market solely for its own gain.
Goldman’s ability to stay afloat throughout the financial crisis is truly extraordinary given that three of its four major rivals (Bear Stearns, Lehman Brothers, and Merrill Lynch) were either forced into bankruptcy or acquired in shotgun marriages. Whatever its motivations, Goldman’s disciplined use of mark-to-market, or, fair value accounting contributed mightily to its ability to successfully navigate the crisis by ensuring that the firm honestly and accurately appraised the value of the instruments it held on its books on a continuous basis. As David Viniar noted in his Congressional testimony, “...daily marking of our positions was a key reason we decided to start reducing our mortgage risk relatively early as market conditions were deteriorating at the end of 2006” (Senate Permanent Subcommittee on Investigations, 2009)
Mark-to-market is just as important today as it was during the financial crisis. Currently, Europe is struggling to extricate itself from a debt crisis that has brought Greece, Portugal, and Ireland to their knees and now threatens Spain and Italy. Just as the price for mortgage-backed securities dropped precipitously during the financial crisis, so too is the sovereign debt of Europe’s troubled countries losing its value on an almost daily basis. The use of mark-to-market accounting will be a critical factor in financial institutions’ ability to manage risk throughout the current market volatility and turmoil. Firms would do well to learn from Goldman’s successes regarding risk management in times of crisis. As Blankein noted in his testimony to Congress, the “process [of marking assets to market] can be difficult, and sometimes painful, but we believe it is a discipline that should define financial institutions.” (Financial Crisis Inquiry Commission, 2009).
André, Paul, Anne Cazavan-Jeny, Wolfgang Dick, Chrystelle Richard, Peter Walton, (2009) “Fair Value Accounting and the Banking Crisis in 2008: Shooting the Messenger” Accounting in Europe. Vol. 6, Iss. 1, 2009
Badertscher, Brad, Burks, Jeffrey J. and Easton, Peter D., (2010) “A Convenient Scapegoat: Fair Value Accounting by Commercial Banks during the Financial Crisis”. The Accounting Review, Vol. 87, No. 1, January 2012.
Chong, Gin Henry Huang, Yi Zhang, (2012) "Do US Commercial Banks Use FAS 157 To Manage Earnings?", International Journal of Accounting and Information Management, Vol. 20 Iss: 1, pp.78 – 93
FASB. (2006) Summary of Statement Number 157. FASB.org. Retrieved April 24, 2012 fromhttp://www.fasb.org/summary/stsum157.shtml
Financial Crisis Inquiry Commission, 111th Congress, (2009) (Testimony of Lloyd C. Blankfein)
Forbes, Steve. (2009, March 06) “Obama Repeats Bush's Worst Mistakes”. Wall Street Journal. Retrieved April 25, 2012 from http://online.wsj.com/article/SB123630304198047321.html
Ganos, Todd. (2012, March 17) “Deeper Inquiry Of Greg Smith’s Assertions: Might Goldman Sachs Have Intentionally Precipitated The Financial Crisis?”. Forbes. Retrieved April 27, 2012 from www.forbes.com/sites/toddganos/2012/03/17/deeper-inquiry-of-greg-smiths-assertions-might-goldman-sachs-have-intentionally-precipitated-the-financial-crisis/
style="height: 12pt; color: rgb(0, 0, 0); direction: ltr; font-size: 12pt; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; font-family: 'Times New Roman'; padding-top: 0px; padding-right: 0px; padding-bottom: 0px; padding-left: 0px; ">
Goldman Sachs. (2011) Annual Report. Retrieved April 24, 2012 fromhttp://www.sec.gov/Archives/edgar/data/886982/000119312512085822/d276319d10k.htm
Khan, Urooj, (2010) “Does Fair Value Accounting Contribute to Systemic Risk in the Banking Industry?”. Columbia Business School Research Paper . Available at SSRN: ssrn.com/abstract= href="tel:1911895">1911895 orhttp://dx.doi.org/10.2139/ssrn.1911895
Levine, Matt. (2011, November 11) “Goldman And Morgan Will Sacrifice Accounting Purity To Win Deals”. DealBreaker. Retrieved April 26, 2012 from http://dealbreaker.com/2011/11/goldman-and-morgan-stanley-will-sacrifice-accounting-purity-to-win-deals/
Magnan, M. L. (2009) “Fair Value Accounting and the Financial Crisis: Messenger or Contributor?” Accounting Perspectives, 8: 189–213. doi: 10.1506/ap.8.3.1
Moore, Michael. (2012, February 17) “Morgan Stanley, Goldman Move Away From Fair Value On Commitments”. Bloomberg BusinessWeek. Retrieved April 26, 2012 from http://www.businessweek.com/news/2012-02-19/morgan-stanley-goldman-move-away-from-fair-value-on-commitments.html.
Reilly, David. (2011, November 11) “Goldman Marks Itself Down”. Wall Street Journal. Retrieved April 26, 2012 fromhttp://online.wsj.com/article/SB10001424052970203537304577030121961033292.html
Shaffer, Sanders, (2010) “Fair Value Accounting: Villain or Innocent Victim - Exploring the Links Between Fair Value Accounting, Bank Regulatory Capital and the Recent Financial Crisis”. FRB of Boston Quantitative Analysis Unit Working Paper No. 10-01. Available at SSRN: ssrn.com/abstract= href="tel:1543210">1543210 or http://dx.doi.org/10.2139/ssrn.1543210
Senate Permanent Subcommittee on Investigations, 111th Congress, (2009) (Testimony of David A. Viniar)
Valencia, Adrian. (2011) Opportunistic Behavior Using Level 3 Fair-values Under SFAS 157 (Doctoral dissertation).Retrieved from ProQuest Dissertations and Thesis Database (AAT 3477278).