Many Views on a Greek Bond’s Value

ppteam

Is there one set of international accounting standards, or can each country choose its own when the going gets tough?

That is the important issue being sorted out now in Europe, where banks have taken widely divergent positions on valuations of Greek bonds.

Broadly speaking, there seems to be a consensus within countries. British banks were most willing to swallow bad medicine and admit the bonds were worth far less than par value. Some German banks were equally forthcoming, but others were less so. Italian banks seem to have done as little as they could, but did take write-downs. French banks went the farthest to find ways to act as if Greek bonds were just fine.

The first-half financial statements issued by the banks were unaudited, but they were reviewed by audit firms. The same firms — well, firms with the same name — seem to have signed off on wildly different ways of looking at the same underlying market for Greek bonds. In some cases there is enough disclosure for investors to try to adjust valuations, but in other cases there is not.

The situation is so chaotic that the chairman of the International Accounting Standards Board, Hans Hoogervoorst, wrote to European securities regulators in early August to protest that “it appears that some companies are not following” the relevant accounting rule, known as IAS 39. He did not name names, but there was no doubt he had the French banks in mind.

The protest — which was kept secret until someone leaked it to The Financial Times — has so far provoked no public response from the regulators.

It is the French securities regulator, the Autorité des Marchés Financiers, whose reaction will matter most. If it forces French banks to change their accounting, it risks incurring the wrath of both the French government and French bank regulators. If it looks the other way and other European securities regulators do nothing, the essential weakness of international standards — a lack of consistent enforcement — will be clear to all.

That the fight is taking place now may be critical to the future of the international rules. The Securities and Exchange Commission is weighing whether to allow American companies to use the international rules rather than the ones set down by the American rule writer, the Financial Accounting Standards Board. The S.E.C. would be able to enforce consistent application of the rules by companies whose securities trade in the United States, but arguments for the change would be undermined if it appeared there was little reason to think those reports would be comparable to reports issued by companies in other countries.

It has long been clear there is no common legal enforcement mechanism for international rules, but some hoped the audit firms would fill that role. In this very visible area, that did not happen.

“Auditors have not enforced a consistent approach among their clients,” wrote Peter Elwin, the head of European accounting research for J. P. Morgan. “Some institutions have taken full advantage of the principles-based IAS 39 impairment rules to achieve the desired result.”

In an interview, Mr. Elwin said that could change. “Interim results are not audited, whereas the year-end figures will be,” he said. “That may tighten things up.”

Or it may not. Although they use similar names in various countries, the auditing firms are organized as national partnerships. There are efforts within the firms to assure consistency across borders, but in the end it is the French partnership — which is no doubt quite aware of what the French government wants — that decides what it will allow French companies to do.

Mr. Hoogervoorst is upset by the way banks are accounting for Greek bonds that they have carried on their books as “available for sale.” Under IAS 39, such bonds are supposed to be marked to market values. But such write-downs do not have to be shown in net income unless and until the bond values are deemed to be impaired.

During the financial crisis in 2008 and 2009, banks could and did argue that there was no active market for some of the strange derivatives that they owned. If that were the case, then they were supposed to look to market values of similar instruments. Only if those were not available were they allowed to go to “mark to model.” If they can use models, they can apply assumptions about expected cash flows and determine current value from those calculations.

In the opinion of BNP Paribas, the largest French bank, the market for Greek bonds is inactive, never mind the fact that there are trades every day. It pointed to “the lack of liquidity seen during the first half of 2011” as it concluded market prices were “no longer representative of fair value.” It is now using a model to determine value.

In his letter, Mr. Hoogervoorst states that the fact that Greek bonds trade less frequently than they once did does not prove a market is inactive. “That is because when measuring fair value, the issue is not about the level of market activity per se, but about whether an observed transaction price represents fair value,” he wrote.

“IAS 39 is clear that unless there is evidence that the prices in those transactions do not represent fair value, for example, because those transactions are forced,” he added, “the observed transactions prices should be used to measure fair value.”

The French may be preparing to argue for a sort of sovereign immunity exception to the accounting rules. BNP Paribas cited “the undertaking given by French banks at the request of the authorities not to sell their position” in Greek bonds, but did not say why that was relevant. The argument may be that if their government won’t let them sell the bonds, then there is no market available to them, even if there is one available to everyone else. With no market, they can go to their optimistic models to get values.

The Greek bailout proposed in July by European authorities — one that is still tied up in disputes — called for an exchange of Greek bonds maturing before 2020. The Institute of International Finance, a trade group of major banks, estimated that amounted to a 21 percent haircut, and many banks cited that figure in taking 21 percent impairment charges. Given that the bonds are generally trading for around half of face value, that seems optimistic.

Many banks applied that haircut to all of their Greek bonds, including the long-term ones not covered by the proposed exchange. But some banks, including BNP Paribas and Société Générale in France and Intesa Sanpaolo in Italy, decided to carry the long-term bonds at full value, on the theory that it would all work out and that European governments had promised not to force exchanges of longer-dated bonds.

“It is,” said Mr. Elwin, “probably more of a faith-based measurement system than a fair-value-based measurement system.”

If those banks really believe that long-term Greek bonds will be paid in full when due, they could buy some at bargain prices. On Thursday, the average trading price for such bonds was about 37 percent of par value.

The accounting hocus-pocus may in the end be counterproductive for the banks. It highlights the latitude banks have in many areas of accounting, and shows that some are quite willing to use that latitude to come up with ridiculous valuations in a highly visible area. It undercuts investor faith in those banks, and is a major reason European bank stocks have fallen so far this year.