Thursday, September 20, 2007

The accounting side of subprime

While we have exhaustively looked at the subprime mortgage crisis over the past few weeks, and tried to discern the implications for Jamaica, there is one aspect that we have not fully examined. This is the accounting side of the subprime mess. We have seen where financial institutions in the US, Europe, and Asia have been reeling under the liquidity crunch caused by the subprime mortgage collapse, and where equity and currency markets have been significantly affected. In fact the subprime crisis can be blamed for the weakening of the US economy and the main reason for the recent 50 basis points (1/2 percentage) reduction in the Fed target rate this week.

The fact is that the US economy is made up of 70% consumer spending and the subprime crisis has resulted in a downturn of consumer spending and income, which in turn has severely affected the US economy. The crisis has also caused the IMF to revise down global growth projections. No doubt this has already begun to impact Jamaica, and we have seen where tourism arrivals to the Caribbean region are 10% lower than last year, and the demand for the greenback may have something to do with the flight to quality caused by the subprime crisis.

May be worse than appears
But the fact is that the subprime crisis, which is projected to last until March 2008, may be worse than appears. The reason for this is because of the accounting rules that call for financial instruments to be marked to market. Marking an instrument to market means valuing the financial instruments at market value and placing the market value on the balance sheet. So if one is carrying a portfolio of financial instruments backed by subprime mortgage securities purchased at $100, if after the crisis the market value becomes $20, then instead of carrying $100 on the balance sheet you would write off $80 from the asset value and carry $20 instead.

This means that the valuation of the company would reduce by $80 and the asset value reduce by 80%. Under International Financial Reporting Standards, if the instrument is classified as Available for Sale then the other side of the transaction would see the $80 being written off against shareholders equity, and if it is classified as Fair Value through Profit or Loss (previously held for trading) then it would be written off directly against profits. So while the US company Lehman Brothers, for example, has written off US$700 million against its portfolio the great possibility exists that there could be a lot more to write off. This is because the market for subprime mortgages has collapsed and there is no benchmark to value these assets. So companies have been using “Mark to Model”, which means using complex models to value these assets.

The problem though is that the models are not consistent, as market values would be, and may overstate the real value of the assets. The crisis has been compared to the 1994 bond crash, Mexico in 1995, Asia in 1997, Russia and Long Term Capital Management in 1998, and the internet bubble. It is clear then that the subprime crisis has now become an accounting challenge and one of the reasons for the flight to quality, where banks are wary of lending to each other and move towards cash and US treasuries, is because the instruments are not yet marked to market and so no one knows the true value and the extent of the crisis. When these instruments are marked to market then we will really see what the situation is.

Local effect
This could also affect local financial institutions, as they do business with US companies such as Bear Stearns and Lehman Brothers, which have been impacted. It is possible therefore that they have bought into some of these securities (Collaterized Debt Obligations) and could be carrying some of these assets on their books. In addition, as Jason Abrahams said a few weeks ago the overseas brokers have been calling loans for conversion to cash and US Treasuries, and this could have impacted local financial institutions. In addition, a global flight to quality would also mean that investors would find emerging market debt instruments less attractive, and this could reduce the demand and price for GOJ debt instruments, for example. The result is that our financial institutions would have to write down the value of those assets also. This is especially as quite a few of our financial institutions have reportedly tainted the Held to Maturity portfolio, which is the only one that could be carried on the books at cost until maturity and is therefore no longer available. The result of course is that balance sheet valuations may be negatively affected.

Consideration of the crisis must also be given by the government as the market will now demand a higher interest rate for any debt issues, and we have seen interest rates increasing marginally over the past 2 to 3 months. This heightens the need for greater fiscal discipline and is even more reason for the introduction of persons such as Don Wehby to the process and the strengthening of the management capability at the Finance Ministry. No doubt it will be challenging but manageable if properly administered. The remainder of the fiscal year will be the true test of the current administration.

Flow not flowing
A few weeks ago I mentioned in an article that I had changed Internet services to Flow, as I was frustrated with the constant disruptions from Cable and Wireless’ (C&W) ADSL. Well with less than a month into the service I have had 5 days of complete disruption because the network was (and is still at the time of writing) having problems. So I could possibly go into over 1 week of disruption within the first month.

When I called the first time a recorded message said that there were problems with the network in Kingston 6 and 8. I spoke with a customer service representative and to my amazement the person (who is supposed to respond to customer queries) was not even aware of the message on the telephone. So obviously there is a lack of communication between technical and customer departments. There was no resolution for 2 days and I then wrote a strong email and was called by the customer service manager and a director. I shudder to think of what happens to persons that suffer quietly.

Anyway they sent someone on the third day and it was back up. The service then lasted one day and then went down again. This time after calling I am told that they do not know when they will be able to send someone as the service team is fully booked. Now if the service team is fully booked that could give an indication of problems. Thank God that C&W was being their usual inefficient self and did not turn off the ADSL as I had requested that they do about 2 weeks before.

I do not think that these ISPs see the link, in a globalized world, between reliable internet services and productivity. In the world we are today it is imperative that everyone has reliable internet service as many transactions are done through the internet everyday. Our communication with each other is heavily dependent on the internet also. So when we do not have reliable internet, and telecommunications, productivity is hampered as this is just as critical as electricity. This is a requirement of competing globally and something for the regulators to carefully consider. In the meantime I am looking for a reliable ISP and if there is one out there please send me an email.

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