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May 20,1 983
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Market Val u e- P art II
Ou r Letter of last week described the concept of market value accounting and compared it to historical cost accounting for
financial institutions. Market value accounting requires that assetsand liabilities be
expressed in terms of their present values,
i.e., the discounted-to-the-present valu.esof
the cash flows they promise, using current
estimates of interest rates expected to prevail
over the life of the contract. In keeping with
the present value concept, income in the
current accounting period includes cash
flows and realized capital gains/losses as
conventionally measured with the addition
of the current period's unrealized capital
gains/losses that arise from changes in
present values of assets and liabilities.
In contrast, historical cost accounting
requires that assetsand liabilities be
expressed in terms of their contractual book
values. Current income in this system includes only actual cash flows and realized
capital gains/losses. Thus, historical cost is
"blind" to projected cash flows beyond the
current accounting period, while market
value accounting includes the implications
for present wealth arising from all future
contractual cash flows. In this sense, it is
superior to historical cost accounting.
aggregate net worth of S&L's and mutual
savings banks, although actual figures are
subject to considerable margins of error.
Among financial institutions, S&L's and
mutual savings banks stand out by their
practice of "lending long and borrowing
short." Because lending long commonly
involves fixed-rate contracts extending a
number of years -I ike mortgages, for example-the present value ofS&L assetsis
especially sensitive to changes in interest
rates, or to what is called interest rate risk.
The typically shorter maturity of their liabilities on the other hand impl ies less sensitivity to interest rates. As a result, the net
worth of S&L's is particularly sensitive to
swings in interest rates. (In contrast, because
commercial bank business lending usually
is confined to variable-rate and/or shortterm contracts, banks are better hedged than
thrifts against interest-rate risk.)
Estimates
In looking beyond the present, however,
market value accounting requires estimates
of interest rates, prepayments, defau Its, and
other factors that might affect future cash
flows and their present values. These esti- •
mates render market value accounting
subject to some uncertainty, but nevertheless make it a useful adjunct to book value
accounting.
Calculating market value balance sheets for
thrifts under different interest rate environments gives a measure of how market value
net worth is affected by the level of interest
rates. Perhapsthe most thorough study of the
market value net worth of thrifts was conducted in 1981 by Richard Kopcke of the
Federal Reserve Bank of Boston. Employing
alternative assumptions for effective maturities of assetsand liabilities, Kopcke made
estimates of the divergence between book
and market value net worth for Massachusetts mutual savings banks and California
S&L's from the late 1970s through mid1981 -a period of an unexpected and unprecedented rise in interest rates.
In this Letter we turn to some of the problems
of market value accounting and to market
value estimates of the impact that interest
rate swings have had on the net worth of
thrifts. The boltom line is that interest rate
changes have had large impacts on the
Whereas aggregate book value net worth
was approximately 8 percent and 6 percent
of total assetsfor the respective thrift groups
in mid-1 981 , Kopcke's calculations of
aggregate market value net worth ranged
between -1 percent and -1 2 percent for
()piniolls
in this newslettpr do nClt
P?f1ect thc'
of the llldnagerrWIl'1
()f the F'('deral Re'serve Bank ()-r Sdn L:ranris(:o,
or oj the Board or' COVC'JTlOrS of tf"w Federal
Reserve Svstem.
Massachusetts mutual savings banks and between - 3 percent and -7 percent for Cal ifornia 5&L's. Perhaps as many as two-thirds
of thrifts were estimated to have negative net
worth at market value, that is, to be technically insolvent if interest rates were to
remain atthe mid-1981 level! But it is important to appreciate the considerable uncertainty that is attached to these estimates.
Alternative estimates of effective maturity
show a considerable range. Data on 26- to
3D-year Federal Housing Administration
(FH A) insured mortgages were compiled by
H U D for the years 1 957-76. The probability
of prepayment (including default) in a given
year was estimated on the basis of actual
experience, and this pattern for FHA mortgages has since been referred to as the
"1 00 percent FHA experience." Mortgages
following such a pattern would have an
average life of 13.1 years. On the other
hand, some experiments done by the
authors using Government National Mortgage Association (GN M A) passthrough
securities, which are backed by FHA mortgages, suggest a shorter effective maturity.
These experiments compared the present
value of the securities calculated under different assumptions about their maturity with
their actual market price.
Problems valuingassets
in
The assets in thrift portfolios consist mainly
of fixed-rate mortgage loans. One of the critical issues in calculating the present value of
a mortgage is its effective maturity. Mortgages usually are repaid prior to maturity, so
that the effective maturity is less than the
contracted life of the instrument. One can
attemptto estimate the average lives of mortgages based on past experience but there is
no reason for future prepayments to conform
to past experience. Prepayment options,
housing turnover, discrepancies between
present and contracted mortgage rates, legal
constraints on due-on-sale clauses, and
defaults all affect the effective life of a mortgage and hence estimated present value.
They suggest that investors priced the
G N M A securities on the basis·of about a
9-year average life. Apparently, investors
price such mortgage-backed securities as
fairly short-term instruments, treating the
mortgages that lie behind them as effectively
medium-term rather than long-term securities. Because of this, high interest rates may
have had a less drastic effect on the market
values of thrift-held mortgages than is often
suspected. Consequently, estimates like
Kopcke's of negative net worth may have
overstated the seriousness of the thrift
situation.
If all lending were contracted at interest rates
that varied along with the level of openmarket rates, interest-rate risk due to large
swings in rates would be reduced. Still,
under current arrangements, they would
usually not be eliminated since variable-rate
lending often is only partially indexed.
Contracted rates, especially in the case of
variable-rate mortgages, move only partially
2
from -7 percent to - 3 percent. As this variation in estimates indicates, assumptions
about the effective life of deposits are of
critical importance.
with open-market rates and often with prespecified lags and limits. Present values
of such instruments are especially difficult
to calculate in the framework of market
value accounting. However, the expanding
resale market for mortgage passthrough
securities should provide a broader information base from which to determine their
present values.
True net worth
Our analysis concludes that market value
accounting must rely on inputs that are
highly judgmental. Herein lies its weakness.
Assumptions and imprecise calculations
must somehow be made if one is to estimate
the current net worth of financial institutions. Market value calculations are made
implicitly everyday in the valuation of equities and are made explictly whenever
mergers, acquisitions, or regulatory actions
are contemplated. Historical cost accounting is adequate for showing book values and
current cash flows, but it gives little indication of true net worth. Market value accounting offers the potential for coming closer to
the truth, although the practical difficulties
in making present value estimates in the current state of the art mean thatthese estimates
should not be used uncritically.
Valuing liabilities
Determining the present values of liabilities
raises even tougher issues, among which
estimating their effective maturities is
perhaps the most difficult. Many liabilities
such as term fixed-rate deposits present relatively few conceptual problems. But even
these deposits normally are subjectto early
withdrawal at the option of the depositor
(usually under penalty). Consequently, their
effective maturity depends in part on future
interest rate movements, economic conditions, and deposit alternatives.
The more difficu It problem centers on determining the effective maturity of "core"
(usually, "non-interest sensitive") deposits
that can be withdrawn without penalty atthe
depositor's option. Passbook savings for
years have had a maturity of one day
although these funds have not been withdrawn despite significant changes in openmarket interest rates. What figure does one
use for their effective maturity or duration?
Jack Beebe and Matthew Blank
Kopcke found that passbooks, N O W
accounts, and comparable core deposits
made up 40 percent of Massachusetts
savings bank liabilities and 16 percent of
California S&L liabilities in 1981. Not knowing the effective maturity of these deposits,
he assumed alternatives of one year and
eight years. The corresponding variations
in market-value net worth of Massachusetts
savings banks varied from -1 2 percent to
-1 percent, and that of California S&L's
3
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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amountsin millions)
Selected Assetsand liabilities
large Commercial Banks
Loans (gross, adjusted) and investments>!'
Loans (gross, adjusted) - total#
Commercialandindustrial
Realestate
loans to individuals
Securities loans
U.S. Treasury securities*"
Other securities*
Demanddeposits-total#
Demand deposits- adjusted
Savingsdeposits - totalt
Time deposits - total#
Individuals,part.& corp.
(Large negotiable CD's)
WeeklyAverages
of Daily Figures
Member BankReserve
Position
ExcessReserves(+ )/Deficiency (-)
Borrowings
Net free reserves(+ llNet borrowed(-)
Amount
Outstanding
5/4/83
164,141
142,094
45,541
56,251
23,631
2,787
8,097
13,949
41,562
28,305
65,626
66,354
59,537
19,670
Weekended
5/4/83
117
121
26
Change
from
4/27/83
Change from
year ago
Dollar
Percent
406
452
301
6
3
113
4
49
2,341
94
636
- 267 80
92
Weekended
4/27/83
4,501
3,286
2,278
908
223
662
2,068
852
1,686
1,565
34,796
26,103
23,389
14,250
2.8
2.4
5.3
- 1.6
1.0
31.2
34.3
- 5.8
4.2
5.9
112.9
- 28.2
- 28.2
- 42.0
Comparable
year-ago period
72
135
63
55
17
38
'" Excludes trading account securities.
# Includes items not shown separately.
t Includes Money Market Deposit Accounts, $uperHNOW accounts, and N O W accounts.
Editorial comments
mayhe addressed the editor (GregoryTong) to the author.... Free
to
or
copies
of this and other Federal
Reserve
publications beobtainedby callingor writing the Public
can
Information Section,Federal
Reserve
Bank of SanFrancisco,
P.O.Box7702,SanFrancisco
94120.
Phone (415) 974-2246.
@FedFRASER