Derivatives are back, but are the risks?
Mortgage-backed securities, credit-default swaps and derivatives were not much more than financial industry jargon until the recession of 2007. When the world economy nearly collapsed—due in part to mismanagement of and poor investment in complex financial instruments—those terms entered the mainstream.
The 2019 survey of business executives reveals that 59% of CPAs have complex financial instruments on their balance sheets. Of those, 28% said they expect complex financial instruments to take an even bigger percentage in the next three years. At the same time, 55% said they are concerned about the valuations of those investment vehicles, and 69% said they expect them to become even more complex, making them harder to value.
The AICPA created the Financial Instruments Performance Framework and the Certified in the Valuation of Financial Instruments—known as the CVFI credential—to bring clarity to complex financial instruments. Susie DuRoss, the chair of the AICPA’s CVFI Task Force and the Chief Valuations Officer at Harvest Investments, sat down with me to shed light on complex financial instruments, why they continue to grow, and their role in the accounting and finance industry:
What are complex financial instruments?
Complex financial instruments are generally investment vehicles structured or based on some other underlying collateral or that have specified payment plans or options.
For example, when you purchase the stock of a major corporation, you have invested into that corporation. It’s a simple investment.
Complex financial instruments go beyond that. They are manufactured investment vehicles that frequently have multiple layers, structures, assets or performance standards tied to them—this makes them harder to value and trade.
Why are complex financial instruments growing on company balance sheets?
There are a couple of reasons. Firstly, companies sometimes use complex financial instruments to insure or hedge against other investments.
But more recently, a main driver is low interest rates. Corporations and investors are trying to find additional yield—complex financial instruments can offer that. At the same time, low interest rates are driving individuals and organizations to take on more debt. In a perfect world, banks and other lenders would hold that debt on their balance sheets, but complex financial instruments allow lenders to package their loans and sell them to increase yield.
Why are complex financial instruments difficult to understand and value?
A challenge with valuing complex financial instruments is understanding the underlying assets. For example, for mortgage-backed securities, what is the value of those mortgages? What is the credit worthiness of the individuals repaying those mortgages? What is the likelihood that home-owners would default on their loans?
You need to know how to dig into them, peel back the layers and understand what is underneath. The more layers and structures in these derivatives, the more difficult that can be. The AICPA’s Financial Instruments Performance Framework offers a process for digging into complex financial instruments and identifying and documenting the procedures for valuing those underlying assets.
What are three things people need to know to better understand complex financial instruments?
People who create and trade in complex financial instruments tend to be experts in their narrow area. They may understand one type of derivative very well, but that does not make them experts in another type.
Investors need to make sure they have competent, unbiased people evaluating these investments, understanding the different markets and fully documenting the value in a way that can be followed by others.
Investors need to be prepared to consider the multiple scenarios that could alter the value of the complex financial instruments. For example, how might an increase in interest rates impact mortgage rates and repayment?
Lastly, the values of complex financial instruments change over time and need to be re-evaluated regularly.
How can the Financial Instruments Performance Framework give CEOs and CFOs more confidence in the valuations of the complex assets on their balance sheets?
The Financial Instruments Performance Framework provides a principled approach to reporting on valuations of any instrument, including complex ones.
The framework provides guidance on how to document valuations transparently and consistently. It lists the basic tenets for clear, transparent and unbiased valuations and sets expectations for documentation that people in the valuation chain—including auditors, investors and management—can understand.
This approach and guidance instills confidence that valuation experts are following a consistent process to estimate fair values of financial instruments, regardless of market conditions or pressures.
What are the big risks associated with complex financial instruments and how might the risks be mitigated?
One of the larger risks with complex financial instruments lies in the underlying assets, and the ramifications of overstated valuations can be felt very widespread, as was seen with the financial crash in 2007.
Another risk is that financial institutions can create several complex financial instruments off a single set of assets, which magnifies the effects should those assets falter.
Right now, interest rates are so low that banks and others are issuing debt at breakneck speeds. Companies are highly leveraged right now, and not all loans are complying with traditional covenants to protect the lender and measure the debt-service capabilities of the borrower.
The global derivatives market exceeded $594 trillion in total value in 2018. That is where the big concern lies. Complex financial instruments magnify debt loads—should those borrowers start to default, and the initial loans fall through, the derivatives based on them will collapse too.
But if you follow a clear and consistent process to value those complex financial instruments, use complete and transparent reporting as outlined in the Financial Instruments Performance Framework, and employ the right people—like those with a CVFI credential—to value and re-value the complex financial instruments, you can mitigate valuation risks.
James Gallagher, Manager – Public Relations, Association of International Certified Professional Accountants
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