Financial Instruments & Fair Value

Sanjay UppalGroup Chief Financial OfficerEmirates NBD

Middle East Policy Forum 12 November 2008Dubai

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Global Financial Markets : Stormy times ahead

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Global banking assets bubble – how loud will be the burst ?

37 37

42

49

5657

79

87

68

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Note: Banking Assets data includes United States, Latin America, Western Europe, China, India & Japan

Contraction to 77trn ?

Challenges in raising capital & funding in international markets will persist

Lower Fed rate has not resulted in lower costs of borrowing as credit spreads widen

The unwinding of the excesses of 2005-2007 will be long and painful

US Fed Funds rate

Cause

Effect

+ W

eak

Gover

nanc

e &

Regul

atio

n

Overshoot possible

Banking Assets (US $ trillion)

The challenges are systemic – pursuit of individual victories will by myopic

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Revisiting the Standards in stressed times

13 October 2008

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IFRS 7 & IAS 39 : Rationale revisited

IFRS 7 : To require the entities to provide disclosures in their financial statements that enable users to evaluate

a) the significance of financial instruments for the entity’s financial position and performance; and

b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks.

IAS 39 : To establish principles for recognizing and measuring financial assets, financial liabilities and some contracts to buy or sell non financial items.

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Current times – an opportunity to test the effectiveness of Standards under stress

IFRS vs. UK GAAP

Turmoil requires speedy response from rule makers [standards setters, regulators, etc]

Reclassifications

Reducing volatility vs. Deferring recognition of true value

Consistency of application : Adoption, Valuation models, etc.

Asset valuation : Potential deterrent to business combination

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Hedge effectiveness…..how effective ?

Hedge accounting / effectiveness served well during normal times….

Hedges may not be effective now – creating additional volatility.

Stressed markets – is economic effectiveness now ineffective ?

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Active markets…..are valuations reliable?

Fair value or ‘fire’ value ?

Reclassification : Relief in earnings volatility……but impairments may still be required

Distressed transactions vs. distressed markets – Can orderly transactions take place in a distressed and inactive market

Illiquid markets – widening gap between market value & intrinsic value

“Fair valuation accounting rules are flawed because they don’t describe how to accurately determine the value of an asset in a distressed market”- American Banking Association to SEC

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Fair valuation…..assets & liabilities

Overarching mismatch between fair valuation of assets & liabilities – Credit Suisse study claimed 34% of assets & 11% of liabilities are fair valued

Fair valuation of debt issued – widening credit spreads or becoming less creditworthy can actually boost companies earnings (e.g. Lehman's Q3-2007)

Can a company monetize changes to fair value of its debt where there is ‘no doubt’that the company will pay back the debt ?

Bull markets & fair valuation allowed us to create capital that never existed – Bear markets have created situations where one has to raise physical capital to cover reversal of gains that perhaps were never really there

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Earnings volatility….self feeding prophecy !

Volatility & fair valuations – is this because of momentum traders rather than fundamental traders ?

$ 1.2 trillion of US sub prime mortgages, with $ 300 billion provided by Federal Deposit Insurance Corporation (FDIC) insured banks and rest held by investors –fair value, if not caused, accelerated the problem with write-down of illiquid securities at fire sale prices compromising balance sheet and regulatory ratios

An infection which is potentially self-propagating

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Credit Default Swaps : The Derivative Chernobyl ?

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Credit Default Swaps – the $ 55 trillion nightmare

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CDS : Sellers’ Profile

Limited transparency presents challenges in understanding potential impact

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ITRAXX EUROPE

ITRAXX -XOVERS

ENBD Capital Structure5 year CDS spreads : On the run

Spreads : Volatility, often with questionable credibility

Widening of spread could result in material write-downs in earnings

iTraxx Europe Index : Composed of 125 investment grade entities from 6 sectors: Autos, Consumers, Energy, Financials, Industrials, & TMTiTraxx Europe Xover : Composed of 30 non financial sub investment grade entities

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Credit Default Swaps…..

Notional amount of CDS outstanding fell from $ 62 trillion to under $ 55 trillion as dealers worked to eliminate offsetting trades

Credit Default Swap market is not regulated making it difficult to estimate value of outstanding contracts. Lehman exposure was originally estimated at $ 400 b –however the actual exposure was $ 78 billion

AIG reported big losses due to writedown of several billion US$ on its CDS holdings

Meltdown in CDS market has potentially wider ramifications than the subprime crisis. If bond insurance disappears or becomes too costly, lenders will become even more cautious about making loans. This will affect the amount & cost of liquidity in the market.

CDS fair valuation with widening credit spreads – what is the real impact ?

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Way Forward : Searching for our Yellow Brick Road

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Key themes to draw

Mark to market is an important component of risk control.

Increased transparency – are we better off ?

Lack of consistent valuation standards, questionable valuation models and veracity of valuation specialist – judgmental issues & lawsuits

Abandoning fair value in response to short term pressures will hurt long term confidence – but, what is fair value ?

Volatility in earnings through distressed valuations detrimental to market confidence; further contribute to downward spiral

Valuations = ‘Fire’ value vs. ‘Intrinsic’ value ?

The lessons have been learnt – it is time for standard setters & accountants to help global economies weather the perfect storm