Tag: fair value accounting

The debate over mark-to-market

As was noted over at The Big Picture, fair value accounting is causing quite a ruckus – Congress in particular is pointing the finger at FASB Rule 157 for “exacerbating the global financial crisis.” And they keep pointing at the losses financial institutions are racking up as the mortgage-backed securities they hold keep decreasing in value. Unfortunately, those losses stem primarily from the fact that firms can no longer decide the value of the securities on their own (via fancy, and suspect, computations) – they must look to the markets for pricing instead. And the markets are frozen solid – the bid/ask spread for these assets is extremely wide – there is no liquidity – and in many cases no bids exist at all.

The powers that be assume that if everyone waits long enough, additional buyers will eventually step in and prices will again rise. Hank Paulson and Ben Bernanke certainly presuppose this by inferring they would pay more than market price for these assets under the “bailout plan.” Time they say, is all they need.

The value of mortgage-backed securities (and their derivatives) is assessed, in the open market, on the basis of the stream of cash flow it provides. Some exclaim that the vast majority of these securities are still performing because most of the mortgages are still being paid, therefore the securities are being unfairly priced. Not necessarily so.

The very construct of these financial products is designed to emphasize the cash flow and the purported low risk of its impedance, while obscuring the value of the underlying collateral. And it’s this collateral (the house or condo) that was over-inflated as a result of housing market fueled by sub-prime, no-money-down, teaser rate, Alt-A, etc. loans. Liquidity works both ways, and what few buyers of mortgage-backed securities remain understand this. Even if the underlying loan is still performing, the collateral may very well be worth less than note par. And market players are quietly assuming that prices will not return to the levels of 2005/06 for many, many years – maybe a decade or more. The MBS market is illiquid for a reason – ten years is too long for an investor to wait.

FASB 157 actually provides for situations where there is little or no market information, and it doesn’t attempt to place undue burden on institutions to find information where none is available (think no bids). But financial institutions may be, to a certain extent, ignoring some bids altogether. There’s a debate on the merits of mark-to-market going on over at Infectious Greed – Paul Kedrosky contends that m2m isn’t inherently evil, but right now it is creating a vicious cycle of write-downs, downgrades, failure, counterparty, failure, and then more write-downs. He’s correct – it is a negative feedback loop, but one that may well be worsened by financial institutions’ own negligence.

You just can’t blame an accounting standard for the adopters’ idiocy.

UPDATE: Henry Blodget

The Bailout will help, but it won’t stop the fall in house or stock prices or fix the economy. Only time–and forthrightness–will eventually do that.

And until housing prices reach an equilibrium state (which may still be a long time off), Kedrosky’s negative feedback loop will persist, FASB 157 or no FASB 157.

Fannie Mae, Freddie Mac insolvent under fair value accounting

Via Bloomberg:

Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac, former St. Louis Federal Reserve President William Poole said in an interview. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae’s assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.

Raising additional capital here is a tricky issue. Existing equity holders have been decimated, and infusions are going to cut them off at the knees. They’d like their knees. But new money is a foregone conclusion if bondholders are to continue getting paid. Plus, the equity holders would have to walk in a restructuring situation, but at the same time the right side of the balance sheet is byzantine – there would be more classes of creditors than you could waggle a telephone pole at.

These are GSEs – sovereign wealth funds will not be stepping up to the plate; the Fed, maybe with the cooperation of money center banks, will most certainly be taking some action, and soon.

UPDATE: You have to step back a few years to find Fortunes’ blow by blow on the GSEs (around accounting scandal time). Good stuff, and well worth the read. I’m guessing nobody read it back then.