Michael Gracie

Shell games

Forget 3% down

Life imitates art other life. Wonder if the FHA is involved.

MG signing off (to avoid the MBS on this shell game like the plague crabs)

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.

Merle Hazard sings funny money

New York, London, and Tokyo are replaced by Nashville – Merle Hazard is the new king of country. Moral Merle is tuned to CDOs, LBOs, and over-the-counter derivatives, and often plays at Hamptons hotspots with Arthur Laffer.

The “Hope Now” Mortgage Plan: Where Are The Investors?

One need look no further than the so-called member list of the Hope Now Consortium to realize an important constituency in all this is missing:

[singlepic id=387 w=500 h=141 float=center]

Of the 33 entities on the list, only three are classified as “investors.” In addition, you could easily exclude all of those – the American Securitization Forum is a trade association, not an investor (and is already included as such), and Fannie Mae and Freddie Mac are quasi-governmental agencies that, while they hold and/or “guarantee” a lot of mortgage loans, also derive a significant amount (if not the majority) of their income from packaging and selling debt to others. The majority of members are lenders or “mortgage market participants” – in other words, the folks whose faulty underwriting standards produced the mess in the first place. Then there’s the sprinkling of not-for-profits…I take it so the initiative has the appearance of “do-good-ness.”

Where the heck are the investors?

UPDATE: As Asia-Pacific credit risk grows as a result of the mortgage debacle…

Treasury Secretary Henry Paulson said yesterday he’s confident the government and banks will agree on a plan to fix some subprime mortgage rates before they reset higher and trigger a wave of defaults. A lack of information has created doubts about the proposal, analysts say.

When the people that actually own the mortgage debt aren’t invited to what is potentially the biggest forgive-and-forget party in the history of modern finance, I’d say that’s worthy of a few doubts.

UPDATE 2: Yves Smith notices the same problem.