“Mark-to-Market Changes Fail to Rally Stocks” Why not?

The FASB recently announced a new project to improve the fair value measurements and disclosures of financial instruments. This was expected and is in response to recommendations from a SEC study on mark to market and input from the FASB’s Valuation Resource Group. The article, Mark-to-Market Changes Fail to Rally Stocks, notes that the announcement did little to move the market as “its promise has been thwarted by government initiatives that could actually prevent a market recovery.”

More significantly, it did not spark a market rally as the measurement of fair value is not the primary concern among financial institutions. The primary concern is when they are required to mark assets down to fair value and that is when the asset is deemed to be Other Than Temporarily Impaired, or OTTI. One of the misunderstandings in the media and general public is that a new accounting rule (SFAS 157) requires every asset to be marked to market. SFAS 157 was issued in 2007 but only provides guidance on how to measure fair value. Other accounting standards already in place determine when an asset should be marked to market and some of those reasons include whether an asset is placed in a trading account or whether it is held for sale or if they are determined to be OTTI. SFAS 157 did provide the OPTION to use fair value for most financial assets but very few institutions chose that option because of the earnings volatility it would cause. And this was understood even before the credit crisis.

Today, financial institutions hold mortgage-backed securities that despite the real estate market are backed by a substantial percentage of performing mortgages. Further, many of these securities are senior securities that won’t incur a loss until a junior security has absorbed all the losses in the trust. However, many of these securities are trading at significantly discounted prices due to a combination of real credit fear and the accounting rules. If cash flow projections indicate a probability of even a minor dollar loss on the security in the future, the accounting rules could consider the security OTTI. But instead of writing off the projected dollar loss, accounting rules require you to write it down to fair value which in a distressed market can turn a $5 dollar loss into a $10,000 dollar loss.

For example, during the 3rd quarter of 2008, FHLB Atlanta’s cash flow projections on approximately $300 million of mortgage-backed securities projected that the credit support from the junior securities would be depleted in approximately 16 to 19 years and the securities would lose approximately $44 thousand dollars beginning in the year 2025. Because the market is inactive and dominated by liquidation sales, these securities were trading at about 70% of par as of September 30. Thus, a $44 thousand projected loss 20 years from now becomes an $87 million loss today based on the accounting rules for securities that are OTTI. These accounting rules only apply to securities as the loss for direct loans held by a bank would require a loss of only $44 thousand. Further, international accounting rules for securities held for investment would also only recognize a $44 thousand dollar loss. Only US GAAP would require an $87 million dollar loss. For further pain, the IRS would not let you recognize that loss for taxes until 2025. Who would buy mortgage-backed securities in this market when those are the rules? How much of the inactive market is due to real credit issues and how much is due to the accounting rules?

Here is the excerpt from FHLB Atlanta’s 10Q in thousands:

Based on the Bank’s impairment analysis at September 30, 2008, the Bank recognized an other-than-temporary impairment loss of $87.3 million related to three private label MBS in its held-to-maturity securities portfolio (the “OTTI Charge”). The Bank recognizes an other-than-temporary impairment when it is probable that the Bank will not collect all scheduled contractual cash flows. The amount of other-than-temporary impairment is calculated as the difference between the current carrying value and the securities’ fair value.

The following table presents the indicated loss of contractual cash flows, the estimated date of first loss of contractual cash flows, and the impairment charge recognized for each of the securities for which an other-than-temporary impairment charge was recognized (in thousands):

It is important that the media follow this issue closely but it is also important that the issues are clearly understood.