I agree, HOWEVER…

Recently, there was a very insightful op-ed article in the WSJ, [$$] How Geithner Can Price Troubled Bank Assets by Peter J. Wallison, involving the difference between the value of what mortgage-backed securities are trading at and the value of their cash flows. The conclusion drawn by Mr. Wallison is that since the net realizable value of the cash flows exceeds the market bids for the securities due to the distressed and illiquid market, the government can purchase the assets at the net realizable value and still be a net benefit to the taxpayers and the bank. The US can hold the securities and earn a positive return and the banks can free up their balance sheet without impairing their capital. The classic win-win. Mr. Wallison argues that no major accounting policies need to be changed, as the seller could liquidate their positions at a price they feel represents the value and not significantly reduce their capital. We don’t disagree. However, the same could be accomplished without major changes to accounting standards, but providing simple clarity to the existing accounting standards. Mr. Wallison writes the following:

The accounting rules relating to assets such as mortgage-backed securities require that they be marked to market if they are held for trading, or in a category called “available for sale.” Most banks hold these assets in one of these two accounts, and so mark-to-market rules apply. What happens, then, when there is virtually no market for these assets — as has been true for at least a year? In that case, accounting rules require the banks use whatever market indicators are available.

The banks follow two steps. First, they establish the net realizable value for the portfolio. This is simply what the value of the cash flows would bring in a fully functioning market, including discounts for several factors like anticipated future losses. Paradoxically, many of the banks’ most troubled assets are flowing cash near their expected rates, and thus their net realizable values are higher than the values to which they have been written down.

This is the most misunderstood part of the mark to market debate. Writedowns reduce earnings and Tier 1 capital ONLY if a security is deemed to be Other Than Temporarily Impaired, or OTTI. Generally speaking, a security is Other Than Temporarily Impaired when it becomes probable that they won’t receive the principal and interest payments they estimated at purchase. However, there are numerous areas in the literature on how to apply the guidance and numerous opinions from the various accounting firms. There is uncertainty in the application, and thus, fear of how it will be applied to their existing securities and any securities they may purchase. Consequently, buyers stay on the sidelines. They won’t sell because the market bids don’t reflect the intrinsic value and selling would directly reduce their earnings and capital. They won’t buy because of the uncertainty of both the market and the accounting treatment.

If a security is determined to be other then temporarily impaired, the write down is to “fair value” as defined by SFAS 157. However, there is an equal amount of uncertainty as to what fair value is in a distressed market. SFAS 157 defines fair value as a price in an orderly transaction and not the price you would receive in a distressed or forced sale. However, the FASB continues to suggest that illiquid markets are not necessarily distressed markets, and since the goal is to determine an exit price, the liquidity spreads need to be factored in when determining fair value. Thus, there is uncertainty as to what fair value is when all the sellers are forced sellers because that is the indication of an exit price.

The FASB tried to provide additional guidance on both these matters in the last three months, but it has done little to clarify the accounting uncertainty. Earlier this week, they issued a press release announcing a new project to improve the fair value model; it is unclear as to the direction the project will go. In our opinion, since the definition of fair value assumes an orderly transaction and not a distressed sale, simply clarifying that the extreme liquidity spreads of a distressed market should not be factored in a fair value estimate, would go a long way to remove the accounting fears and preserve capital of the financial institutions. This does not seem to be a major change or suspension of an accounting policy but consistent with the definition.

The securitization market participated in by financial institutions has been a significant part of lending to consumers for homes, autos and credit cards. In addition to the fair value accounting project, the FASB is in the process of reviewing and amending the principal accounting standard on securitization which directly affect how banks account for issuing these securities and purchasing them. The future outcome is still uncertain. The impact of this uncertainty on a bank’s willingness to lend or buy securitized loans cannot be underestimated.