Somebody Tell Hank There is a Hole in the Bucket
(Uncertain and inconsistent accounting and regulatory rules for fixed income investments will wipe out benefit of fresh capital)
As the Treasury pours capital into the banking system, some interpretations of regulatory, accounting, and bond rating rules are draining it out at an even faster rate.
The issue centers around rules that don’t fit all financial instruments at all times. On the regulatory side, we are starting to see some discussion of these issues from the Office of the Comptroller and even in testimony before Congress by the American Bankers Association. On the accounting side, there is a movement towards a “principle” vs. a “rules” based accounting system. However, time is running out to fix these crucial problems.
The uncertainty is particularly acute for certain mortgage-backed securities, particularly privately-issued mortgage-backed securities (PMBS). PMBS are essentially securitized pools of individual mortgage loans that are not guaranteed by a government agency. Approximately 60 percent of all mortgage loans end up in mortgage-backed securities and 30 percent of those end up as PMBS (roughly $2 trillion). Hard-line interpretations relating to the accounting treatment of PMBS are severely impeding their recovery and hence the recovery of the overall mortgage market.
The national regulatory and accounting leadership can take away this uncertainty and put the bankers back into the lending markets by clarifying or affirming five existing accounting and regulatory guidelines. This can be done without radical changes to existing guidelines and by simply following the key principles already in place.
1. Statement of Financial Accounting Standards (SFAS) 157. This rule was issued in 2006 to provide more guidance in determining fair value of financial instruments. A key part of SFAS 157 includes the assumption that when defining fair value, the transaction was orderly and not a forced sale. Yet, the Financial Accounting Standards Board (FASB) clouded the issue in October with the release of FSP FAS 157-3 (“157-3”), which said the wider “liquidity risk premiums” present in the current distressed market should be used to help determine fair value.
But some accountants are interpreting this to mean that fair value equals today’s fire sale value. This interpretation could force a performing fixed income security that is generating positive net interest income to be written down to its immediate liquidation value, directly reducing earnings and capital. This would be the case even if the security is projected to receive 100 percent of its cashflows! This is a big mistake because it is inconsistent with FASB’s definition of fair value itself as well as the accounting for most other items on the balance sheet of financial institutions.
2. Other Than Temporarily Impaired (OTTI). This inconsistency would not be as critical if all accountants were in agreement on when a security becomes “other than temporarily impaired” (OTTI). If a fixed income security is determined to be OTTI, the charge is applied directly to earnings and reduces a bank’s capital. Various accounting statements have said that a security is not OTTI if the investor will receive the cash flows they expected at purchase. However, many accountants are relying on fair value to determine if a security is OTTI, rather than cash flows. If fair value is determined by the high liquidity spreads of a distressed market, the result is that many accountants will misapply the accounting guidance and force institutions to unnecessarily write down performing securities. Clarifying that “fair value” is based on orderly transactions in active markets and that OTTI is based on the probability of receiving expected cash flows would improve the consistency in financial reporting, reduce significant charges to capital on securities that are performing and put many institutions back in the lending markets.
3. Statement of Position 03-3 (“SOP 03-3“). Based on a review of financial statements, it appears few financial institutions are applying the principles of SOP 03-3 to investment securities. This applies specifically to the purchase of distressed assets and essentially eliminates the fair value issue because the accounting (both income recognition and OTTI) is based solely on the expected cash flows of the investor. If investors and accountants were on the same page with SOP 03-3, they would be more comfortable buying distressed assets, which in turn would support higher prices for these instruments.
4. Published ratings for certain fixed income securities. Financial institutions that own downgraded fixed income securities are being forced by regulators to use the worst of the published ratings to determine its capital charge. This might work in an organized market when we have full confidence in the ratings assigned by the agencies. But in today’s market, we have seen the same PMBS pool rated AAA by Moody’s, and BB by S&P. Who is right? Let’s at least give the institution the ability to average the rating when there is such a disparity in ratings opinions.
In addition, many investors will not or cannot purchase below investment grade securities. The ratings reflect the probability of collecting 100 cents on the dollar. But if one pays say 80 cents on the dollar for one of these securities, they might effectively own a AAA rated security given the price they paid. While ratings agencies and regulators acknowledge the substantial difference in risk between owning a bond at 100 cents on the dollar versus 80 cents, the letter of the law makes no allowance for such a distinction. This phenomenon alone is not only significantly clogging the market for PMBS but its effects are felt all the way up to the retail rates offered on new mortgage loans.
5. Treatment of loans pools. Related to downgrades is the issue of treating PMBS as essentially one big loan as opposed to a pool of smaller loans. As projected defaults increase, say from 3% to 8%, a bond might get downgraded to below investment grade, even though 92% of the loans might still be current. Without a clear change in guidance, regulators might examine the security and classify the entire amount substandard. That is tantamount to saying a bank has 8% of loans past due, so all loans are considered substandard. This unfair treatment can certainly lead to a restriction of the free flow of credit because these downgrades impact capital charges. These securities should be looked at as a pool of loans, which is what they are.
These valuation methods outlined here are not asking accountants and regulators to “go easy” on banks for now, but rather they take into consideration an unprecedented dysfunctional market. Banks strive for safe lending, earnings and self-preservation. They will not lend if they think they might lose precious capital to ambiguous and excessive write downs.
The Treasury is doing its part to help unclog the credit markets at the front end of the capital chain. However, this unnecessary, and for some institutions sizeable, hole in the bucket needs to be plugged before the banking industry begins to feel free to lend again.
Brian J. Battle, VP
Phil Nussbaum, Chairman
Jim Lorentsen, CFO
All three are with Performance Trust Capital Partners, LLC Based in Chicago, Performance Trust works with hundreds of community banks, focusing on educating fixed income investment professionals and assisting client institutions to invest through total return. For more information, go to www.performancetrust.com.
