At last week’s House hearing on mark-to-market accounting, representatives from both sides of the aisle blamed accounting standards for skewering bank balance sheets and demanded, as Congressman Paul Kanjorski (D-PA) put it, that “the Financial Accounting Standards Board and the Securities and Exchange Commission to do the jobs they are required to do. Emergency situations require expeditious action, not academic treatises. They must act quickly.” The most irate committee members asserted that, if FASB didn’t act, Congress would. That was Thursday, March 12, and FASB did not call their bluff. By end of day Friday the 13th, FASB had sent notice it would be discussing fair value measurement and other-than-temporary-impairment first thing March 16 (yesterday morning). The definition of fair value in FAS 157 has always allowed for the use of analysis and judgment when no orderly market exists or the only market-based inputs available are derived from distressed transactions. However, practice -- and the considerable legal liability imposed on auditors by Sarbanes-Oxley -- have resulted in a continued emphasis on the use of stale and/or distressed transaction pricing. In addition, reporting entities have difficulty generating evidence that transactions from which their pricing inputs were derived were distressed. In brief, banks have protested they are valuing their assets at fire sale prices, far below their economic value or the price they would fetch if the markets would “unclog.” The proposed guidance attempts yet again to clarify these issues. In order to evaluate if a significant adjustment to quoted prices, security holders would use a two-step process. First, determine if factors exist that indicate the market for the asset is inactive. These are the usual suspects – infrequent trades, low trading volume, stale prices, considerable variability among quotes, abnormal spread and bid-ask widening, and so forth. If the market is demonstrably inactive, determine if a given price quote reflects a distressed transaction: was a normal marketing period allowed and were their multiple bidders? If yes to both, then the quoted price should be “considered” in estimating fair value, although adjustments might still be warranted. If both cannot be demonstrated, then the security holder should estimate fair value using a Level 3 technique such as a present value technique. The necessary market inputs (spread, for example) cannot be solely derived from the distressed price. Instead -- and here is the tricky part -- “the inputs should be reflective of an orderly (that is, not distressed or forced) transaction between market participants.” How do you do that? The wittiest accountant I know (actually, he would still rank witty alongside a witty non-accountant) asks does that mean you go back to 2006 spreads to get a rate commensurate with the risk inherent in the asset as perceived by willing buyers and selling in non-distressed markets? Think of it -- was 2006 a world of make believe and denial, or a world a valid assessments of risk? The fact is, under the proposed changes determinations of “distressed” and “orderly” will be very much in the eye of the holder. Those holders may be able to win more arguments with their auditors, but investors will have to work that much harder to figure out if Omega National Bank’s private label CMOs really are worth what they are reported to be worth. And speaking of investors, will the market like Citigroup (C) or Bank of America (BAC) (I own securities issued by both) any better because fire sale prices have not been applied without adjustment to their “troubled” assets? Next, OTTI guidance The press has focused on the additional guidance for measuring fair value in inactive markets, but the changes to the guidance for other-than-temporary impairment (OTTI) may well be the “beef” of FASB’s response. Charges for OTTI are what banks and their codependents in Congress, the media and the blogosphere are complaining about when they talk about millions of dollars of permanent writedowns when expected credit losses are only in the thousands. That’s the issue Kajorsky was referring to last Thursday when he spoke of the case of the Federal Home Loan Bank of Atlanta:
… Last September, the bank estimated that it would lose $44,000 in cash flows on three private label mortgage-backed securities starting in about 15 years. The magic of mark-to-market accounting required this relatively minor shortfall to be treated as an other-than-temporary-impairment loss of $87.3 million. I find that accounting result to be absurd. It fails to reflect economic reality. We must correct the rules to prevent such gross distortions.
Current accounting guidance requires holders of debt securities (not held for trading purposes) to (1) determine if all amounts will be received according to the contractual terms of the security, (2) determine if they have “the intention and ability” to hold the security until all contractual amounts are received. If the answer to either step is no, then the security must be written down to its current market value. The amount of the write down -- the difference between amortized cost and current fair value -- is taken against earnings and reduces capital. After deliberating several alternatives yesterday, FASB voted to propose a new treatment. Instead of determining whether it has “the intent and ability to hold a security to recovery” to find OTTI, the entity need only consider if it intends to sell the security or would be required to sell the security before recovering its cost basis. If they intend to or anticipate they must sell, the entire impairment loss would be recognized in earnings (and sayonara capital, same as today). If NOT, then only the portion of impairment “representing credit losses” would be recognized in earnings and the balance of the “impairment loss” or difference between amortized cost and current fair value would be reflected in other comprehensive income (OCI). At first blush, this looks like a big concession to critics of “the magic of mark-to-market accounting.” It provides regulatory relief -- recall that losses accumulated in OCI are not included in calculations of regulatory capital. And they could be measured, using easier to achieve and more flexible Level 3 pricing. But it does not resolve the biggest problem created by OTTI -- as my witty accounting guru points out, it’s a DETERRENT to selling. If a bank sells a “toxic” or “troubled asset” it realizes a loss and destroys capital. As one of the irate Congressmen put it, they were calling on the standard setters to act now “to make these clogged assets marketable again.” Which really begs the question, to whom would they be marketable? The fact is, the ranks of willing investors have been decimated. And the underlying risk has ballooned. An unknowable chunk of the underlying mortgages and consumer loans are backed by falling property values and owed by borrowers who have heard all about the bailouts for the undeserving, the overreaching borrowers who drove away, leaving the pets to starve in the empty house, the hope of bankruptcy relief, the buying of cars and TVs and whatever on home price appreciation. Potential buyers of these clogged assets must weigh the non-zero risk that risk premia suggested by “distressed” transactions may not be wrong. The prudent will be asking, “is 2009 to 2012 as 2006 was to today?” And while I have your attention, can I ask, how can the same Congress that is furious with banks for taking the bailout dough and not lending to reinvigorate spending and paying outsized compensation to undersized risk managers talk about suspending mark to market accounting? Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC. Disclosure: The author held investment positions in C and BAC when this story was published. Additional indirect holdings may exist via mutual fund investments.