More Glib Press on FASB
If you read the headlines (and most people don’t bother to go much farther beyond the headline than the lead paragraph –- to our collective disgrace), you already think FASB eased the rules for measuring fair value on Thursday. You might believe that it has at last caved in to pressure from banks and Congress, and decided to allow “preparers” and their auditors to use judgment when valuing illiquid assets. Not so. They are reiterating for the third time that “fair value is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date.” And for the second time it is “highlighting and expanding on the relevant principles in FAS 157 that should be considered in estimating fair value when there has been a significant decrease in market activity for the asset.” The first time, of course, was when they issued FAS 157. The second is the SEC/FASB staff clarifications on fair value accounting issued September 30, 2008. This is the third statement, second clarification and expansion. Despite press reports on the Board meeting, the March 16 exposure guidance was toughened to reflect comment letters. In particular, staff recommended removing the “presumption that all transactions [in an inactive market] are distressed unless proven otherwise.” The handout and Board discussion acknowledged this proposed language confused people and might serve as a pretext to exclude relevant transaction information or preclude the use of pricing services or brokers in fair value measurement. The requirement to use all factors and information still stands. Press reports on of FASB’s vote are also somewhat overreaching. The discussion centered on questions the staff had about possible changes to the proposed guidance and the kinds of language that might be added. In other words, precise sections of the next draft of the guidance were not read and voted on. Instead staff –- who do the writing of these things –- were given more guidance on what should be in the final guidance. I might be alone in this, but I’m hedging a bit on what was decided until I see FASB’s summary of decisions taken at the meeting (usually posted the evening of the meeting) and read the final FSP when it is issued, not before the end of next week. Moreover, the discussion on Thursday clearly indicated that more tweaks and adjustments could occur as Board and staff continue to digest comment letters and each others’ opinions. And the door is not closed on comments, especially because normal due-process was foreshortened by the political pressure brought to bear on this traditionally independent standard setter. Whatever the fine points of expansion and clarification provided in the final FSP might be, one can hope the third time is a charm and that there will be no further protest that FASB doesn’t allow preparers and auditors to use “significant professional judgment” in arriving at a fair value in a market where there has been a significant reduction in trading activity. Inactive markets not the real issue I didn’t come here to praise FASB, however, but to bury the notion that the devalued and disgraced RMBS securities on banks balance sheets are illiquid. Nor should the observable market prices be described as “fire sale” or “distressed sales.” Not that there have not been fire sales. There were some very large and visible fire sales last year as the biggest “sinners” in structured products (a blanket term that includes fairly vanilla non-agency RMBS and CMBS as well as CDO, CDO’s backed by CDS, CDS and so on) shed assets on their way to bankruptcy or acquisition (Merrill’s infamous 22-cents-on-the-dollar sale will come instantly to mind for many). That those fire sales took place has provided a smoke screen, as it were, for banks and their enablers in Congress, free-enterprise, free-market “think tanks” and industry groups, and the media, to claim these markets are inactive. The other mythos this crew hides behind is the notion that these riskier-than-first-thought assets are too complex to easily value (please notice that I am not going to say “troubled,” “toxic” or, no not never, “legacy” with regard to this batch of soiled laundry). First, there is plenty of pricing information on triple-A private RMBS and CMBS. They may not trade where banks holding lots of this paper at a loss wish they traded, but they do trade. Let’s get something clear, too -- they NEVER traded with the kind of depth or frequency that Treasury, agency debt or Ginnie, Fannie and Freddie MBS do. Each bond is unique enough that it has to be manually evaluated -- anything from a simple cash flow calculator that uses market conventions for prepayments and defaults – or elaborate option pricing models that take into account hundreds of different interest rate, credit performance and prepayment scenarios. The cash flow calculators are ubiquitous -- the sophisticated tools are available at a market price. They trade less frequently because significant sources of demand have been eliminated. Except for the big trading books at the big banks, banks have eliminated themselves as potential buyers on the re-trade. They also cannot sell held-to-maturity triple-As unless they are downgraded, they can’t realize much in the way of losses on available-for-sale triple-As. Ditto for insurance companies, though the rising tide may let them wriggle out of some clunkers. What’s left is the subset of investors who are marked-to-market. Ergo they have experienced their losses. This would include money managers of various kinds of funds (mutual to pension) using what we call “real money” and leveraged investors -- the hedge funds and private equity managers. This segment of the market can and does trade this paper. It has been slow, but their activity has been significant enough for trading desks on both sides of the trade to track market levels, make offers and attempt to buy paper from known holders. Most pertinently, sources on trading desks tell me they make “on the market” bids to banks for their paper and banks won’t sell. These same sources will explain that hedge funds are still the buyer on the margin, and prices have adjusted to reflect the hedge funds’ required yield –- typically 25 percent. However, hedge funds used to achieve that yield by leveraging securities that traded at much higher prices, back when triple-A was assumed to mean risk-free (not a waiting game or playing chicken with a falling housing market). Now hedge funds’ traditional sources of leverage are gone. Security pricing has adjusted to reflect this loss of leverage. To summarize: there are lots of tools for assessing the cash flow value, even for adjusting for credit, prepayment and interest rate risk. So market pricing would incorporate those factors, transactions will incorporate a “market view” of those risks. Those prices are further adjusted to satisfy the risk appetites of hedge funds that no longer can easily leverage to their required returns. There is necessarily a liquidity premium as well, but it is not sized on the assumption that only a fire sale will entice a buyer. It is sized given the fact that the securities must be manually examined and the field of buyers has shrunk. The PPIP/TALF-expansion announced last week caused spreads to tighten and speculative buyers to build positions. It also triggered research from every major bond house left standing that (1) provided current market levels for the affected sectors –- either generically or for specific bond examples –- and (2) modeled expectations of price improvements when TALF and PPIP reintroduce leverage for secondary RMBS (originally rated triple-A) and triple-A CMBS. For one thing, an illiquid market would not be graced with so much professional research. Nor would an illiquid market adapt so rapidly to the hope of new buyers (rather than the fact). In fact, if PPIP/TALF do nothing else, they should at last stop institutions that made bad investments (and, in the case of SIV, ABCP assets come home to roost, bad funding decisions) from hiding behind claims the assets are too complex to value and anyway their market prices don’t capture their true long term worth. 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.