By Matthew Wolf
Newt Gingrich has come out with a plan to solve our financial problems:
The only problem with this is that his remedy is tantamount to curing a problem caused by deregulation and lack of enforcement of accounting and other rules by increasing deregulation and suspending accounting rules. In effect, this would allow even the biggest risk takers, who manage what are now the most insolvent banks, more free reign to take more risk. Like a gambler in Vegas who has lost borrowed money, they will invariably make bigger bets in hopes of being made whole and avoiding reality.
The Wall Street Journal, on October 2, claimed that the bailout bill approved by the House and quickly signed into law by President Bush on Friday “…reaffirms the Securities and Exchange Commission’s existing authority to suspend ‘mark-to-market’ accounting.”, noting also that “The SEC and FASB stopped short of bowing to pressure for a complete suspension of fair-value accounting.”
The same article stated that “Banks and a diverse coalition of lawmakers scored a victory on the issue Tuesday, when the SEC and Financial Accounting Standards Board issued “clarification” to the mark-to-market accounting rules. The clarification allows executives to use their own financial models and judgment if no market exists or if assets are being sold only at fire-sale prices. FASB said it is preparing additional guidance for later this week.”, and quoted John McCain, in his knee-jerk anti-regulation fashion, as saying, “There is serious concern that these accounting rules are worsening the credit crunch, making it difficult for small businesses to stay afloat and squeezing family budgets.”
Such language exhibits a misunderstanding of the applicable accounting rules and the bail out bill’s approach to fair-value accounting. Possibly worse, McCain’s statement seems to blame the credit crises on accounting rules rather than the lack of oversight and enforcement of existing rules, which are the true culprits. Maybe those who claim McCain is not conservative enough have a point; fair-value accounting is based on the principle of conservatism in accounting. This principle cautions against over valuing assets and revenue, and against undervaluing expenses and liabilities in financial reports.
Applicable accounting rules are not making the situation worse, only doing what they are supposed to do; establish a conservative valuation of a company’s assets and therefore, equity, or shareholder value, so that investors can make an informed decision about buying and selling. The pertinent fact here is that the market has failed to do its job, which is to establish a market value for these assets. There is no market for these assets due to their very poor and uncertain quality.
I did not read the entire 451 page bill to find any and all reference to “mark-to-market” rules. However, HR 1424, Division A – Emergency Economic Stabilization, Section 133, entitled “Study on Mark-to-Market Accounting”, found on page 89 (lines 10 through 24) and page 90 (lines 1 through 14) requires that the SEC study the effects of mark-to-market rules (specifically those contained in Statement of Financial Accounting Standards, or SFAS, 157) on financial institutions’ balance sheets, bank failures, and the impact of these accounting standards on the quality of financial information available to investors. The study is to assess the possibility of modifying the rules or applying alternate rules and report back to Congress within ninety days.
The following video contains a concise lesson in how bank accounting is affected by MBSs, but doesn’t acknowledge that mark-to-model is part of GAAP (Generally Accepted Accounting Principles; the rules that dictate how financial reporting must be done) when mark-to-market is unavailable:
SFAS 157 is not the only source of direction as to the valuation of assets such as mortgage-backed securities (MBS). SFAS 159 and SFAS 115 also apply depending on the particular nature of the MBS in question. Krumwiede, Scadding, and Stevens present a good overview of these rules and their specific applicability to MBSs in an article titled “Mortgage-Backed Securities and Fair-Value Accounting” published by the New York State Society of CPAs in May 2008.
SFAS 115, which has been around since May of 1993, requires that, whether classified as held-for-sale, or held-to-maturity, securities that have “other-than-temporary” impairment in value must be written down to their market, or fair, value. SFAS 115 explains:
“For example, if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred.”
In other words, interest rates change in cycles and can change the value at which a security trades, but this can be considered temporary if the mortgagor is expected to pay under the terms of the mortgage. Clearly the present MBS situation is other-than-temporary, because the problem is one of widespread default on mortgages. To wit, the Mortgage Bankers Association’s latest National Delinquency Survey:
WASHINGTON, D.C. (September 5, 2008) — The delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 6.41 percent of all loans outstanding at the end of the second quarter of 2008, up six basis points from the first quarter of 2008, and up 129 basis points from one year ago on a seasonally adjusted basis, according to the Mortgage Bankers Association’s (MBA) National Delinquency Survey.
The delinquency rate includes loans that are at least one payment past due but does not include loans somewhere in the process of foreclosure. The percentage of loans in the foreclosure process at the end of the second quarter was 2.75 percent, an increase of 28 basis points from the first quarter of 2008 and 135 basis points from one year ago.
The percentage of loans on which foreclosure actions were started during the second quarter was 1.08 percent, up 7 basis points from last quarter and up 49 basis points from one year ago on a non-seasonally adjusted basis.
The seasonally adjusted total delinquency rate continues to be the highest recorded in the MBA survey. The increase in the overall delinquency rate was driven by increases in the number of loans 90 or more days past due, primarily in California and Florida. The 30 day delinquency percentage remains below levels seen as recently as 2002.
Once again this quarter, the rate of foreclosure starts and the percentage of loans in the process of foreclosure set new records.
Because of the high rate of mortgage foreclosures and delinquencies, and the falling value of the underlying collateral – homes – there is almost no market for MBSs, or the companies upon whose balance sheets these MBS portfolios lie. Merrill Lynch sold a large portfolio in July 2008 to an affiliate of Lone Star Funds (the secretive company run by John Grayken, former adviser to Robert Bass). The portfolio had a gross value of $30.6 billion, but was only being carried on the books of Merrill Lynch at $11.1 billion. To complicate matters, Merrill Lynch financed 75% of the $6.7 billion sale for Lone Star with recourse only to assets of the entity (Lone Star’s affiliate, a private entity, which does not release information to the public) purchasing the portfolio, and must buy the MBSs back if their value drops too far (details on how far were not mentioned in several articles).
This Merrill Lynch sale is one of the only recent sales of MBSs to occur, unless you count sales of entire companies, which leaves many asset and liability variables that must be taken into account to arrive at a value for the MBS portfolio. Clearly, there is not an active market for mortgage backed securities.
In anticipation of such a situation, which is not unprecedented, except in magnitude, SEC regulations and Generally Accepted Accounting Principles (GAAP) – including SFASs and other FASB clarifications – contain provisions that allow for valuing securities by other means when there are not active markets for them. Although SFAS 115 has been in existence for over a decade, SFAS 157 was written in 2006 to clarify contradictions between SFAS 115 and other FASB rules.
Thus, the generally accepted requirement to mark to market is not new and is not, as yet, subject to “suspension”. In fact, suspension of such rules makes no sense in light of investors’ need for information with which to make decisions about investing. The important question that begs an answer is; What is the market value of these MBSs? And GAAP, even as it existed before SFAS 157, has answers. It requires that when a market exists it must be used, but if one does not exist, management and accountants must use their judgment to conservatively value securities, such as MBSs.
As with any estimation of asset value, there are three approaches; cost, income, and market. Although the best estimate, and favored by GAAP and the SEC for securities valuation, the market, as discussed above, is not available or accurate (i.e. most of the securities are not worth zero). Cost is an approach used in appraising homes and other fixed assets under the theory that the cost of building a similar home at today’s prices would approximate today’s value. It seems obvious, especially in light of the Merrill Lynch example that original cost seems to have little or no relation to the present value of MBSs.
This leaves the income approach, which assesses the timing, amount, and certainty of cash flows earned by the security in order to arrive at a reasonable, discounted value. Thus, companies holding MBSs will need to dig into their portfolios and determine a reasonable value of them based on the note terms (including any substantial rate adjustments), the present and likely future default and foreclosure rates, and the probability of these predictions to arrive at a fair value that should be scrutinized by their CPAs, the SEC, and their investors.
Such a valuation methodology is similar to what the US Secretary of the Treasury will need to employ to administer the Troubled Asset Relief Program (TARP) prudently on behalf of tax payers, who are putting up to $700 billion at risk. One might hope that the government would lead by establishing some guidelines, or even requirements, restricting the use of this highly subjective method of valuing MBSs. TARP should identify the most important factors that determine the value of MBSs, such as the type of MBS, their specific terms, interest rates, and historical and predicted default rates. It should then, based on its experience in drilling down through MBS portfolios, set limits (in terms of minimums and maximums) as to the parameters that can be used for each component of valuation.
Sound like a more active form of regulation? It is, but to allow management to haggle over valuation and methodology with their accountants and then eventually the SEC will drag the process out over too long a time and likely allow unrealistically high valuations to persist. As noted by The Economist, “(mark-to-market) rules are deeply unpopular with many firms that have suffered losses and impaired capital positions. They would prefer to recognise losses in the traditional way – that is, slowly and when it suits them.”
The result of TARP taking charge of this process would be to place more realistic valuations on MBSs, but would also avoid writing them down to zero, which is probably not realistic for most portfolios. Normally, the metrics get increasingly accurate with experience. Such a process will not save those institutions which, by the measures developed, are shown to be insolvent, but will provide a more accurate valuation of corporate capital than exists now, which is what America needs. Actual suspension of mark-to-market rules would be a blatant bail out of the companies that took the most ill conceived and unwarranted risks with their capital, and I think most agree that these are ones that need to be allowed to fail.
In conclusion, mark-to-market rules do not need to be suspended, only enforced with more diligent oversight. Arguably, had they been more consistently and diligently enforced along the way this crises would have come to a head much sooner, avoiding some part of the fallout. The following documentary was made as an indictment of John McCain’s judgment, but also serves as a good indicator of what a bank will do when allowed to avoid or delay its day of reckoning by two years:
Incidentally, its presentation is professional and the truth of its claims is corroborated by the Truth Squad at CNN in the following video:
The Federal Reserve has published quantitative studies that indicate bad loans surround bad lenders and lending practices. Supervision of banks predates the Securities Acts, and over the years, a substantial body of data and research has supported the need to regulate banks, and to restrict or outlaw practices that put public deposits at undue risk. We are clearly at a juncture where some changes need to be made, and more deregulation is not the answer.
The carnage will continue until the banks are reigned in, conservatively valued, and prudently supervised. Even then it will take years to recover. The most difficult recovery will be that of the confidence of the public, which is so vital to healthy markets.
Matthew Wolf has been involved in accounting and finance for over twenty years. He spent several years directing audits of federal programs as part of Ronald Reagan’s “cut the fat” initiative, several years auditing banks and assessing the quality, risk, and value of their loan portfolios, and many more years making and monitoring (sometimes collecting) commercial loans. Through his banking experience, Mr. Wolf has had broad exposure to many industries, has served as the chief financial officer of a mid market telecommunications company , CEO of a small software company, and has an extensive background in private equity capital investments. He is now a private investor and a student of political science and literature.