Editor's Note: The debate over mark-to-market rules could result in major changes for financial companies such as Citigroup, AIG, Bank of America, Wells Fargo, Goldman Sachs, JPMorgan Chase and many others. We welcome a variety of opinions about how this should be addressed. To submit an opinion, please click here to send an email to the editor.
By Ian A. O'Connor
Securities held by financial institutions that are backed by non-performing level 3 assets (i.e. home mortgages) have frozen the world's credit markets.
Unfreezing the credit system, however, can be done without abandoning the FASB mark-to-market rule, which states that "starting Nov. 15, 2007, fair value at any given moment is the price you can sell the thing for, period."
The ending of the U.S. mortgage-backed securities debt instrument crisis lies in utilizing a tool found in the insurance industry's toolbox -- the tried and true concept of insuring the underlying asset for
replacement cost value
actual cash value.
This places a stable, quantitatively known "mark to market" value on homes, condominiums, commercial buildings, etc., because insurance underwriters do not promulgate a premium based on what someone paid for a property. Their singular task is to make sure the insurance company gets the correct premium for a replacement cost policy.
There are several property valuation companies that operate in all 50 states and the key to their industry-wide acceptance and their success starts with a zip code. Each zip code has a unique "cost of construction index" which falls either below or rises above a nationally accepted "base index" of 1.0.
For example, a single story, 3,000 square foot, brick, barrel tile roof, four bedroom, three bath, living room, dining room, kitchen, laundry room, 2-car garage, no pool, 10-year old home in Fairfield, Connecticut, zip code 06825, will have a replacement cost of $600,000, as of March 2009. Let's further say that this value is 2.25% above the national base construction index for all homes with similar amenities and upgrades.
Regardless of the fact that the owner may have paid $200,000 for the home 10 years earlier, and subsequently refinanced it for $900,000 in 2006 -- $600,000 represents this property's insurable replacement cost at this moment in time. The value
the $300,000 value assigned to the land the home sits upon. It should be noted here that land is an uninsurable asset for the simple reason that generally nothing can ever happen to it.
Yet the overwhelming majority of lending institutions wrongly force homeowners to carry more insurance than they need or will ever collect, even in the event of a total loss. Property carriers seldom, if ever, objected, because they were only too happy to collect an additional premium for a risk that didn't exist.
Now consider an identical home in Miami, Florida, zip 33176, the insurable replacement cost for such a structure as of March 2009 is $450,000. Again, it is immaterial that the house was refinanced for in 2006 for $820,000 (which included the appreciation of the land under the dwelling) that building is now worth $450,000 for insurance purposes.
The concept is akin to the auto industry's use of a valuation bible called the Kelley Blue Book. It simply provides a starting point for the selling price of any make or model car and takes into account regional variables that affect price.
The beauty of using the existing replacement cost coverage formula is that it can be applied to any home, apartment building, condominium building, warehouse, shopping center or other structure -- and it provides a definitive determination of a property's current mark to market value. Several national companies have provided such services to the insurance industry for over 20 years, and it does not rely on a property appraiser "guesstimating" the value.
This approach can solve the problem of placing a value on at least 98% of all properties either already in default or close to default. This universally accepted insurance industry formula for property valuation would allow for "toxic" assets to be purchased by the federal government and quarantined in a "Bad Bank" at whatever price the government is willing to pay -- either at the insurable replacement cost, or at any other agreed upon figure somewhere below the mark to market value.
In all probability the government will have to purchase most of these properties at close to 50 cents on the dollar just to end the crippling credit crisis, but once the nation's housing market recovers -- and it will -- these assets can be sold at prices substantially above what the government will pay for them in 2009 and 2010. And taxpayers will be rewarded with the profits from these sales going back into the national treasury.
This possible solution to the credit crisis does not undermine, or evade, the accounting rule of mark to market that has now paralyzed America's financial markets. In fact, it embraces it!
Ian A. O'Connor is a 39-year veteran of the property and casualty insurance industry with a background in underwriting and sales. He is also a retired USAF colonel, having served 26 years both on active duty and in the reserves. Ian is a graduate of the Industrial College of the Armed Forces.. He is the author of The Seventh Seal, a novel, and co-author of SCRAPPY: Memoir of a U.S. Fighter Pilot in Korea and Vietnam. He resides in Palm Beach Gardens, Florida