Editor's Note: FASB's Financial Crisis Advisory Group meets Thursday to review reporting issues that impact major financial services companies such as Citigroup, AIG, Bank of America, Wells Fargo, Goldman Sachs, JPMorgan Chase and many others. We welcome alternative opinions about how the FASB should respond. To submit an opinion piece, please click here to send an email to the editor.By Paul D. Mendelsohn, president and chief investment strategist at Windham Financial Services We are at a critical point in time in our economic history, where if we do not understand the trigger points that brought us to this level of crisis, there will be little hope of solving our current dilemma. It is easy to look back at the 1930's and see that the Smoot-Hawley Tariff Act and Federal Reserve monetary policy played a major roll in creating and prolonging the worldwide depression. So, why is it so difficult for policy makers to understand the roots of our current crisis and address today's problem? One of the major trigger points of the current disaster is FASB 157, better known as the "Fair Value Rule" or "Mark To Market Rule" that took effect for corporate financial statements produced after November 15, 2007. This rule shifts the burden of accounting for assets under GAAP to market participant based assumptions, as opposed to an intrinsic model or theoretical based assumptions. Here's the problem. Let's say a bank has purchased a series of geographically diversified securitized mortgage backed securities. How do we value them? Let's say that within that mortgage series, 20% of those mortgages have defaulted and the prices of those defaulted houses have declined and can be sold at roughly 50% below what they were valued at when the securities were originally issued. What is the intrinsic (theoretical) value of the security? The answer is approximately 90 cents on the dollar. 100 - (0.20 x 0.50).
Now it gets a little more complicated, because we have to discount the adjusted stream of interest payments over the life of the issue and we also have to adjust for the credit rating that makes the lower quality tranches of these securities more responsible for the losses than the higher quality tranches. Also, the derivative side of this market complicates things a little further. However, let's keep it simple for the time being and assume that 90 cents is somewhere near the correct value. Banks bought these securities and borrowed money through the issuance of short-term commercial paper (usually maturing in 180 day or less) and leveraged their positions 10-to-1, 20- to-1 and sometimes even 30-to-1 in order to profit from the spread between their short-term cost of money and the long-term income stream produced from these securities. Not unusual, this is what banks do. But at a 20-to-1 leverage ratio, a 10% decline in the value of those securities calculated above ($1.00 - $0.90) equals a catastrophic 200% loss of principal. Now let's take this one step further. As defaults grew and housing prices declined, the investors that bought the commercial paper sold by the banks to support these mortgage securities, decided to cash-in their loans as they came do. However, there was no liquid market for the longer-term mortgage backed securities held by the banks and they, therefore, could not easily be sold. The banks were then left holding these securities with no collateral to support them. The banks made the classic mistake of borrowing short and lending long, ran out of short-term money and had to use their own capital in an attempt to support these positions.
Now let's look at the absurd situation we now find ourselves in. Some of the banks are forced to sell these long-term securities, but because of extreme credit market conditions they can only get 20 cents on the dollar. Now FASB 157 kicks in and says that this is the fair market value of these securities. Now we have an 80% ($1.00-$0.20) real loss on these bank-held assets instead of the 10% intrinsic (theoretical) decline, which means at a 20 times levered ratio, the holder has suffered a catastrophic 1600% total loss on their investment. But has the intrinsic (theoretical) value of the security really changed? No, it is still worth whatever the current or projected default rate is times the adjusted value of the home prices in default, then further adjusted for the level of exposure in the tranche and then discounted by the income streams forward. Now, while it's hard to recover from a 200% loss on the intrinsic (theoretical) value of these securities, there is not enough money in the world available either through the Federal Reserve, U.S. Treasury, Bank of England, Bank Of Japan, European Central Bank or Peoples Bank of China to cover a 1600% loss in the bank capital tied to these securities at mark to market accounting. The argument that defenders of FASB 157 make is that it provides market transparency. This is nonsense. These securities were bought by the banks on the expectation that they would be held to maturity. An accounting footnote at the bottom of a bank's balance sheet describing how the intrinsic (theoretical) value was calculated would give investors, and analysts who value the companies that hold these securities, a very good picture as to whether there was or was not any merit to those calculations.
Investors could then make their own decisions as to what these companies were really worth. I suspect they would value them higher than current prices, making it easier for the banks to raise much needed capital from the private markets and requiring less from world governments to bridge their capital gap. FASB's attempt to create a one size fits all accounting approach, has played a major role in creating this crisis through the law of unintended consequences, just as the Smoot-Hawley Tariff Act did in the 1930's. We do not have the time to wait for FASB to study this problem and recommend changes to these rules sometime late in the second quarter. Time is running out and we need a temporary suspension of this rule until they can come up with a longer-term solution. This would go a long way in calming the markets and buying some much needed time to resolve our credit problems.