Dave Spicer: Economic Tailspin: The Disaster Aboard FAS 157

No, FAS 157 is not an airline flight number in a disaster movie, it’s something much worse when it comes to the disaster that has become our economy; FAS 157 is an Accounting Rule we’re riding straight into the ground—an Accounting Rule!

FAS 157 is the “mark-to-market” accounting rule created by the Financial Accounting Standards Board (FASB) that I spoke of in my original post that decoupled mortgage-backed securities from their underlying real estate assets back in November 2007 and simply stated, FAS 157 must be repealed or we will experience a rerun of this credit disaster movie. Can it really be that simple? Read on…

The 110-page congressional “Rescue Bill” is now available online for your reading enjoyment. It’s the result of a week’s worth of Washington legislative shenanigans that served as the best advertisement for congressional term limits I’ve seen. These are the people we’ve put in charge of our country! Makes me want to vote this election season for the people with the least amount of time in Washington…how about an Obama/Palin ticket!

An Example: SampleBank

To understand the mark-to-market issue we need to climb into our time machine and travel back to pre November 2007 and the value of a mortgage when a bank sells it to another bank. The value of that mortgage is simply the unpaid principle along with the risk that the homeowner will default (in which case the value is that of the underlying property) or that the homeowner will prepay and thus lessen the interest part of the return. To keep the example simple, let’s assume neither of those occurs because both are a rarity.

Enter mortgage-backed securities (MBS), which are bundles of mortgages, and in some cases thousands of them. And for the sake of this example, let’s have an MBS bundle of 1,000 mortgages with an average principle balance of $100,000 which means the value of our MBS is $100M dollars.

Now let’s assume that SampleBank buys this MBS with the intent to hold it until maturity. This is the bank’s capital and if we assume they have the leverage to loan out 10 times their capital, this means they can make loans up to $1B based on this asset. They also begin to process the individual loans in the bundle, sending out coupon books, receiving monthly payments, and producing statements.

Along comes November 2007 and the requirements of FAS 157, mark-to-market valuation of mortgage-backed securities. FAS 157 says SampleBank must no longer value its MBS based on the unpaid principle, but instead must value it at the price of other MBSs that have been recently traded! Well, mortgage-backed securities are not the most liquid of securities given the infrastructure needed to process them. This concerns the president of SampleBank who decides he now has additional uncertainty as to the value of his MBS and thus the credit leverage it provides, so he decides to sell it. Over time, so do a lot of other banks, which drives the value of the MBS down, and thanks to FAS 157, when the price goes down, so do the values of every other MBS even though the intrinsic value of the underlying unpaid principles and backing real estate have not actually decreased. The result is panic selling and complete uncertainty of the value of a bank’s MBS portfolio and thus the amount of money they can lend…so they stop lending! An estimate from William Isaac, former chairman of the FDIC, is that since FAS 157 was enacted, banks have had to artificially write down $500B in assets which means they have lost $5 Trillion in lending capacity.

In contrast to what the talking-heads on your television say, this is not just a problem for homeowners… it’s a problem for anyone who directly or indirectly depends on credit which includes homeowners, renters, children living with parents, every man, woman and child in the country. It certainly does decrease the availability of new mortgages and thus the number of potential buyers of real estate which lowers the price of that real estate, but it also impedes the purchase of everything else.

Repealing FAS 157

So what would happen if we simply repealed FAS 157? The value of SampleBank’s MBS would resort to it’s pre November 2007 value. The winner would be the bank that bought it at an artificially distressed price and the loser would be SampleBank that sold it at that price. Banks that held their portfolios—in some cases because they couldn’t sell them—would have their portfolios restored, and in all cases, capital would magically return freeing up ten times that amount of credit. This means that if we (the government) start purchasing these distressed MBS portfolios according to the “Rescue Bill” and THEN repeal FAS 157 we would have a windfall profit when we put them back on the market.

If you read the HR Rescue Bill in it’s entirety (have an ample amount of No-Doz handy) you will find buried in Section 132 “The Authority” to suspend FAS 157, and in Section 133 the initiation of a “Study on mark-to-market accounting” which implies they are considering the issues just discussed. They need to do more than “study” and consider, they need to act! It’s interesting that we don’t really need a bill of any kind to solve the credit problem since FASB didn’t need one to cause it. They can repeal FAS 157 as easily as they created it.

This credit meltdown was triggered by the stroke of a pen, the penning of FAS 157. It can be rectified by another stroke of the pen that repeals this absurd rule as applied to mortgage-backed securities. This is Henry Paulson’s task and he just needs to overcome the major proponents of FAS 157 who architected this disaster, the largest being, ready for this… Henry Paulson himself! Talk about a movie plot!

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4 comments:

Anonymous said...

So here is where you argument is flawed. If Sample Bank truely has the intent to hold the MBS it purchased until maturity, then it classifies this instrument as a Held to Maturity Security and does not have to be marked to market. It simply has to be reviewed for Other than Temporary Impairment and if it is money good as you imply in your example then their is no devaluation required.

The positions being marked down in accordance with 157 are positions in which the holder intends to turnover quickly in order to seek a short term profit. Under this premise it should be marked to the exit price as it is the most useful measurement of the banks financial positions.

HarleyDave said...

Anonymous, thanks for your comment. The length of time held should have no bearing on the documentation required for the value of the underlying real assets. For existing MBSs banks should be required to provide that documentation which will have a dampening effect on the wild swings we will have otherwise. If they don’t have that documentation they need to get it.

richardM said...

Sorry Anonymous, I side with HarleyDave. Aside from time held having no bearing on the security's value, in a falling market, the SampleBank's CEO would be off his rocker to classify an MBS as HMS. In a comment on Bob McTeer's Blog "Mark to Market Frustration", I suggested that m2m is not only irrational as many now agree but is also unnecessary, since a rationally reasoned and conceptually sound asset valuation alternative method is available (see http://stockmarketpredictor.spaces.live.com/)

Bye the bye, the last sentence in the original Post should prompt the taxpayer to beg the question: what's the real reason for changing the original intended use of the TARP money?

HarleyDave said...

Richard: Well said. M2M has created an MBS pricing dichotomy, maybe even a paradox: Assets (MBSs) that are paying the holder 98% of their interest (assumes 2% are in default) cannot be worth nothing, yet M2M makes them so. In other disciplines in which I am more familiar, e.g., engineering, when theory does not agree with reality, the theory must be changed, reality can’t. But that’s for physics, not finance. Ironically, in this case, if we don’t change the M2M theory, reality COULD change since it will ultimately bring down all real estate values and thus their mortgages.

As for TARP, I defy anyone to tell us where the money went, or how much we now own of the banks that were so “gifted.” Typically, when investors put money into new stock for a company, they negotiate a “term sheet” that stipulates the deal that includes investment amount and percentage ownership. Where is our term sheet for these bank investments…better yet, can anyone tell us where $350B went? This could be the biggest Bank Heist in history!