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securities from their underlying real estate assets back in November 2007 and simply stated, FAS 157 must be repealed or we will experience a rerun of this credit disaster movie.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!