Bear with me here folks as I wade out of the friendly confines of mortgage morass and step ever so trepidly in to the world of big business economics. A piece of recently-heralded accounting code may send shockwaves through large financial institutions by requiring them to re-value their structured investments (such as SIVs, CDOs and MBSs) based on best-available market value and not via some esoteric modeling valuation that banks have been using to-date to put a “value” on these relatively illiquid vehicles. This may be the true “mark to market” that we’ve all been watching for, instead of a “mark to fantasy” number that is conjured out of some fancy math.
Dr. Nouriel Roubini of the RGE Monitor has an elucidating piece on the subject which is well worth the read to get a full grasp of the impact this new accounting rule could have on available credit - essentially putting the squeeze on an already decimated credit market.
The reality is that most financial institutions – banks, commercial banks, pension funds, hedge funds – have barely started to recognize the lower “fair value” of their impaired securities. Valuation of illiquid assets is a most complex issue; but starting with the November 15th adoption of FASB 157 the leeway that financial institutions have used so far for creative accounting will be much more limited. Valuation of illiquid assets is a most technical issue. But new regulations will limit the ability of financial institutions to put “illiquid” asset in “level 3” securities, i.e. securities where the lack of market prices allows them to use dubious “valuation models” and “unobservable inputs” to value such assets.
As put it by the FT:
“the banks have not yet made write-offs as large as the ABX might imply. Merrill Lynch analysts, for example, calculate that mid-quality ABX debt is on average now trading at 40 cents in the dollar. But these analysts say that Merrill Lynch itself has only written this type of debt down to 63 cents in the dollar – and UBS is still assuming this debt is worth 90 cents. “Simple math would imply that UBS needs an additional $8bn write-down [on its $15.4bn holdings] if the ABX pricing is correct,” Merrill says.”
Indeed, according to a MarketWatch article from September – based on Bernstein Research – many Wall Street firms put an excessive amount of securities in the level 3 bucket that uses unreliable models for valuation. The share securities in the level 3 is:
15% for Goldman Sachs;
13% for Morgan Stanley;
8% for Lehman Brothers;
7% for Bear Stearns
and only 2% for Merrill Lynch.
No wonder that Merrill has been one of the few firms to report massive losses: it is at least one of the few firms that has come out clean on this valuation game and put only 2% of its assets in the voodoo valuation model bucket; compare that with the 15% put by Goldman or the 13% by Morgan Stanley. But the forthcoming adoption of FASB 157 (unless current lobbying pressure by interest group forces the postponing of its November 15th adoption) will reduce the ability of financial firms to play such accounting games and tricks.
The implication is clear. That the banks have been marking to the best case market scenario and not to actual market. This has made the losses, while huge, seem bearable. The implementation of FASB 157 may force billions of dollars of instruments to be valued to market pricing; which as in the UBS example above, can result in billions in additional write downs.
These write downs would put another wave of massive downward pressure on the credit markets, require banks to bring SIVs back on to balance sheets, sap liquidity, up inter-bank lending rates, and put some of the big players in intensive care. A scary scenario indeed. Of course, this will tighten underwriting guidelines and shove rates quickly higher for non-agency mortgage loans. Putting the squeeze on an already failing market.
There is some political pressure to keep this regulation from being implemented on November 15th, for obvious reasons. The system does need to be purged; but will one big sweep out bring the merry-go-round to a stop? What do you think?
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