Housing and Urban Development Secretary Shaun Donovan has promised to announce a “standardized net present value test” for the troubled mortgage sector on March 4, 2009. The specificity which Secretary Donovan seeks to bring to President Barack Obama’s effort to help nearly 10 million American families facing foreclosure is laudable indeed; investors have been waiting for months for somebody in authority to reveal a credible asset valuation methodology. But in today’s environment, that specificity is likely to spread chaos beyond the housing market, to banking and insurance, and even across the broader American business spectrum.
I have already ascertained sufficient cause to retain a decidedly short bias in five key financials: Bank of America (NYSE:BAC), Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS) and Wells Fargo (NYSE:WFC). So the announcement of the standardized NPV test will merely provide an incentive to increase the size of short positions. But it is those who are holding on to bank shares who need to be concerned about the potential for equity values going to zero. Treasury Secretary Timothy Geithner is supposed to unveil details about his rescue package shortly; but whatever the nature of the details made public, the March 04 NPV test will serve to challenge certain core assumptions relating to the pricing of bank-issued preferred instruments and common shares the government has been buying, and plans to buy during the first half of this year.
By its very nature, a net present value assessment of an asset is predicated on two fundamentals: (1) the future earnings the asset can generate and (2) the interest rate, e.g. the “risk-free” rate, at which the future earnings are discounted to arrive at the present value. Quite clearly, the ability of home-owners to service their loans over an extended period will be a crucial component of the NPV test, as far as the Obama Mortgage Plan is concerned. But, perhaps unintentionally, the constituents of the NPV methodology will provide a fresh window into the value of hundreds of billions of dollars worth of Level 2 and Level 3 assets (per FSAS 157) on the books of Wall Street’s banks.
The impact of the NTV test on the valuation of trillions of dollars of derivative contracts may not be direct; but the dire need to provide for default risk in this highly uncertain global economic environment will become more than evident. Lawmakers have been debating the viability of the mark-to-market mechanism, in terms of price, in the current conditions for many months now. The NPV test should turn the focus on marketing counterparty risk to the market, a formidable proposition for those still engaged in escapism.
This writer is of the opinion that an honest appraisal of the level of counterparty risk on bank books will make a conclusive case for bank nationalizations. Unless, of course, one is targeting to keep the global financial system alive, somehow, for it to rectify itself at some point in the future. In simple terms, the Obama Mortgage Plan is a bet on the housing market bottoming out by late 2009. Timothy Geithner’s bank bailout package will surely reflect a similar bet.
The problem is that, thus far, nobody is sure of the pricing considerations which are being applied to the trillions of taxpayer dollars being invested in bank-issued instruments, regardless of the nature of the bet. One version of events is that the Treasury is reluctant to disclose a valuation test, somewhat similar to the one which is scheduled to be announced on March 4, for banks and financials in the event that the results create widespread panic. The second, and more plausible, version is that regulators never intended to go beyond the framework established by existing accounting and SEC guidelines in any event. “The one rule in a crisis of such magnitude is to stop digging yourself deeper into a hole,” one senior European hedge fund manager told this writer recently. “The more you try to know, the less you end up knowing.”
Perhaps we all will know less about the problems in housing when we start applying Secretary Donovan’s NPV test to mortgages. But, most certainly, many of us will stop asking any more questions about the health of our banks by that time.
Disclosure: Short BAC, C, JPM