Time to Exempt Mortgage Securities from Mark-to-Market Rules

Mortgage securities are trying to be something they're not. We're forcing an illiquid asset to be liquid. It's like watching Shaquille O'Neal try to keep up with Steve Nash in the Phoenix Suns fast break offense. The Shaq experiment ended in a first round failure and the mark-to-market mortgage derivative experiment faces a similar fate.

When FASB 157 went into effect last November, the write-down panic began and it has pushed our financial system to the brink of failure. The next shoe to drop appears to be the regional banks. Regional bank ETF KRE was down over 8% yesterday led by the carnage in Zions (ZION), Huntington (HBAN), KeyCorp (KEY), Fifth Third (FITB) and Sovereign (SOV). Mortgage-backed securities are not stocks, they are not bonds, they are not futures contracts; they should not be treated as if they were. The simple solution to this entire financial crisis is to exempt mortgages from the mark-to-market accounting requirement. The fact that government officials from the Federal Reserve, the Treasury and Congress haven't figured this out is mind boggling.

Jim Cramer suggested the government turn their heads for 24 months while the real estate market finds stability and allow these banks to rework their balance sheets (source: thestreet.com). We all understand the need for transparency after the public embarrassment at Enron, but mark-to-market accounting on mortgage securities is severely flawed. It is fundamentally incorrect to account for an illiquid asset as if it were liquid.

Lets assume that we survive this real estate correction after hundreds of billions of dollars in write-downs along with numerous bank failures and/or bailouts. What happens next? When real estate valuations head back up, these same financial institutions will begin recording write-ups and we will experience a financial boom! Such volatility has no place in our financial system. The relationship between financials and real estate must be tempered by historical models, instead of being irrationally exposed by short term market prices. If FASB 157 remains, we will go through a vicious sell-off every time real estate cycles downward. We cannot turn real estate corrections into bank failures.

If you're still wondering whether these new disclosure principles are good or bad, consider what the short sellers have done with them. The situation has become so dire that the SEC had to come out with an official announcement related to the unwarranted financial distress. Chris Cox, the chairman of the Securities and Exchange Commission, issued an edict Sunday declaring that the SEC and other financial cops will conduct immediate examinations at Wall Street firms "aimed at the prevention of the intentional spread of false information intended to manipulate securities prices." Short sellers have totally manipulated this ridiculous law to the point that all they have to do is send out a false rumor and it causes a run on the bank. It's time to put an end to this short term nonsense and re-establish a proper market valuation for mortgage-backed securities. The solution to this financial panic really is that easy.

Disclosure: None

Comments

[pdd]

what a joke ! the relationship between financials and real estate must be tempered by historical models, instead of being irrationally exposed by short term market prices.

[bbzz24]

Jason,
How about excluding them for another reason: they are liabilities rather than assets?

[ETFnerd]

Jason, if you have an illiquid asset it makes sense to find its fair value and then to take a liquidity DISCOUNT if it is illiquid. That should write the asset down further, not write it up to a fantasy book value number.

If short sellers are successful, it is because they correctly assess that the asset is overvalued in the books.

The argument that does make sense is that valuation models are sensitive to inputs/assumptions which give a fairly wide range of valuations. Different numbers can be justified, but the market, not an accrual accounting rule, should determine the value of a company's assets.

Finally I hope you will realize that it is unfair to blame every economic problem on the Fed, the SEC, and the Treasury Secretary, etc. These are convenient scapegoats, but usually they are people working hard to ensure the best outcome for the economy, with a few exceptions. Blaming them is like blaming the police for murders while ignoring the role of the murderers. I don't recall the SEC underwriting any loans, nor underwriting them so badly that it drove all the buyers out of the market.

[Anil]

I don't understand why they would start marking up? They own mortgage not the house. When there is risk in realizing the full amounts due due to deterioration of underlying collateral - only then they have to write down.

They can write up only to the extent the write down is due to such down turn.

Once the write down is over, more likely the write ups will be in line with historic averages for home price appreciations.

Have I missed something?

[User 44878]

One of the things driving this is margin calls with assets being dumped at whatever price is bid.

Perhaps it is time to legislate margin calls out of existence.

[najdorf]

Why would the market be good at pricing stocks, bonds, etc. and not good at pricing mortgage-backed securities? There's no inherent reason for whatever junky MBS banks are holding to be less liquid than other bonds or even Treasuries, except that they're risky junk with mediocre coupons and no one wants to buy them. When times were good, banks bought and sold MBS like they were stocks and bonds, and they did it for the small apread over safer fixed income options. Well, when you choose a yield edge over capital safety, and you're not diversified, capitalized or liquid enough to survive a market disruption, you get punished. This is the way of the world. Nobody ever says "maybe these marks are no good" when they're way up and they're adding to earnings and share prices.

If the writedowns are as overdone as you think, why don't you call up LEH or BAC and offer to buy some of their MBS at a 5% premium over the value at which they're currently carrying them? I guarantee you would be able to get all that you want. A lot of these are level 3 assets, meaning that if the banks thought they had real future value they would mess with the model until they got a better valuation, prevent some damage to the share prices, and justify their decision when their projected future cashflow materializes. They've marked down securities with decent current cash-flow because the future holds a large risk of loss of principal. If a 30-year MBS is already in trouble after 1-2 years, even with the slowness of the foreclosure process and the further economic disruptions in store, it needs to be marked down. Let's remember that some of these securities are already in default, so it's not like the whole crisis is made-up.

[najdorf]

I hope 44878 is kidding but I can't tell if that post is in sarcastic voice or not. The point is valid, anyhow: one of the reasons that companies have to mark this stuff to market and that the market is so poor is that companies leveraged up to hold more of these securities. If you borrow money to buy risky stuff, you can't just look at the upside of that trade. Potentially profitable trades have downsides, especially when you use other people's money to do them.

[User 209500]

Wall street, Hedge funds, Traders, and Investment house have made huge amounts of money packaging and selling these MBS, CDO's and like instruments. Banks & S&L's have been purchasing these so called investments to capitalize on greater returns. Now These same funds with huge amounts of $ are shorting the same
asset in order to buy them back @ 50 cents on the dollar or less.
Free market society. This is creating a huge profit potential for the ultimate purchaser or these instruments. Yes, some are bad debts
but you need to buy enough to average out the losses.
FMA or some other goverment backed fund should start buying these
instruments from the banks @ face value thus giving the banks liquidity and much needed capital to continue in business. Start regulating the mortgage business again and only purhase conforming fully documented loans. Create this fund in partnership with any institution selling CDO's or MBS into it. 50% government owned with the other 50% split among the selling institutions proportionatly.
All original funds will come from long term bonds issued by the Gov.
for 30 years. Every 5 years audit the fund & access profits or losses
amoungst the owners.

[glassbox]

Jason, agree with your view on the use of MTM.

[Kinabalu]

The mortgage debacle that we're currently going through isn't the first time that new accounting rules had unintended consequences. But to say that elimination of the mark to market requirements would be an end-all solution is going too far. The fact of the matter is that the market, and the rating agencies, did a terrible job of evaluating the risk in many of these complicated mortgage backed securities when they were first issued. They were way over-priced then and they are way under-priced now.

Sorry najdorf, I generally agree with your comments but you can't have it both ways. When you ask "Why would the market be good at pricing stocks, bonds, etc. and not good at pricing mortgage-backed securities?" Either the market was right when these complex securities were issued or its right now, or... it was wrong both times. I think some investors are going to make a lot of money on the mispricings.

[paso]

Lets just step back a few months, banks typically had over levered, bloated balance sheets with $bns of MBS. Not writing these down would just give shareholders, lenders, and other users of financial statements a false sense of security and would allow bankers to continue as they were. As an investor I would want a balance sheet to represent the accurate financial position and economic reality of a company.

Without writing down these 'assets' we would not have been alerted to the failings of management, inadequate risk controls, poor underwriting standards, etc.

I agree with Kinabalu, if the securities had been priced and rated correctly to start with the write downs would have been much smaller. If banks learn lessons from this then we might not have similar writedowns in future although I would not hold your breath, "these things tend to happen very 10 years or so, gets rid of all the bad blood".

[paso]

A lemon market will be produced by the following:

1. Asymmetry of information
* no buyers can accurately assess the value of a product through examination before sale is made
* all sellers can more accurately assess the value of a product prior to sale
2. An incentive exists for the seller to pass off a low quality product as a higher quality one
3. Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)
4. Either there exist a continuum of seller qualities OR the average seller type is sufficiently low (i.e. buyers are sufficiently pessimistic about the seller's quality)
5. Deficiency of effective public quality assurances (by reputation or regulation)
6. Deficiency of effective guarantees / warranties

Some of this sound familiar?

[dougnhi]

The key to this failure is excessive leverage. It only takes a 10 percent hit to wipe out a fund that has levered 10 to 1. Marking to make believe encourages moral hazard, and the banks played this game much higher than 10 to 1. Look at the ABX...it tells the story. Even if you don't believe the markings there are right, they're not as wrong as they are right. Add to this gearing at 25 or 30 to one (industry average), and you see that the banks are insolvent (no matter what Bernanke and Paulson have said). Hiding losses will only make matters worse.... didn't your parents teach you anything about this kind of crap? The sooner we take the medicine of truth, the sooner we can recover. Until then, we can only guess how bad it is, and we'll probably guess it's much worse because the banks keep on hiding from the truth! There's the clue that it actually is much worse! If it were not that bad, they'd have already written off the level 2 and level 3 assets.

[glassbox]

dougnhi, in case you don't know - everyone knew that these companies were leveraged anyway to those levels for the last umpteen years. And it just happens that the markets (at this point largely short sellers) chose to use now to sell, and justify it by saying that 'sooner we take the medicine, the sooner we can recover'. Why now, and not years ago. Because now is easier for shortist to profit from shouting 'fire' as there is so much fear around. Shortists were never interested in making money from the leverage level, they are only interested in making money when the leverage level somehow creates a fear that can start a price spiral downwards. Note that they make money only when there is a momentum downwards. There are no long term shortists around - LT shortists don't short the stocks - they have a choice to ignore the stock. And all shortists know that in the longer run, companies and their shareholder will somehow work out their efficiency. Shortists are only interested in short term issues. Hence, whilst I would say excessive leverage is one of the reasons in this instance, its not necessarily the trigger to it.


On Jul 15 04:37 PM dougnhi wrote:

> The key to this failure is excessive leverage. It only takes a 10
> percent hit to wipe out a fund that has levered 10 to 1. Marking
> to make believe encourages moral hazard, and the banks played this
> game much higher than 10 to 1. Look at the ABX...it tells the story.
> Even if you don't believe the markings there are right, they're not
> as wrong as they are right. Add to this gearing at 25 or 30 to one
> (industry average), and you see that the banks are insolvent (no
> matter what Bernanke and Paulson have said). Hiding losses will only
> make matters worse.... didn't your parents teach you anything about
> this kind of crap? The sooner we take the medicine of truth, the
> sooner we can recover. Until then, we can only guess how bad it is,
> and we'll probably guess it's much worse because the banks keep on
> hiding from the truth! There's the clue that it actually is much
> worse! If it were not that bad, they'd have already written off the
> level 2 and level 3 assets.

[icandoitdon]

yes, the accounting contributes to the problem but that is not the only issue. it's like blaming short sellers for the decline in financial stocks. they have an impact but banning short sales won't help solve their structural problems.

the core problem is excess leverage, cheap credit and too much of it. we're in for a very tough haul. the best we can hope for is protecting capital until the dust settles. and hope that our regulators have learned something from the experience.

[JPD]

You have got to be kidding.

This is a market that calls for MORE transparency on the balance sheet, not less. Mark-to-model is how we got into this mess, so it's time to put this practice to the well-deserved death it needs.

[glassbox]

Yes, we are indeed in for the long haul. And the best we can do is to support our regulators to get rid of the non-value adders, the pests in the way of real restructuring.


On Jul 15 05:24 PM icandoitdon wrote:

> yes, the accounting contributes to the problem but that is not the
> only issue. it's like blaming short sellers for the decline in financial
> stocks. they have an impact but banning short sales won't help solve
> their structural problems.
>
> the core problem is excess leverage, cheap credit and too much of
> it. we're in for a very tough haul. the best we can hope for is protecting
> capital until the dust settles. and hope that our regulators have
> learned something from the experience.

[chagrinned1]

Some of the readers do not understand your analysis, but I do and you are absolutely correct. The Financials will have a boom once this cyclone turns and values return. So, now they write off absurd sums to mark to absurd market; tomorrow they raise the values and their earnings marking value to tomorrow's market. I thought about this after first quarter earns were publicised. It will happen and it is absurd.
While there are few experts in the future, most Fin'l execs have seen this happen before and have some idea of what the asset will be worth after this time of distress. Their SWAG
(scientific wild ass guess) will be reviewed by the Acct Firm and modified or not based on judgement. This has been done well by Private Equity Firms in the past. Checks and Balances "may" be necessary to ensure honesty. Rick