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

 |  Includes: IYF, KBE, KRE, XLF
by: Jason Schwarz

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 (NASDAQ:ZION), Huntington (NASDAQ:HBAN), KeyCorp (NYSE:KEY), Fifth Third (NASDAQ: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