mikeg3

FAS 157: Blackstone and Its Banker Buddies Have It Wrong

Not all valuable financial assets are liquid. Many are expected to be held to maturity. Think of CD's, worth much less if cashed in early.

I believe that banks should be allowed to account for CDO's by treating them as portfolios of individual mortgages. Mortgages are valued as discounted cash flows, less reserves for expected losses.

If a portfolio is expected to foreclose half the mortgages (a high number even in Vegas), and the forclosure will return half the principal plus accrued interest of the loans (a number widely accepted), then the CDO is worth 75% of face value. Since a super senior tranche gets the first 85% of recoveries, that means the bank's piece is worth 88% of face value.

FAS 157 was created in response to a problem where Japanese banks were refusing to recognize losses on commercial real estate in the 1990's, leaving little lending power and stagnating their economy. US banks must reserve for expected losses, so there is no point in not foreclosing when a loan stops performing.

With CDO's characterized as "toxic", the market is not objective but emotional. Pricing CDO's based on a few bottom-fishing transactions simply drains reserves and requires equity dilution.

The rules for accounting for direct loans are well understood by everyone. They should be applied to the mortgages underlying CDO's.

BTW, leverage does not apply to super senior tranches. They were constructed and retained by the banks, not purchased on margin. If they were, the margin would have been called a year ago.