With the credit crisis and market turmoil, a lot of media talk - both financial and general - has centered on the debate over mark-to-market accounting rules; in particular, the Financial Accounting Standards Board's SFAS 115 and the Emerging Issues Task Force's EITF 99-20.
The fact is, while government actions will help some, unless FASB changes its rules the financial crisis is likely to get worse and it will be a very long time before the secondary markets improve.
That's because without amending FASB rules - returning market valuations to normality-the painful chain of events will continue. Institutions won't be able to sell loans, causing liquidity to remain tight, resulting in even fewer loans being made and bringing about a slower economic recovery.
Past Sins, Present Problems
Right now, FASB's other-than-temporary-impairment (OTTI) requirements are significantly impairing institutions' capital levels. And while these strict rules were established to ensure transparency based on the market's past sins of non-disclosure, they simply aren't working in the current environment.
First, let me clarify: ALM First has occasionally been taken to task for being too conservative. In our firm's 13-year history, we have purchased only the most senior "AAA"-rated securities on behalf of clients; non-conforming securities represent a small fraction of our aggregate $8-billion under advisement. As a result, OTTI isn't a major issue for ALM First or our advisory clients. So, my concerns as related to our own clients are unbiased.
There's no doubt that some mortgage-backed securities will lose significant principal. But institutions with senior credit bonds that can prove their ability to hold them to maturity are being pushed by auditors to take brutal writedowns in OTTI.
Try This Example
Here's an example: Take a high-quality bond that, given conservative assumptions, is projected to lose 7% of principal in years five through 15. Today's accounting rules require a write-down of the security to its current market value, typically at least 50% of original value. Now, ignore the fact that the 7% loss in principal is more than compensated with incremental yield. And forget that the bond may be safer and higher yielding than any comparable loan made in the market today. Why should accounting rules require an institution to make a 50% loan-loss provision immediately, rather than holding the loans outright, when a provision can be accumulated over time?
Yes, the investor must write down the security's value by 50%. But if markets improve in the next year, the current accounting rules require the gain to be amortized over the bond's life - which could be up to 30 years. An institution holding $100 million of these securities would have to take a $50 million hit to net income even though losses might not occur for 10 years, if ever. As you can see, investors aren't purchasing these types of securities because the accounting penalty is too high.
Preventing Future Market Chaos
If left as they are, these rules also will raise havoc in the markets going forward. Over time, as actual losses don't compare to those realized and value is returned to most investment-grade securities, capital will return in strides. Some economists project this could then cause an inflationary nightmare. Interest rates would spike up and institutions would be burdened with 4.50%, 30-year mortgages on their books.
We have found great value in certain fixed-income sectors today, and a few of our clients are dabbling in double-digit yields, purchasing super-senior, non-conforming securities. Our questions to them are, "Can you hold to maturity? And can you take the heat?"
One ray of sunshine is that FASB recently announced it has added an initiative to improve and simplify fair-value accounting guidance to its agenda. Stay tuned and be prepared to weigh in when and if comments are requested.
Emily Hollis is Partner with ALM First Financial Advisors, LLC, Dallas. For info: www.almfirst.com.
