reader Sammy guest post
Section 132 of the Emergency Economic Stabilization Act of 2008 (“restates the SEC’s authority to suspend the application of FASB 157 if the SEC determines that it is in the public interest and protects investors”), is an important part of the solution to the current financial crisis, and may lessen the need for nationalization or taxpayer support.
FASB 157, which only came into effect on Nov 15, 2007, is the mark-to-market accounting rule that requires financial assets to be adjusted based on their market value – “the price in an orderly transaction between market particpants to sell the asset or transfer the liability….” The intention of FASB is theoretically good – to increase transparency and information for investors, but its practical application has created serious problems.
1) Banks are reluctant to, or can’t, sell impaired assets at a discount as those prices then become the basis for marking down the value of other assets in their portfolio, which directly reduces the Equity portion of the balance sheet, tri ggering all sorts of regulatory and market risk events. This is a major impediment to setting up a Bad Bank.
2) Is the market for impaired mortgage debt “orderly” defined as Any market in which the supply and demand are reasonably equal? I would argue no, as the supply of impaired mortgage debt ($1T?)far outstrips the available pools of capital with an appetite for this debt. Mortgage securities, in particular the more exotic types, are often described “no one knows what the value is.” That is bull; give me, Sammy, the security and I would be able to price it using NPV of future cash flow. The problem is there is so much uncertainty regarding the Probalitity of Default, and the Average Loss per Default that I would assign a very high discount rate to the cash flow, resulting in a low price for the security. So the bank might now sell the asset strictly as a business decision.
It is important to remember that we have recently faced a situation where the major money-center banks would have been (we didn’t have FASB 157) insolvent on a mark-to-market accounting basis (liabilities exceed book value of equity), that is theLatin American Debt crises of the 1980’s. What solved that problem?
Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away……Because these accounting rules force banks to write off losses before they even happen, we lose time.
So if we allow the banks not to write down assets, what will this look like?
Banking is a unique industry. Unlike virtually any other industry on earth, banks deal in a product that never goes out of style – money. As long as a bank maintains adequate technology and human capital to compete in the marketplace, long-term profitability is virtually assured, because demand is assured. As long as a bank can generate positive cash flows, and as long as the NPV of these cash flows exceeds the NPV of the losses from the defaulted assets, then the present intrinsic value of that bank’s common equity is positive. A bank can therefore have a very negative net worth and still have a highly positive net present value
So is allowing the banks to operate with negative equity in HTM terms a free lunch? No. Carrying the non-earning toxic assets on their balance sheets will cause US banks to earn a lower return on assets over the next few years; this reduces the NPV of their common equity.