Financial Regulation

Briefing Note on Regulation: FASB

Early this week the Financial Accounting Standards Board (FASB) issued guidelines on the valuation of instruments for which there is no actively traded market. Mark to market has been the rule for the marking of financial assets. When an actively traded market does not exist there are approved procedures for coming up with a proxy for the market. For example in the case of aged corporate bonds, which commonly do not trade for days at a time, it is commonplace to identify cohorts, i.e. bonds with similar characteristics and then discount the price of the actively traded cohort by a reasonable amount to reflect the illiquidity of the security that is not actively traded. In other cases such as tailored derivatives a sample of dealer estimates of a fair market price is often obtained and averaged. Similarly private placements can be compared to market traded securities and again discounted for their illiquidity. Without belaboring the point illiquid securities are not a rarity and there are established procedures for assigning a market price.

Why tinker with the system now? Banks are currently burdened with significantly more non-traded securities than they had anticipated. The proliferation of mortgage backed securities, credit default swaps and other categories of ill considered securities has created a burden on bank earnings and capital that in a couple of well advertised cases has proven fatal. The market estimate for such securities is not surprisingly a fraction of par value. Any reasonable market price would have to be quite low.

Banks with some logic argue that although these securities may have been overvalued in the past they are far from worthless. They generate a revenue stream and in time the vast majority of underlying collateral will survive having less of an impact on these securities than the market currently estimates by its pricing. FASB has been under pressure to allow banks to generate alternative valuations that would basically reflect the discounted stream of cash flows over some average life properly adjusted for the likely mortgage defaults. Although this may sound logical it depends on the banks becoming more adept at valuing collateral than they proven so far. The only thing we can be fairly certain of is that banks will value these securities higher than any market driven estimate, and that’s where the timing comes in.

Recently the Treasury announced the introduction of a well-received plan to combine public and private capital to acquire these toxic assets from banks. The core issue in all such proposals is how will the two parties to these trades come together on price. Until now there was little doubt that there would be a wide spread between the bid and offer. However, given the way this particular plan is structured there was optimism in the market that the spread, at least on securities, would not be insurmountable especially given the inducements for buyers in this plan. Clearly anything that contributes to a widening of the spread increases the likelihood that market-clearing prices will not be discovered. FASB’s guidelines are likely to make that happen. While the sellers, the banks, are valuing securities on the basis of self-serving assumptions, the buyers will be looking for guidance from the market. This game isn’t going to be pretty if each side is playing by different rules. I doubt that the Treasury has sent a thank you note to FASB for their ill-timed contribution to continued financial instability.

Post Script: As of July 7th this program of making a market in toxic assets has yet to begin.
Ben Wolkowitz Headstrong April 15, 2009