In a release sent out today, Andrew Davidson & Co. lashed out on existing accounting rules, stating that many financial firms are addressing accounting issues such as FAS-91, FAS 133 and Sarbanes Oxley instead of focusing on impending market risks including potential home price depreciation and credit risk in IO loans.

"Jumping through such accounting hoops dominates much of the time of financial firm executives," the firm said. "Maybe this would be fine if the accounting rules were bringing clarity to investors, but these accounting rules only bring confusion to the presentation of financial results." Flawed accounting, including FAS-91 and FAS-133, will result in sub-optimal behavior, the firm states. "Faced with such twisted rules, firms will seek first to avoid the uncertainty created by the rules." This will result in techniques like "smoothing, threshold levels and hedging to models rather than to markets."

The prepayment analysts cited FAS-91 as a "particularly insidious rule" because it creates prospective uncertainty about past amortization of premium and discount. This accounting rule requires firms to show the same level of income as a percent of amortized balance (or internal rate of return) over the life of an investment. Analysts added that these financial firms must recalculate the amount of amortization to date as actual and forecast prepayments change, explaining that for premium loans, slower prepayment forecasts result in gains while faster predicted prepays leads to losses. As forecasts fluxuate, the same premium is added and subtracted from income over and over.

"Maybe FAS-91 was supposed to be the start of the move to mark-to-market reporting. But it isn't that at all; at most it is the mark of premium to a non-market rate," the firm said, adding that if a loan becomes a market value discount, the premium still needs to be marked-up if prepayments slow, even though the loan value is dropping.

In terms of FAS-133, Andrew Davidson said that when the financial accounting system needed unification, this rule further divided the balance sheets of financial institutions. Analysts said that FAS-133 has introduced so much uncertainty that many firms have opted not to hedge appropriately than face the burdens that FAS-133 bookkeeping present.

Thus management will set up levers to control the accounting results, analysts said. At first, management may seek to change the accounting results to match what it believes are the true economics of the firm. However, the temptation to manipulate earnings, hiding the true economics of the firm, might become irresistible at some point. The prepayment firm said that when accounting rules are uneconomical, it becomes more difficult for management to differentiate between adjusting accounting results to better show the true economics of the establishment and manipulating earnings to hide what its actual condition is.

Though these rules need to be followed, analysts said they should not be made a permanent part of the accounting landscape. "Firms should actively oppose these flawed rules," the firm summed, adding that being complacent about both accounting rules is a disservice to management and investors.

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