The release of the Treasury's plan for public-private investment funds (PPIFs) has received substantial attention and triggered a huge rally in financial stocks. However, the proposed changes in accounting rules by the Financial Accounting Standards Board (FASB) may have a more significant and lasting impact on the financial system. While they risk making financial statements even more opaque, the accounting changes, if approved, should serve to limit the debilitating cycles of write-downs and capital depletions that continue to plague the financial sector.
The first proposal (a modification of FAS 157) allows firms to determine whether a market price is "associated with a distressed transaction" for valuation purposes. If the subject transaction is judged to be distressed, the institution can use alternative valuation methodologies to either adjust the quoted price of the security or, in some cases, ignore the market price entirely.
The second proposal alters FAS 115. In order to determine if a devalued security has "other than temporary impairment (OTTI)," current rules require that management has both the intent and the ability to hold the security until its value can be expected to recover. The proposed change would allow management to avoid the OTTI classification if it does not intend to sell the security and can assert that "it is more likely than not that it will not have to sell the security."
However, a bond must still be classified as OTTI if the investor is unlikely to collect all payments contractually due, irrespective of management's ability and intent to hold the security. In that case, only losses directly attributable to the credit impairment would be taken in earnings; remaining losses (e.g., those resulting from a drop in a bond asset's value) are taken as "other comprehensive income" and amortized over the expected life of the bond.
A fundamental assumption underlying both the FASB proposal and the Geithner plan is that the current market values for many securities are well below their intrinsic values. While FASB envisions allowing banks to carry the bonds at values above current (distressed) prices, the Geithner plan is designed to boost the market prices of assets by injecting government capital and financing into the system. The operative question: are asset prices artificially depressed, or are the bonds simply junk? An examination of a small sample of private-label tranches shows how difficult it is to generalize. Some bonds (backed largely by Alt-A and option ARM loans) are performing so poorly that any bid above zero is a good one. However, other securities are being bid at huge discounts to par value that imply onerously high yields, no voluntary prepayments, and extremely severe credit assumptions. More reasonable yield premiums and marginally less draconian assumptions push these bonds' prices 30 to 40 points higher.
Banks may ultimately decide to hold many of their legacy assets and take advantage of the relaxed reporting requirements contained in the FASB proposals. (Citigroup's CEO is on record as saying that selling assets at current prices would violate his fiduciary responsibilities.) While it would be preferable for banks to cleanse their books of deteriorating assets and make their financial reports more transparent, the proposed accounting changes should stop the cycle of write-downs and capital depletion. In light of the FASB proposals, it is reasonable to ask whether the Geithner plan, with its risk to taxpayers, is even necessary at this point.
Both proposals, however, are grounded on the contention that banks' legacy assets are intrinsically worth much more than their current market values. Otherwise, the PPIFs won't significantly boost asset prices, while the proposed accounting changes will further obfuscate the true condition of the banks.
Bill Berliner is a mortgage and capital markets consultant based in Southern California. His web site is www.berlinerconsulting.net
(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.