Sub-prime CDOs and the mark-to-market rule

S@rzi of Investment Banker on Life blog made a pointer to this New York Times article on an ongoing debate about the possible effect of the mark-to-market accounting rule on the current writedowns on Wall Street. The debate is currently being led by private equity financier Stephen Schwarzman. Excerpts from the article:

FAS 157 represents the so-called fair value rule put into effect by the Federal Accounting Standards Board, the bookkeeping rule makers. It requires that certain assets held by financial companies, including tricky investments linked to mortgages and other kinds of debt, be marked to market. In other words, you have to value the assets at the price you could get for them if you sold them right now on the open market.

The idea seems noble enough. The rule forces banks to mark to market, rather to some theoretical price calculated by a computer — a system often derided as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model — and yes, the potential for manipulation too.)

But here’s the problem: Sometimes, there is no market — not for toxic investments like collateralized debt obligations, or C.D.O.’s, filled with subprime mortgages. No one will touch this stuff. And if there is no market, FAS 157 says, a bank must mark the investment’s value down, possibly all the way to zero.

That partly explains why big banks had to write down countless billions in C.D.O. exposure. The losses are, at least in part, theoretical. Nonetheless, the banks, in response, are bringing down their leverage levels and running to the desert to raise additional capital, often at shareholders’ expense.

Mr. Schwarzman and others say FAS 157 is forcing underserved write-offs and wreaking havoc on the financial system. There is even a campaign afoot in Washington to change the rule.

Some analysts, even insiders, say banks like Citigroup and Lehman Brothers marked down some of their C.D.O. exposure by more than 50 percent when the underlying mortgages wrapped inside the C.D.O.’s may have only fallen 15 percent.

This is a loaded debate that could go on until we know for sure what the real value of these CDOs loaded with sub-prime mortgages are. And that can only happen once the last of the underlying assets pooled into these CDOs reaches maturity. Otherwise, no one can know for sure how much of the underlying assets will eventually default. Hence, the only proxy to value them now is the current market price of the assets, which at this point, is largely diminished, both because of the current deleveraging going on throughout Wall Street (the largest potential buyer for these assets) and the current flight to security by all investors in general, away from risky assets like the CDOs.

But I see the merit with arguing against the single-minded implementation of this accounting rule. Some of these accounting regulators could be mistaking non cash-generating assets, i.e., broken equipment, which can theoretically have zero value if nobody will buy them in the market - with cash-generating assets, like securities, which at the end of the day, are still worth something for as long as they earn some income from their underlying assets. The latter cannot be marked down indefinitely, or at some point, you create incentives for company insiders to buy them out from the company at the under-valued prices. After all, insiders are in the best position to determine the creditworthiness of these securities going forward.

S@rzi says that we are, in fact, seeing that happening now: Yesterday, for instance, I read about former Lehman officers who set up a hedge fund which bought up Lehman CDOs. Well, it could be just an accounting hocus-focus to help Lehman's bottom line (a suspicion which was raised by the writer because he doubted whether this was really an arms-length transaction), but then again it might be a truly profitable arbitrage deal for the ex-Lehman officers.

More from the NYT article: For Mr. Schwartzman’s part, he says that that (most) banks haven’t been willing to unload the investments at the distressed prices. Besides, the diligence required for most buyers is almost too complicated.

Hence, we are now in a situation where the banks have designated a price for these assets in their books, but a price where, for most as we’ve seen, there are no willing sellers or buyers. How can we say that CDOs have been properly marked-to-market then?

If the mark-to-market rule’s objective is to provide transparency in the valuation of securities, have we actually attained this objective with the current level of writedowns at the banks? Or has it done more bad than good?

From Mr. Schwarzman in the same NYT article: “The concept of fair value accounting is correct and useful, but the application during periods of crisis is problematic. It’s another one of those unintended consequences of making a rule that’s supposed to be good that turns out the other way.”

Update: Similar-themed posts here and here.