Mark to What Market? The SEC Made the Right Callby William R. Cline | October 3rd, 2008 | 06:06 pm
On Tuesday the Securities and Exchange Commission (SEC) issued guidelines that gave banks greater leeway to avoid marking down their complex mortgage-backed assets to current fire-sale prices. That was the right decision and can help complement the $700 billion Troubled Asset Relief Program (TARP).
The new SEC guidance provides that “when an active market for a security does not exist … [expected] cash flows … [and] appropriate risk premiums” are an “acceptable” basis for valuation.1
The new guidelines came after pressure from bankers and conservative Republicans in Congress. The American Bankers Association (ABA) argued that fair value rules under SFAS (Statement of Financial Standards) No. 157 are “flawed because they do not provide a framework … when markets become illiquid.” The ABA called for the SEC to “provide immediate guidance that intrinsic value or economic value are appropriate proxies for fair value.”2 The new TARP law adopted by Congress includes a provision clarifying that the SEC has the authority “to suspend … application of [SFAS 157]” if it is “necessary or appropriate in the public interest and is consistent with the protection of investors”(section 132).
The Financial Accounting Standards Board’s “fair value” accounting seeks “the price that would be received in an orderly transaction”.3 SFAS 157, which took force this year, provides the following framework for fair value. “Level 1″ assets are to be valued at “quoted prices in active markets for identical assets or liabilities” (Herz and MacDonald). More opaque “Level 2″ assets are valued at “mark to model” based on “observable” market prices and other variables. “Level 3″ assets without a liquid market are based on unobservable inputs to their models. The key new SEC determination is that “distressed or forced liquidation sales are not orderly transactions,” so the existence of a distress-market sale price does not require marking to that price.
The international debt crisis of the 1980s is a good example of when mark-to-market would have been seriously destabilizing. By the mid-1980s a secondary market had developed, often characterized by sales of holdings by smaller banks that wanted to be able to say they held no Latin debt. Argentine debt, for example, fell as low as 20 cents on the dollar. Banks that planned to continue holding the claims in the expectation that the economy would recover did not need to mark them down immediately to this distressed level, although they did set aside reserves against possible losses. Eventually the claims rebounded to about 70 cents on the dollar, with the help of the Brady Plan, named after Treasury Secretary Nicholas F. Brady. If banks had been forced to write down drastically early in the crisis because of the presence of a limited number of secondary market transactions, a number of them would have been technically bankrupt, because their claims on Latin America governments exceeded their capital. Artificially forcing a collapse of the US banking system in the mid-1980s in the name of absolute belief that “the market” is always right at every moment, even if the only market transactions taking place involve a limited set of distressed sales, would have needlessly damaged the US and global economies.
Mortgage-backed securities, especially subprime and “Alt-A,” are in a similar distressed market now. In late July, Merrill Lynch sold $31 billion in face value of mortgage-backed securities at 22 cents on the dollar. An overly ambitious accountant might then have demanded that all other holders of such assets mark them down to this price. In contrast, Bill Gross, managing director of the investment management firm PIMCO, argues that on average the mortgage-backed securities are worth about 60–65 cents on the dollar. Every such asset has a CUSIP (Committee on Uniform Securities Identification Procedures) number. Each such asset has specified properties (e.g. whether it is at the front or the back of the repayment queue for the mortgages backing it). Probability distributions exist for the likelihood of default and the amount of recovery given default for these differing characteristics.
The TARP is premised on holding government “reverse auctions” that purchase these assets at prices consistent with such medium-term valuation analysis. A similar valuation process should be considered fair for the accounting of banks that decide to hold such assets rather than sell them in a TARP auction.
Those who argue that investors will be cheated if mark-to-market is not imposed, despite a distressed market, miss the point that such valuation can in fact mislead the investor even more than the type of valuation just described. Especially the small investor who bails out at the bottom will be the one cheated by unnecessary mark-downs imposed by the mark-to-market straitjacket. Nonetheless, it would be extremely valuable for increased transparency if the banks were to include in notes to quarterly balance sheets a disclosure of the total mortgage-backed securities being held on their books, with a breakdown according to the principal classes and vintages.
A new problem could arise as the TARP is applied. Because of its restraints on compensation of top executives of banks seeking to sell assets, the program may wind up setting prices that are still below what many institutions believe comparable assets are worth. Technically the question would be whether the TARP auctions constitute an orderly market. Arguably the answer is no, because the sales occur under duress. In practice it seems likely that valuation by institutions not seeking TARP assistance will tend toward TARP auction prices if they are considerably closer to expected longer-term cash flow values than recent distressed prices, but that such institutions will instead continue Level 3 treatment if not. The SEC guidelines would appear to permit them to do so regardless of the TARP prices, although that too remains to be seen.
1. SEC, Press Release 2008-234, September 30, 2008.
2. Letter from Edward L. Yingling, President of the ABA, to SEC chairman Christopher Cox, September 23, 2008.
3. Robert H. Herz and Linda A. MacDonald, “Some Facts about Fair Value.” (Financial Accounting Standards Board, May 2008)