Banks May Be the Only Winner In New Rules for Toxic Debt
There’s little dispute that the government-sanctioned move to allow accounting flexibility in valuing toxic assets will be good for the banking industry. The big question is whether it's good for anyone else—including the federal government.
In voting to let banks exercise more judgment in using the so-called mark-to-market accounting rule, the Financial Accounting Standards Board is also thought to be trying to revive the market for such troubled debt-based assets so banks can remove them from their books, rebuild capital ratio levels and undertake new lending.
Sounds good. But the change may be solving one problem while creating others, say market and accounting professionals, as well as former regulators and government officials.
“The banks won't sell as long as they can keep the assets on their balance sheet at unrealistically high values,” says Robert Glauber, who supervised the first Bush administration’s handling of the S&L bailout and now serves as a trustee of the International Accounting Standards Committee Foundation.
The FASB ruling on fair-value accounting—which many call confusing and poorly articulated—essentially allows banks to value what have become hard-to-price assets based on their cash-flow value—not their so-called market value, which in most cases is non-existent, or illiquid. The same thinking would apply to losses or gains on positions, which directly affects earnings.
Until the accounting board move, pricing or re-pricing the assets—a key step in recreating a liquid marketplace, analysts say—was thought to be extremely difficult.
For that reason and others, the Obama administration felt it necessary to intervene in the marketplace by conceiving a government-subsidized bidding system, known as the Public-Private Investment Program or PPIP, that would connect banks looking to sell assets with private investors such as hedge funds and private equity firms interested in buying them.
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Some say the mark-to-market change will undercut the attraction and effectiveness of that bidding program, despite its generous government guarantees.
“The banks are going to say why do I need to deal with the PPIP,” says Lawrence White, a former White House economist and savings-and-loan industry regulator. At the least, it “raises the price at which they would be willing to sell to a PPIP entity.”
Glauber, who was recently named interim non-executive chairman of Freddie Mac, says the toxic asset program, which was problematic in the first place, has been weakened. “The best way to get price discovery is to get transactions," he says.
Veteran money manager Jim Awad, managing director at Zephyr Management, says the government’s PPIP is likely to become less attractive to potential buyers, as well.
Hedge fund and private equity firms have been trying to buy troubled assets for months at distressed prices, but have been turned away by sellers.
“If they can't get these things at the right price, then why bother?” says Awad.
The right price, of course, depends on who's applying the new equation.
The value of mortgage-backed securities any given time, for instance, depends a lot on default rates, say analysts, which is a key factor in determining cash flow, as well as losses or gains on positions going forward.
“To me that's what it is all about,” says White. “Banks have always had a more optimistic view of what the default rates would be than the outside market.”
The more optimistic the scenario, the higher the value.
“Why wouldn't you if you were a banker?” says Awad. “As long as you can justify it on the models.”
Model is an interesting choice of words, because skeptics of the accounting rule change say it essentially creates a hybrid between mark-to-market and mark-to-model principle, the latter of which uses internal assumptions, variables and timeframes on assets that don’t have a regular market.
“It really will permit people to mark to model,” says former SEC Chairman Harvey Pitt. “The thing that’s been creating the problem has been the lack of a coherent methodology that everyone follows so there is comparability across financial statements.”
Pitt and others say the change essentially replaces one artificial approach with another.
“Its not an accounting issue,” says Pitt, who opposes outright suspension of mark to market. “It’s an economic issue. Do we really want the accountants making national economic policy?"
“It’s almost a wink and a nod to price discovery," says Rep. Michele Bachmann (R-Minn.), one of the more ardent proponents in Congress, where there was unusually high bipartisan support. “We all realize this is fake price discovery but it will lead to real price discovery.”
Supporters of the accounting change say potential buyers also needed something of a reality and that's been accomplished.
“The expectation of a fire sale was ridiculous,” says Scott Talbott, SVP of government affairs at the Financial Services Roundtable, a major industry trade group. Talbott says the new valuation approach “helps price discovery” and should narrow the spread between bidder and sellers with or without the government's participation.
Successful or not, the mark-to-market change may at least make the PPIP “politically palatable,” says Joshua Ronen, an accounting expert at NYU’s Stern School of Business. “It gives political cover to [Treasury Secretary Timothy] Geithner "because the government and its partners “won't have to offer prices significantly above what’s on the books.”
Some in Congress say the accounting change may even wind up making the government’s toxic assets purchase program unnecessary.
“I would hope that it would. Ultimately the price discovery has to come from willing buyers and sellers,” says Rep. Bachmann, who adds she’s “not a fan” of the Treasury's plan. “Some of the [financial] commitments we’ve made, we may not see them realized.”