This summer’s implosion of the sub-prime mortgage industry has put the measurement of fair-value accounting in a very harsh spotlight.
The spiking number of defaults and foreclosures in sub-prime mortgages is taking its toll on hedge funds, investment banks, and others holding exotic financial instruments backed by that mortgage debt. In theory, the value of those instruments is based on fair market valuations of what that debt is worth. The market’s turbulent reality, however, has made clear just how painful things can get when people suddenly start thinking an asset has no value.
Greenberger
Mortgage-backed instruments “are embedded all over the place,” says Michael Greenberger, a law professor at the University of Maryland. “Even on our faculty here, people are asking ‘How much of this paper does our pension hold?’ People don’t even trust money market funds.”
Already, two large hedge funds operated by Bear Stearns collapsed in June thanks to investments in sub-prime mortgage securities that went sour, forcing a multi-billion dollar bailout. Other investment banks and hedge funds around the world have experienced similar problems, and how many others are quietly sitting on similar bad news is anyone’s guess. Even policymakers say the ultimate damage is difficult to predict, given the complexity behind the packaging and resale of mortgages and other types of debt into various financial products.
A significant portion of sub-prime mortgage debt is packaged into collateralized debt obligations, or CDOs, Greenberger says. He describes it as a kind of insurance, established to sell credit protection on a range of underlying assets. A 2005 market study estimated CDOs would be worth as much as $2 trillion in U.S. markets by the end of 2006.
“CDOs are billions and billions of dollars in bets that are placed,” Greenberger says. “One side is betting that these people are going to pay back their mortgages, and the other side is receiving a kind of insurance in case they don’t.”
With fears about default and foreclosure rising, holders of the CDOs are trying to sell them for more reliable investments—and finding the CDOs are worth as little as 10 cents on the dollar, Greenberger says, because practically nobody wants to buy them right now.
Enter the uncomfortable question of fair value accounting.
Robak
“The accounting rules say you have to mark these instruments at fair value, and for all intents and purposes that’s market value,” says Espen Robak, president of Pluris Valuation Advisers. “If the market is undershooting the value, the books should reflect that undershooting. If managers feel the market is irrational or not reflecting true value, that’s really irrelevant to what the true value is.”
What’s more, valuation of CDOs may be complicated somewhat by the Federal Reserve—the only major entity right now accepting CDOs as collateral, Greenberger notes. The Fed’s intention is to show skittish investors that liquidity (that is, buyers) do exist for these instruments, but it also leaves the market uncertain about how to determine the value of CDOs, especially as new accounting rules defining fair value measurements are due to take effect with the beginning of 2008, said Tim Mahon, an economist with Anderson Economic Group.
The Valuation Challenge
Financial Accounting Statement No. 157, Fair Value Measurements takes effect for fiscal years beginning after Nov. 15, with early application encouraged but not required. FAS 157 establishes a three-level hierarchy for how fair value should be measured where it’s already required in accounting literature, including financial assets like CDOs and others that might be touched by sub-prime mortgage debt.
Mahon
The strongest basis, or first level in the hierarchy, for determining fair value is the market, according to FAS 157. “The premise is an active market, but the status is an inactive market,” Mahon says. “If the Fed comes in, that’s not an active market. People are scrambling to say ‘What are these CDOs worth?’ No one is going to want to say there are no buyers and so these are valueless.”
Given that CDOs are not highly liquid securities subject to regular transaction, Greenberger says, valuation specialists may decide to concentrate more on modeling than market inputs to establish CDOs’ values.
“We know trying to value instruments that have no market observations becomes a challenge,” says Raymond Beier, head of national technical services at PricewaterhouseCoopers. “It’s important to understand that residuals have always had to deal with marks. It’s not uncommon to have to deal with mark-to-model scenarios.”
“If managers feel the market is irrational or not reflecting true value, that’s really irrelevant to what the true value is.”
— Espen Robak,
President,
Pluris Valuation Advisers
Wallace Enman, an accounting analyst with Moody’s Investors Service, says insurers’ valuation of CDOs is generally based on quoted market prices where an active market exists. Absent any active trading of a CDO, companies can mark to model by estimating future cash flows, discounting at an appropriate rate, and carrying the asset at the value derived from that analysis, he says.
Enman warns that CDOs marked down due to discounted cash flow analyses may result in “other than temporary” impairments, if the chance of credit loss is deemed to be greater than remote; that would result in a hit to earnings. Mark-downs due to interest rate fluctuations, in contrast, are recorded less conspicuously through other comprehensive income, he says.
Mahon says auditors will be watching valuations closely. The Public Company Accounting Oversight Board has made its interest in valuation issues known via its inspection reports on audit firms, where the Board more frequently spotlights problems with auditing of valuations (most notably, in some recent high-profile criticisms of Deloitte & Touche).
Risks of Modeling
Beier
Beier admits that inputs to the model can be subject to interpretation. “One of the key challenges using models is assuring assumptions are relevant and appropriate,” he says.
Greenberger worries that use of modeling and assumptions leads to unreliable values. “I believe accounting standards are not sufficiently precise that they really do provide fair value,” he says. “Fair value is being established through means that bear no relationship to the real world. People are picking numbers out of thin air.”
Robak cites the recent tumble in CDO values as an example of why modeling is not a good idea. “The market can change rapidly, and a model is almost certainly not going to reflect that,” he says. The impending pain over booking big declines in value might have been reduced, he contends, if valuations used more market inputs more consistently before now.
Mix
Walter Mix, managing director of Secura Group, takes the optimist’s view, saying CDO holders might still be rescued by investors looking for bargains. “There are many investors observing opportunities in the market, so it’s reasonable to expect, given the fact that these investors are stepping into the market, that there may be a tendency to see these values increase—I would say in the not-too-distant future,” he says.
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