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]]> http://www.streetdisclosure.com/sdc_blog/2009/09/blog-admin/feed/ http://www.streetdisclosure.com/sdc_blog/2009/03/fas-157-r/ http://www.streetdisclosure.com/sdc_blog/2009/03/fas-157-r/#comments Wed, 01 Apr 2009 03:24:09 +0000 John http://www.streetdisclosure.com/sdc_blog/?p=74

Reading the dissenting views for revision to FAS 157’s fair value method, there is a strong tone of “they can’t do that”. It’s viewed as politics taking over financial reporting or the failed bankers getting their way.

The right answer for fair value is when it accurately represents recoverable cash flows of the asset at the measurement date. Current practice isn’t close to that for mbs, cdo’s & related financial assets that do not trade in active liquid markets, such as those for commodities, bonds and equities.

The debate on FAS 157’s fair value and the rescue of banking would be greatly served by disclosure of performance rates on the securities that will be subject to PPIP purchase. The taxpayer is financing 93% of the bid price and the cash flow stream on the securities will be effectively collateralizing the $trillion of US debt financing. The information warrants being in the public domain.

When the performance rates on the securities are disclosed, they can be seen against what FAS 157 is valuing the same securities at. Seeing a 65% - 85% performing range on the assets underneath the securities would do a lot to demonstrate the current 15% valuation reported on FAS 157 audited balance sheets is dubious. The audited valuation says $4 of every $5 currently performing will default, soon.

There’s a sinful amount of politics in play in the FAS 157 fair value issue, for reasons of profit and power. Much rhetoric can be displaced by a transparent disclosure of performing cash flows. Getting the standard right, accurately representing the recoverable cash flows at the measurement date, is a bi-partisan, non-profit motivated solution.

The only troubling part is that politicians and failed bankers will look like they knew something for once. But they were really just standing at the spot where a bomb went off and a lot of light flooded a heretofore shadowy place. The luck will be if it moves fair value closer to what it’s name says it is.

In a fairly valued transaction, the price paid for the nonperforming financial assets (MBS, CDO, etc.) is going to be principally based on the performing cash flows, with a negotiated discount for estimated additional erosion in performance. A previous blog in October highlighted this as a routine element of executing a failed asset repurchase program at the federal level.

The banks know the substantial balance of these loans are performing. They can look at their holdings database. It’s not 98% but not 35% either. This is beginning to dawn on some outside of banking. The larger point is that the government can hold these assets and collect the cash flows to fund the debt it puts on to buy them from the bank. The value is in the performing cash flows of the securities and the US will own that cash stream. It doesn’t need hedge funds or private equity involved.

The act of repurchasing the assets will immediately exert a substantial force on market value to reflect the level of underlying cash flow performance. The market for credit instruments can further stabilize and find its footing because the US can hold the assets as long as it likes or reissue the cash flow performance as a federal security. The US is guaranteeing them whether the banks hold them or the US holds them.

The only relevant issue is the cash coming in on them. Assume the performance rate is a weighted average 70%. When the nonperforming assets remain on banks balance sheets, they get valued based on a fear discount, expressed by investors lack of demand for the asset class, which puts them at 15% or 20% of par. When they move onto the US’s balance sheet, where they can be allowed to stay and pay, the value rises to near the true cash flow performance level. And that lifts the value on all banks’ balance sheets. This improves industry capitalization significantly without any new capital added, through the unwind of fair value reporting’s liquidation basis stranglehold.

It also highlights a true flaw of fair value reporting. Genuine fair value is the recoverable cash flows. It’s not spot price , which is heavily shaped by the speculative agents of greed and fear.

Being able to sustain the performance rate on the repurchased assets is separate from the rescue element. Once the US owns the assets, the fiscal policy side of its action has to stabilize employment and then create genuine, lasting job growth, so people can pay mortgages. Further erosion in the nonperforming assets would mean less cash flow from the assets to pay the US Treasury debt funding them and that leads to more government borrowing and so on.

Other obstacles remain. House prices must still fall to what wages can pay for them and consumers must pay off substantial debt. The debt reduction is a years long task in the face of limited wage growth and will require sense be established in household financial management.

Tossing a trillion dollars out under the stim_u_less idea and waving it off as just a first try – we’ll throw more money later on too – was not understanding there has to be an awful lot more global interest in owning treasuries, for long periods of time.

Somebody has to buy the droves of debt we want to print and that means they’d have to believe we were directing it incisively and accurately at the problem. They’d expect the utilization rate of every dollar to be high.

Europe’s out. They’re not buying our bonfire of money approach toward rescue and recovery. The B R & I in the BRIC economic theory are fiscal adolescents (Brazil, Russia & India). They have limited interest and means. It’s China & Japan that would have to really want to think a paltry interest bearing, long term government promise to pay - from the place with all the broken banks, job losses and debt-bloated consumer/taxpayers – was a sage idea to invest heavily in.

The bottom falling out of that plan leaves the question…who’s buying what we’re selling?

That gets us to the “Buy Bonds” days of WWII, without the war. The government turns to society to put their savings into the grand plan of rescue and recovery. Otherwise, they would have to take it from society with taxes, which would contract GDP further.

It could be through bad ideas like nationalization from swelling ranks of zombie banks, or better ideas that include reconstruction of banking, it’s role and governance or as announced today, through a design like the Public Private Investment Program (PPIP) to purchase the failed assets, package them and resell them into the capital markets. This last approach was previously blogged about in October.

PPIP is a necessary part of reconstruction. But its final regulatory codification and execution is where the effort will be won or lost. As outlined by the Treasury Secretary, its aim is true but there is a good amount of trouble in its preliminary structure. The approach strikes me as a mutation of a PIPE. There is public investment financing private fee revenue and capital gains, for the sake of hoping it unlocks the lending markets.

A particularly troubling element is that the principal buyers of PPIP assets will be the unregulated community of private equity (PE) and hedge funds (HF). And…they will be bidding for PPIP assets with future US tax revenues. 93% of their buying power is financed by the Treasury (FDIC also but Treasury funds them too).

The terms of the program require private investors provide only 7.5% of the funding (and bear corresponding limited risk of loss) but they will be determining the bid price, with the leverage of 93.5% US financing. There’s so much not to like about that.

As an industry, along with the banks’ own negligent risk management, these groups were substantially responsible for the reckless investment practices that led to the insolvency of US monetary system and we’re expecting them to change their stripes and get us out of the problem responsibly. They are an industry driven by constructing unrealistic and unsustainable deals that garner them up front fee revenues and offload risk to syndicated borrowers. Pensions, endowments & states are buried under junk rated debt and deeply discounted ownership interests from their deals, while PE holds the cash from fees and possesses little remaining ownership risk.

There is no reason to believe these groups can accomplish anything more than being a 1^st stage transfer agent for the government. They can be expected to establish the initial bid price, take momentary possession and then redistribute the assets and risk back into the marketplace, for a fee.

“If this is profitable, and I think it will be very profitable, you’re giving more profit to private investors,” added FDIC Chairman Sheila C. Bair.

For this profit, PE and HF will relocate the nonperforming assets, at a discounted price. The furniture will be re-arranged but nothing will have been done to improve the underlying performance of the assets, so the risk of loss will remain, leaving the US on the hook as guarantor. But PE and HF will have bloated up with some more fees.

Treasury officials made changes to the plan in recent days in a way that makes it more favorable to private investors, according to government and industry sources. The Treasury increased private investors’ share of potential profits from 20 percent to 50 percent.

The unsavory characteristics of this model for reacquiring the failed financial assets are a pill the White House feels it has to swallow. Congress has closed the door to funding a good plan based on reconstruction. They’re afraid for their seat at reelection but not afraid for the nation’s well-being. So what we’re left with is us, the taxpayer, taking the same role and model of the failed banks and providing mammoth leverage to the PE and HF community to purchase deeply discounted assets.

They will again earn fee revenue from reselling US government insured PPIP assets back into capital markets and offload the limited risk they briefly took on. The taxpayer will retain possession of the risk of loss as the redistributed assets will not have gone away. They will only have changed their address.

Send the bonus & plane sinners to Alcatraz and be finished with them. They’re not what’s in the way of economic rescue and recovery. The glaring lack of informed and decisive leadership in Congress, as well as the White House, is. There is no understanding that someone has to be willing not to be liked by the angry mob of society, in order to do the things necessary to reestablish order and security in our national system of finance and its markets.

The Treasury, the council of wizards known as the President’s Economic Advisers, with its handpicked best-of-breed, hyper-credentialed do-nothings and the Congressional committees on banking have all been chasing the populist demons of bonuses and its sibling outrages, like rabbits. With every “we’re disgusted” dance these arms of government do, they posture for their voters and play Nero’s fiddle while the burning of Rome goes unattended.

It has become clear the Treasury, at the White House’s order, has been shut out from promoting any banking rescue plan that costs money. Congress has hung the “don’t ask” sign on the door. The Federal Reserve’s decision to purchase long dated treasuries in the open market, as a means to push some liquidity back into the economy, is a response to this. The Fed realizes it needs to accomplish whatever it can in the face of the Executive and Legislative branches sitting out on constructive strategic resolution.

Our Congress is afraid of how they’ll be seen by the voter if they willingly appropriate the kind of funds it will take to stand behind banking while it is reconstructed. Though they are unable to see how they will look to the voter when the problem is beyond their belated acceptance of its magnitude to do anything about it.

At the time my feeling was the audit had to have been faked or be fraudulent. That raised its own questions on why no one in the pool of investors would have done basic due diligence on the audit firm. Today’s news release discussed the topic:

The acting United States attorney, Lev L. Dassin, said that while Mr. Friehling was not accused of knowing about Mr. Madoff’s scheme, he was charged with deceiving investors for years by falsely certifying that he had audited Mr. Madoff’s books.

Joseph M. Demarest Jr., the head of the New York F.B.I. office, said that Mr. Friehling, …did little or no testing or verification of the records he was hired to certify as an independent auditor.”

“…Friehling failed to do his job and lied to investors and regulators in saying he did.” Demarest said.

Mr. Friehling “essentially sold his license to Madoff for more than 17 years while Madoff’s Ponzi scheme went undetected,” said James Clarkson, acting director of the S.E.C.’s office in New York.