Does Fair Value Accounting + Credit Default Swaps = Global Deflation? Written by Christopher Whalen

 
The US housing market continues to reel under the double weight of asset price deflation on the supply side, which is making banks reluctant to lend, and shrinkage of consumer demand for financing.  The good news is that the decline in existing home prices is going to fix the issue of affordability and demand over time.  It is on the supply side, though, in terms of credit available financing for buyers and builders of homes, that the market outlook remains uncertain.

Consider the drivers behind the falling supply of financing for all aspects of housing.  First, the collapse of the market for private label securitization, a once multi-trillion dollar source of gray market financing which has disappeared.  Second, the deleveraging of the banking system globally, which has consumed more than a trillion dollars in capital via mark-to-market (“M2M”) and realized losses over the past 18 months and looks to be set to consume another trillion in the next year.

The fact of the market excesses behind these grim figures is undisputed.  But the one thing that arguably has accelerated the process of deflation, the one change in public policy put in place by the SEC and the Financial Accounting Standards Board at the start of 2008, is fair value accounting or “FVA.”  For housing professionals in all aspects of the financial chain, this obscure accounting rule should be “Target A” when you interact with elected officials at the state and local level.

FVA is the last remnant of bubble-think, a well-intended effort to restore market transparency that is instead driving us into the proverbial Thresher (SSN-593) scenario, straight down into the deepest trench of an economic correction that is well-beyond crush depth.  Think of FVA as a reasonable effort by academic experts from the audit world to deal with the increased opacity of the OTC markets, but one that has gone badly astray.

Over the past several months, my colleagues and I have come to the conclusion that we must make a correction in the FVA rule. We see two issues:

First, FVA relies on efficient market theory, namely that short term price = value and that consequently income, assets and liabilities should be adjusted in real time to reflect same. We think that the collapse of all of the other market efficiency based constructs, from structured assets to hedge funds, ends the discussion of derivative notions such as FVA, but readers of HW should recognize that the price=value assumption, which goes back to the Chicago School of Economics, is a huge intellectual driver behind the deflation we see in many markets today.

Second, FVA fails to recognize the historical role of banks, depositories, pensions and insurance companies as repositories for long-term value and consequently as havens from swings in short-term market pricing and economic trends. The whole point of capital adequacy regulation, with the notable exception of liquidity tests for broker dealers, is to give such institutions the freedom to take the long view. FVA makes the long view impossible and basically turns what are supposed to be low-beta, low risk, highly solvent hold-to-maturity vehicles into mark-to-market liquidations every day via the derivatives markets.

Just as you cannot buy bad assets from an insolvent bank at "fair value" without worsening the insolvency, likewise when you mark down assets you are reducing the ability of the entire financial system to support leverage. When you combine the zero effective collateral and margin operating in the derivative markets for instruments such as credit default swaps or CDS with the quarterly idiocy of marking down performing securities and loans to satisfy the advocates of FVA, it would be difficult to imagine the enemies of the United States constructing a more perfect weapon to bring about our collective demise.  Or to put it another way, what bank is going to be willing to buy residential mortgage collateral and hold same for sale in an FVA world?   Ask your MCs and Senators what they are doing to help repair the private secondary market for home mortgages.

That said, I am not against disclosing the short-term fair value of assets. In fact, my colleagues and I at IRA want to see expanded disclosure of swings in FVA for all public companies, financials and otherwise. And as we have written in The Institutional Risk Analyst, the bank regulatory community is moving, painfully, slowly, to expand disclosure for banks and BHCs via efforts such as the expansion of the Shared National Credits reporting matrix, Basel II and a monthly reporting series on credit cards, a vast task that could require the collection of half a trillion records containing your personal credit and financial information, some 100 data elements per discreet record.

IRA is actively competing as a subject matter expert and system design architects for some of these new data collection tasks before the OCC, SEC, FDIC, etc, and we shall keep you in the loop to the extent we are allowed under the very tight confidentiality that is required. But suffice to say that we believe that there will be vast amounts of new data available on assets and liabilities as the restoration of prudential limits on finance proceeds apace.  The question for financial professionals is what to do – or not do – with this data.

We agree with those who believe that a compromise must be struck between the utopian goals of complete and total market efficiency and transparency and the real world of human action and inefficiency. The fact is, normal people are simply not able to react to and understand the torrent of short-term swings in assets prices, thus the net effect of FVA is not greater understanding, but instead fear, panic and systemic instability.

Believe us when we say that we have seen the wild eyed, "don't you get it" look from the proponents of FVA in our colleagues in the XBRL community. We love their idealism and their vision, and we share same. But we at IRA also live in the real world of operating and delivering decision support systems for investors and fiduciaries. These systems must operate in the objective and very arbitrary rules of scientific method, because as Graham and Dodd taught us 80 years ago, the more speculative, the more unstable the data inputs, the less the analysis matters.

The subjective, speculative perspective that is the essence of FVA, when applied to illiquid assets has, we believe, the net effect of increasing the instability in the global economy. We'd like to ask the reader of HW to answer the following question: Is FVA accelerating the slowdown in the economy?  Because if the answer is yes, than nothing the Fed or Treasury try to do in nominal terms will be effective in stabilizing the banks, consumer prices or GDP because FVA, imposed just as the great real estate bubble was imploding, is now driving the global economy to a fire sale liquidation.

Disclose swings in market value of assets, you can even put aside reserves against the weaker credits, but so long as the asset is money good, it should not be charged against reserves. We might even construct some type of averaging rule for FVA swings in assets, affecting income and even reserves once the swing in value if confirmed over time, but the notion of instantaneous and immediate price discovery, disclosure and financial adjustment is a childishly idealized notion that must be gently restrained.  If we want to first fix the banks and then the secondary market for necessary things like mortgage finance, then I believe that the SEC and FASB must make an adjustment in the FVA rule.

Christopher Whalen is the co-founder of Institutional Risk Analytics, the Los Angeles based publisher of bank risk ratings and provider of risk management tools and consulting services for auditors, regulators and financial professionals.  He edits The Institutional Risk Analyst, a news report and commentary on developments in and around the global financial markets.

We thank Chris Whalen for sharing this commentary with our readers.

Christopher Whalen, Institutional Risk Analytics

This article will appear in the upcoming issue of HousingWire Magazine (www.housingwire.com)
 

David Kotok, Chairman & Chief Investment Officer



source: Cumberland Advisors