December 3, 2008
RE: File No. 4-573, Roundtable on Mark-to-Market Accounting
Dear Nancy M. Morris, Secretary of SEC,
I thank you for the opportunity to express comments regarding Mark-to-Market Accounting, and in particular FAS 157, FSP FAS 157-3 and their interaction with FAS 115 for debt securities.
I propose for your consideration just a few changes to the standards and their related FASB Staff Positions, but could have a marked improvement on presenting financial statements so that they more accurately reflect the fundamental economic value and earnings of the firms activities and holdings and hence better present the information to investors.
The First Proposal is to revise the meaning of liquidity risk premium used in determining a discount rate applied in the various Income Approaches using present value models for deriving a fair market value. Rather than apply a meaning that infers the liquidity risk premium inherent in the current market, clarify this to mean the liquidity risk premium applicable to planned holding period the firm has the ability and intent to execute.
For example, if a firm has the intent to sell a whole-loan mortgage backed security (or an inability to hold a security for longer than) a month or less, then the liquidty premium used in the discount rate would be reflective of current market liquidty premiums for same or similar assets which in todays market might be 10% when 2 years ago that same liquidty premium might have been 0.10% and if the firm plans to hold the whole-loan mortgage backed security to maturity, irrespective of the designation for the security as 'hold-to-maturity' or 'available for sale' as require under FAS 115 but rather based on the intent and ability to hold the security to maturity, then only a negigible (i.e., the longer term premium like 0.10%) or NO liquidity premium would be applicable. This change will have a material impact on current capital and earnings reported in a way the more accurately reflects the underlying economic fundamentals this can also be supplemented with a Fair Market Value disclosure comparing the values using a liquidity risk premium based on an immediate liquidation vs. the planned holding period of the firm.
A variation of this would be to simply apply this revision in the application of reducing the cost basis of the debt security if the debt security has been determined to have other-than-temporary impairment. Whereas this might narrow its application, I would not propose this.
The Second Proposal would be to clarify that for a present value model the expected cash flows that are discounted should be the contractual cash flows of the debt instrument adjusted by their expected losses at their respective terms. I find that discount rates are being applied to cash flows that are not adjusted for expected losses if held to maturity.
The Third Proposal would be to clarify that for a present value model the discount rate should reflect the credit risk premium of the expected cash flows that have been adjusted as described by the Second Proposal so that after application of the Second Proposal there still remains some residual credit risk to the remaining transaction and that residual risk has a cost to it which is equivalent to the cost of capital for that particular residual amount. For example, if the mean loss estimate is 1% for a one year debt instrument and the residual or 'worst case' loss outcome is an additional 8% (refer to existing economic capital as applied in risk based capital measures, for instance), then the discount rate would be adjusted not by the 1% as that has already been accounted for in the reduction in cash flows, but by the cost of the 8%. In this example if the cost of capital is 15% then the credit risk spread is not 1.00% or the amount of expected losses, but 1.20% for the cost of capital on 8% of the Par value of the security (or 8% X 15%).
The Fourth Proposal, but much less desirable since it would not fix the distortion created in the capital accounts through AOCI but more desirable then making no changes at all, would be in the case of other-than-temporary impairment to change the cost basis of the debt security not to the current measure of fair value but simply by the amount of the actual expected loss based on a present value using a discount rate equal to the original yield spread plus the current benchmark interest rate and using cash flows based on current expectations reflecting less than full or timely payments. In this case the firm would continue to report and carry the debt security at its fair market value measured under current existing standards, but the earnings would be more reflective of the underlying economic fundamentals. For example, if a firm owns a security of $100 Par with a current cost basis of $99, a fair market value of $40, and a probable loss of $0 based on future payments the cost basis would be written down to not $40 but to $98 and hence earnings would be effected by only $1 and not $59 which could be the difference between a perception of solvency or not in this environment.
To illustrate the impact on an individual firm of current accounting standards in this environment marked by severe illiquidity in capital markets, and extremely scarce capital consider the following example:
a. Bank B owns 10 mortgage backed debt securities at $100 cost each with Fair Market Value of $100 each and all are AAA rated by SP, Moody's and Fitch. The firm has the ability and intent to hold the debt securities to maturity. Bank B pays no taxes.
b. Bank B has $100 in Capital, and $900 in FDIC insured deposits.
c. Bank B and the rest of the capital markets suffer from a severe economic shock. Bank B expects they will lose $1 on each of their securities through maturity, their planned holding period.
d. Bank B's security holdings suffer from an inactive and distressed market as a result of the capital market and economic environment and the Fair Market Value of the debt securities declines to $50 each after inclusion of current market liquidity risk premiums. Bank B's debt securities in total are Fair Market Valued and hence carried at a new value of $500,000 rather than the $1,000,000 originally.
f. As a result Bank B reports their financial statement in one of two ways: a) the securities are determined to be NOT other than temporarily impaired and so their capital including AOCI is $-400,000 and as a result investors and depositors perceive the bank is insolvent b) securities are determined to be other than temporarily impaired and so their capital is reported at $-400,000 and as a result investors and depositors perceive the bank is insolvent.
g. The Bank fails for a multitude of potential reasons, a deposit run due to the lack of confidence due to the negative or low capital, the bank regulators take the bank into receivorship due to the adverse capital condition, etc. Regulators liquidate the debt securities for no more than $500,000 and in the end costing the FDIC bank insurance fund $400,000. The buyers of the debt securities will enjoy additional future gains of $490,000 at the expense of the FDIC bank insurance fund, the bank shareholders, depositors outright or in the form of having insured deposits at a failed bank, and potentially tax payers and consumers.
h. NOW SUPPOSE, Bank C had the same assets but held them as loans. Bank C reports using current accounting standards as well, but the result is they mark a $10 ($10 X $1) loss provision that reduces their capital (but increases their loan loss contingency) appropriately by $10. The Bank is appropriately perceive as solvent and appropriately reserved for its anticipated loan losses. Capital is destroyed at the bank only to the extent of the estimated future losses.
This is a significant issue for a broad array of asset backed debt securities in particular encompassing a signifacant portion of financial institution holdings. As an anecdote, I ran a simulation today for a security priced at roughly $40, with a probable loss of $0-5. Given a high loss severity for the underlying assets I show that even if all the underlying loan assets defaulted (there is over 1,000 1st lien fixed rate ALT-A owner-occupied mortgages in the pool with an original LTV of 70%) and were liquidated the bond would lose approximately only @$30 nettign $70 that is a full $30 distant from the current Fair Market Value using FAS 157.
Now, at the macro economic level, play this out and there is an exascerbation of capital destruction in the current period on one hand adding to the distress in capital markets and the unwillingness or inability to lend by creditors. In addition, in the future there will be a significant gain reported by a select and narrow few further concentrating assets by those few who were significantly endowed with cash and less risky assets prior to the economic and capital market shock (an economic rationale would suggest these are not just the thrify but the very wealthy further concentrating wealth of a narrow few with a signficant amount of that attributable to accounting standards alone).
I would implore some urgency in any changes given the grave nature of the impact at this time on our economy. Not that accounting standards has caused the problem necessarily, but it is making it worst and standing in the way of a recovery in our economy that will play a role a reduction in the immediate reduction and future transfer of wealth as reported in financial statements.
Sincerely, Patrick Straka