The piece dissects, in greater detail than I have been personally aware, the mess that has become commercial bank accounting for CDOs, CMOs and other structured instruments.
Since mid-2007, I have believed that, either by Presidential Executive Order, FASB ruling, or Congressional action, existing mark-to-market rules should have been, and be, modified to allow cash-flow-based expected value to be used for non-trading structured financial instruments, especially those composed of mortgages or mortgage-backed securities. This belief is rooted in the fact that underlying performance, in terms of cash flows, may not necessarily be reflected in the prices of the securities into which such mortgages have been bundled.
Chanos, however, casts a very different light on the matter. In his opinion, banks have long-used market values on these instruments when they were rising, thus abrogating their ability to now declare them to be held for investment purposes,
"Financial institutions had no problem in using MTM to benefit from the drop in prices of their own notes and bonds, since the rule also applies to liabilities. And when the value of the securitized loans they held was soaring, they eagerly embraced MTM. Once committed to that accounting discipline, though, they were obligated to continue doing so for the duration of their holding of securities they've marked to market. And one wonders if they are as equally willing to forego MTM for valuing the same illiquid securities in client accounts for margin loans as they are for their proprietary trading accounts?"
Further, Chanos notes that, in the current environment, you don't really want to trust the executives who mistakenly bought and held these instruments with telling you that their intrinsic economic value is actually much higher than the market thinks they are. He continues by observing,
"According to J.P. Morgan, approximately $450 billion of collateralized debt obligations (CDOs) of asset-backed securities were issued from late 2005 to mid-2007. Of that amount, roughly $305 billion is now in a formal state of default and $102 billion of this amount has already been liquidated. The latest monthly mortgage reports from investment banks are equally sobering. It is no surprise, then, that the largest underwriters of mortgages and CDOs have been decimated.
Commercial banking regulations generally do not require banks to sell assets to meet capital requirements just because market values decline. But if "impairment" charges under MTM do push banks below regulatory capital requirements and limit their ability to lend when they can't raise more capital, then the solution is to grant temporary regulatory capital "relief," which is itself an arbitrary number.
There is a connection between efforts over the past 12 years to reduce regulatory oversight, weaken capital requirements, and silence the financial detectives who uncovered such scandals as Lehman and Enron. The assault against MTM is just the latest chapter.
Instead of acknowledging mistakes, we are told this is a "once in 100 years" anomaly with the market not functioning correctly. It isn't lost on investors that the MTM criticisms come, too, as private equity firms must now report the value of their investments. The truth is the market is functioning correctly. It's just that MTM critics don't like the prices that investors are willing to pay."
In effect, Chanos contends, correctly, I now think, that the banking executives who mistakenly created, bought and/or held these instruments, and were happy to take advantage of their rising market values, now want to call the whole thing off and claim that they really meant to hold them long term as investments.
In the time since I originally reflected on mark-to-market pricing and its modification, several investment and commercial banks have failed, no publicly-held investment banks of any size now remain, and several hundred billion dollars of financial service company writedowns have occurred, mostly related to the ever-falling values of mortgage-backed assets which were structured from now-suspect subprime home loans.
Chanos' major focus is really the need for those who initially benefited from the first blush of rising values from structured instruments to now be forced to take the pain of their falling values.
Up until a few months ago, I think I would have disagreed with him. Now, I don't.
The recent failures of WaMu and Wachovia have proven that Chapter 11, FDIC seizures, and orderly closures of banks can occur without undue damage to the economic or banking system. Since depositors are protected, and assets will be sold at market prices anyway, I no longer see a downside to Chanos' insistence that financial service firms mark to the tradeable values of instruments which they originally treated as, well, tradeable assets. Not investments.
The piece goes on to detail some of the more hilarious ways in which FASB is about to allow bank CFOs to 'value' assets such that nobody in their right mind will believe balance sheet values anymore.
Chanos ends his persuasive editorial by stating,
In this, he echoes Anna Schwartz' views from her interview in the Wall Street Journal last October. That is, the crisis has never been about liquidity, but, rather, solvency and trust that banks are actually solvent, on a market-based valuation.
Until this is accomplished and enforced, once and for all, private capital will not flow to suspect financial institutions holding assets marked by fundamentally dishonest means.
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