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Putting Perfume on a Pig!!

Posted by Larry Doyle on April 2, 2009 9:45 AM |

***Bumped up from original publication time of 7:30AM. The FASB has now just voted its approval of the change in mark-to-market accounting.

It is speculated that the FASB (Federal Accounting Standards Board) will today relax its rule known as the mark-to-market. This rule requires firms under the FASB’s purview to mark their assets to changing market prices on an ongoing basis. The institutions subject to this rule have been lobbying FASB and Congress for a change because the markets for these assets have imploded and in certain cases totally dried up.

What does the FASB plan to do? The FASB is going to cave to the lobbying pressure and will allow institutions to use their own internal models based upon cash flow analysis to price these assets. This change in the mark-to-market will not only allow institutions the flexibility to not mark down certain assets, but simultaneously mark up other assets.

The media only presents the impacted assets as “hard to value” or the dreaded “mortgage-backed securities” or “securitized assets”.  In fact, many of these assets are very simple and plain vanilla. Let’s enter the world of the Federal Home Loan Banks.

The FHLB system consists of 12 regional banks and it provides liquidity (capital) for its respective members to operate. The FHLB system invests its own capital, primarily in plain vanilla conventional mortgages (Freddie Mac, Fannie Mae, Ginnie Mae) and Jumbo ARMS (adjustable rate mortgages) and fixed-rate pass-thrus. Certain banks within the FHLB system may have moved slightly off the plain vanilla path to purchase a small percentage of sub-prime assets, but that was much more the exception than the norm. 

The FHLB funds itself by issuing simplistic debt issues.

The point I am raising is that the FHLB business model is a VERY simple model. The fact of the matter is the valuations of their assets have fallen through the floor. If the FHLB system marked these assets at levels at which the assets are currently trading (and yes, they are trading everyday….I could get a bid on a large block of bonds within the next 10 minutes!!), then the FHLB would need significant capital injections.

Who gets this? Charles Bowsher, who resigned just last week as chairman of the Federal Home Loan Banks Office of Finance. Bloomberg’s Jonathan Weil does yeoman work in profiling Mr. Bowsher and the joke that is FHLB accounting:

Bowsher, who was comptroller general of the U.S. from 1981 to 1996, had a simple reason for resigning last week as chairman of the Federal Home Loan Bank System’s Office of Finance. He didn’t want to put his name on the banks’ combined financial statements, because he was uncomfortable vouching for them. Bowsher, 77, had held the post since April 2007.

With so many top executives complaining they can’t figure out what their companies’ assets are worth, the real wonder is that more corporate directors haven’t quit rather than certify financial reports they don’t understand.

The job Bowsher left is a crucial one. The Office of Finance issues and services all the debt for the 12 regional Federal Home Loan Banks. That’s a lot of debt — $1.26 trillion as of Dec. 31, making the FHLBank System the largest U.S. borrower after the federal government. The government-chartered banks, which operate independently, in turn supply low-cost loans to their 8,100 member banks and finance companies. If any of the FHLBanks were to fail, taxpayers could be on the hook.

Where have we seen this nightmare before? Freddie Mac and Fannie Mae were the poster children for private profit and social loss. While I know of nobody at Freddie Mac or Fannie Mae who willingly exposed the holes in their internal accounting, Bowsher will not acquiesce:

“I was not comfortable as an audit-committee member in signing off on the financial statements, after I became aware of the standards and processes for valuing the mortgage-backed securities,” Bowsher told me.

In typical political fashion, the finance office was less than forthcoming about Mr. Bowsher’s departure.

The finance office didn’t say why Bowsher was quitting, when it issued its March 24 press release announcing his resignation. On March 30, a spokesman, Michael Ciota, told me the people who work there didn’t know, including its chief executive, John Fisk. “We’re not aware of any reason,” Ciota said. “There’s not a whole lot to tell.”

After I told Ciota yesterday about Bowsher’s comments to me, Fisk called me back. He confirmed that “Mr. Bowsher has expressed his concerns to me around the complexity of valuing mortgage-backed securities and the process of producing combined financial statements from the 12 home loan banks.” He added: “I don’t think it’s appropriate for us to speak for Mr. Bowsher.”

For what it is worth, John Fisk formerly worked at Freddie Mac. With all due respect to Mr. Fisk, his experience at Freddie Mac is not exactly a resounding vote of endorsement.

Thus, the equity markets will rally on news of this accounting change, but as they do, please do not forget about Mr. Bowsher and his principles. His principles are being run over in the name of “creative accounting.” To wit,

The year-end balance sheet at the FHLBank of Seattle, for example, showed $5.6 billion of non-government mortgage-backed securities that it says it will hold until maturity. Yet the estimated value of those securities was just $3.6 billion. The bank, which reported a $199.4 million net loss for 2008, said the declines were only temporary. They’ve been anything but fleeting, though. Most of those securities have been worth less than they cost for more than a year.

The FASB’s rules on this subject, which have never been well defined, are now in flux. Today, after caving in to pressure by the banking industry and members of Congress, the Financial Accounting Standards Board is set to vote on a plan to relax its rules on mark-to-market accounting, so that companies can disregard market prices and ignore losses on their securities indefinitely.

While that wouldn’t make the banks any healthier, it would make their numbers look prettier. The FHLBanks have been among the most vocal lobbyists pressing for the change.

I commend Mr. Bowsher for having the character and integrity to stand his ground on this topic. I commend Mr. Weil at Bloomberg for profiling him and highlighting an Honest Man Emerges From Banking Crisis.

The cost to taxpayers is not only in the risk of real losses on FHLB finances, but also the lack of capital that will flow through the system. This relaxation in the mark-to-market is, in my opinion, a classic Japanese style move of not recognizing losses. I believe we will look back at this day and this rule change as a watershed event.

In my opinion, this change in the mark-to-market for an entity such as the FHLB system is the equivalent of “putting perfume on a pig!”


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