Monday, March 31, 2008

Is SFAS 157 the real reason for forced sales? - B.R. says 'Yes'

I wanted to way in on a post from Barry Ritholtz', s blog the Big Picture:
SFAS 157: Market Prices Too Low? Just Ignore Them!
He caught a very interesting piece of information regarding SEC guidelines for banks to value level 3 assets:

Here's a honey of an idea that almost slipped by unnoticed last week. Thankfully, the NYT's sharp eyed business columnist, Floyd Norris, caught it. An SEC opinion letter advising companies how to deal with their Level 3 assets made a rather curious suggestion. They advised that if the prices of mark-to-model crappy paper are underwater, well then, declare it the result of forced liquidation -- and then you can simply ignore them. It truly boggles the mind.

This is the actual passage from SEC opinion letter that is in question here:

Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.

B.R. argues that under this SEC rule (referring in particular to the part that is highlighted in red) banks would have an incentive to make the value of their assets appear as a result of margin calls and consequently move them into level 3, where they could be valued market to model rather than market to market. This would lead to "window dressing down" and for the banks "as to not have to come up with a legitimate value for tier 3 junk".

If this is correct it would mean that banks operate on two standards, one for the values of assets on their own books and another for assets they lend out to borrowers like HFs. The SEC opened an investigation into this problem as early as last August. How can banks reprice certain assets they hold as collateral for money they lend to investors in order to not reprice similar assets they are holding on their own books (moving them to level 3), and not anticipate to run into severe problems with regulators? It would need an elaborate scheme of fraud to make even Wall Street blush. I do not see this as an incentive for banks to force liquidations in order to clean up their books. While forced sales as a direct result of margin calls are an important part of the current crises it is repricing of risk that is the real incentive for the deleveraging process that is taking place. As the pendulum of easy money has turned around and is now swinging in the other direction it might well overshoot in the process of it.

source: SFAS 157: Market Prices Too Low? Just Ignore Them
Barry Ritholtz

source: S.E.C.

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