A major market problem relates to how financial institutions must recognize the value of securities that are not trading in a liquid market. The financial assets include complicated securities including various tranches of mortgage debt. Everyone agrees that these are difficult to value.
Given this problem, buyers have stepped away. There is no legitimate market, one of the major problems for achieving some stability in equity markets. The Fed has addressed this by accepting, at a discount, such securities in TAF auctions, and more aggressively in opening the discount window and taking action in the Bear Stearns buyout.
Anyone in the money management business respects market pricing -- when it is valid. At "A Dash" we certainly agree. Freely trading securities should be market to market.
The Problem
Difficulties ensue when specific securities are sold in a distressed market. Since there is no real market for many CDO's, the various methods of evaluating them may be generating questionable pricing. Under the recently adopted FAS 157 rules, companies are compelled to recognize such pricing, even if the expected payouts do not conform to the actual sale prices.
FAS 157 was intended to force financial institutions to recognize actual pricing on balance sheets, with the consequences flowing through to income and earnings. So far, so good. The problem came when there was no legitimate market for the securities.
This led to a death spiral, where a distressed firm would be forced to blow out assets. Those who chose to hold the assets -- anyone not under compulsion -- expected to achieve much better results.
But what about the "temporary" marks?
The SEC Action
The SEC released a letter to firms offering advice on how to handle this situation. It did not give a free pass for bad assets. It did allow companies, with advice and consent of their accountants, to make a FAS 157 exception when certain assets, sold by other companies, had been, in the indelicate terms of traders, "puked out" , at prices that did not represent reality.
The Impact
This is an important step. Some have argued that "mark to market' should be suspended. The SEC is not doing that. The proposed interpretation is more measured and more thoughtful. It is very bullish for financial stocks, since it allows them to make more realistic valuations of assets.
The Spin
The story has been picked up by all of the big-time bearish blogs, including Ritholtz and Mish. It was featured by the New York Times. At "A Dash" we have some questions for these sources:
- Do they distinguish pricing when it comes from liquid markets as opposed to distressed markets?
- Why are they so confident about the true value of Level III assets?
Conclusion
The critics of this move are all guilty of a logical fallacy -- affirming the consequent. They believe that they are the only ones who really know the value of complex CDO's and that companies should be compelled to use any trade as a mark. Is this approach one that will actually help investors?
What has really happened is an intelligent step by the SEC to allow companies some latitude when market trading is not a good indication.
Meanwhile, the average investor who checks out the top blogs and the New York Times sees something that is downright scary. It is another example of where an intelligent investor, seeking information, confuses sensationalism with sound advice.
We wish we had a specific catalyst to cite, but we do not. The SEC action is another important step to solving the related housing and mortgage problems. Who knows when more traders and investors will grasp this point -- something that seems quite obvious to us.
