Is Accounting Part of the Problem?

We all know that one of the headaches of hedging interest rate risk for an asset such as mortgage servicing rights is figuring out the accounting ramifications. Fortunately for servicers, the rules have been simplified in recent years. But many still have to measure whether or not they qualify for hedge accounting and worry about what impact LOCOM (lower of cost or market) accounting might have on their financial reports.

Now, some voices say the Financial Accounting Standards Board itself might have played a role in the turmoil currently roiling the financial markets.

Now, one of the nation's wealthiest hedge fund gurus, Stephen Schwarzman, has hypothesized that one recent change to accounting standards, known as Financial Accounting Standard 157, is requiring financial institutions to overstate their problems. Mr. Schwarzman's complaint, detailed recently by business columnist Andrew Ross Sorkin in The New York Times, holds that the accounting rule is "accentuating and amplifying" potential losses that big financial firms face as a result of the mortgage credit downturn and other forces in the market.

FAS 157, like its cousins FAS 159 and FAS 133 (the accounting rule that guides hedging activity) and other accounting edicts issued in recent years, places an emphasis on requiring financial institutions to report the "fair market value" of assets and liabilities. The FASB's goal has been clear and admirable: increase transparency into the true financial condition of financial institutions. But the results, some critics argue, have been just the opposite. Institutions planning to hold complex securities to maturity sometimes have to report big losses that likely will never be realized. Even determining the "fair market value" of complex mortgage assets such as servicing rights and financial instruments used for hedging requires is often open to debate. Relying on marketplace valuations, rather than values calculated by models, gives investors a better picture of a firm's financial health, the FASB believes.

The problem with mark-to-market as incorporated into FAS 157, as Mr. Sorkin's article points out, is that it might force companies to write down an asset's value to zero if the market dries up completely. Just try selling subprime mortgage securities in the market today and you get the picture. No market equals no value. No value equals a big writedown.

FAS 157 actually recognizes that not all assets have a liquid enough market for market prices to be readily determined, and it divides assets into three categories. The third category includes the most illiquid assets that must be valued relative to a bank's models. But that doesn't mean "level three" assets get treated favorably. To the contrary, some critics warned as FAS 157 was being implemented amid the subprime mortgage meltdown that it could drive a "flight toward quality," because financial firms might shun the more complicated and volatile assets.

And don't forget FAS 156, which gives companies the option of implementing fair market accounting for mortgage servicing rights instead of relying upon complicated hedging analysis required by FAS 133. But in the spirit of "be careful what you wish for," this widely lauded rule could come back to bite mortgage servicers when values fluctuate wildly, just as FAS 157 reared its ugly head when subprime mortgage assets became nicknamed "toxic waste." (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/