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Did fair value fail in sub-prime crisis?
August, 30th 2007

Tomes have been written about the sub-prime crisis in the US and its effect on international markets. Stock markets have tanked and many hedge funds have closed some funds and laid off people. To the layman, however, the mechanism is too complicated to merit logic and would remind one of the Enron fiasco.

The fact that banks proffer loans to borrowers with less-than-good credentials and then sell these off to other institutions seems un-bankable. These institutions package the loans into what are termed collaterised debt obligations (CDOs) and sell them to investors with a good appetite for risk. The fact that the CDOs are rated by credit-rating agencies would not hold water especially after the folding up of a few hedge funds. Credit-rating agencies are under fire now for not presenting an accurate rating of these funds. The question that has not been asked is whether the accounting principles followed by these hedge funds were appropriate.

Although it has been claimed that it is well-nigh impossible to value a sick asset, the fact that in case the hedge funds had provided for possible losses for troubled loans, the rating agencies could have given a different rating cannot be ignored. In spite of its inherent complications, securitisation should be considered to be another type of business where proper provisioning should give a fair idea of the saleable value of an asset.

Accounting Standards

The Financial Accounting Standards Board (FASB) in the US has issued SFAS 134 (Accounting for Mortgage-based Securities retained after the securitisation of mortgage loans), which was preceded by SFAS 65 (Accounting for certain Mortgage Banking Activities), SFAS 115 (Accounting for certain investments in debt and equity securities) and SFAS 125 (Accounting for transfers and servicing of financial assets and extinguishment of liabilities).

Statement No 65 itself was clear that after the securitisation of a mortgage loan held for sale, an entity engaged in mortgage banking activities classifies the resultant mortgage-backed security as a trading security. Classifying an asset as trading security would mean that the asset would be valued at market-determined rates.

SFAS 134 amended SFAS 65 to state that after the securitisation of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resultant mortgage-backed security or other retained interests based on its ability to hold or sell those investments.

The Statement conforms with the subsequent accounting for securities retained after the securitisation of mortgage loans by a mortgage banking enterprise with the subsequent accounting retained after the securitisation of other types of assets by a non-mortgage banking enterprise.

SFAS 157 one of the more recent standards issued talks about fair value measurements for both assets and liabilities which brings us to the question that in case the troubled loans were measured at fair value, could this crisis have been averted? The immediate answer should be yes.

A valuation issue

The basic premise of the concept of fair value of an asset is the highest and best use of the asset by market participants considering the use of the asset that is physically possible, legally permissible and financially feasible at the measurement date.

Two situations determine the highest and best use of an asset-in-use and in-exchange. The sub-prime loans, irrespective of who was taking care of them at any point in time, would certainly fall in either of the above parameters since the asset would be either be used or in exchange.

The problem for the sub-prime assets appeared to be the value which could be assigned to the asset, which could probably be the reason for the ratings given by the credit-rating agencies. Hypothetically speaking, assume the entities had created a provision annually for the troubled assets, the rating agencies could have seen a red flag.

The Reserve Bank of India encourages banks to create an omnibus provision on their total assets annually so that there is a cushion during bad times. Such conservative accounting combined with a practical application of fair value would ensure that large accounting surprises are minimised.

Mohan R. Lavi
(The author is a Hyderabad-based chartered accountant.)
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