New Accounting Pronouncement Will Likely Increase Mortgage Mess Write-Offs

November 2007

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The enormous write-offs by those banks that invested in subprime mortgages has dominated recent Wall Street news. The unanswered question is whether more write-offs will be necessary. The answer is complicated by a new accounting pronouncement. While not necessarily changing what the banks have done to date, this analyst believes the write-offs will be larger.

The new accounting rule specifies more precise rules regarding how valuations occur. The Financial Accounting Standards Board declined to delay implementation of Statement of Financial Accounting Standards 157, “Fair Value Accounting”. Consequently, calendar year companies will need to implement this new pronouncement, beginning with the first quarter that will start soon.

The problem arises with assets that cannot be valued with observable market quotes – called level 3 assets. (Easy-to-value assets with observable market information are called level 1 and level 2 assets). Level 3 assets must be appraised with the assistance of an appraiser who follows the new accounting guidance.

Prior to the new rule, most investors in securitized mortgage obligations valued their investments using theoretical models that value securities on what they should be worth – but not necessarily what they are actually worth in the current topsy-turvy credit market that now exists. These theoretical models generally do not comply with the new guidance. Here is a summary of the changes specified in the new guidance:

1. Fair value is the exit price to sell an asset. Prior guidance emphasized an entry or transaction price.

2. Valuation assumptions must be based on market conditions, not entity-specific assumptions.

3. Risk assessments must be based on what market participants would do in current market conditions.

For additional information, see Fair Value Accounting.

Many of the largest investment banks have an enormous amount of Level 3 assets – often more than their entire stockholders’ equity. Consequently, implementation of the new accounting pronouncement could have a material effect on their balance sheets. The current credit crunch will likely increase the chance of having these assets classified as belonging in Level 3, since the market liquidity of these investments has declined to the point where no one can realistically expect these large portfolios to be sellable as would be required for a Level 1 or Level 2 asset.

The new requirements also require additional disclosure regarding the amount of Level 3 assets, and how these assets are valued. This will certainly make interesting reading for both financial analysts, and those stockholders brave enough to remain invested in these companies.

Fulcrum Inquiry performs business appraisals for financial reporting and other purposes.