While the mark to market provision is a
laudable standard for corporate financial reporting during
normal times, recent events have made it quite clear that no
such law is immune to the law of unintended consequences.
Specifically, it seems clear that the impact of that provision
on the financial foundation of our economy when panic runs the
market was not fully considered in the legislation.
Now back on the farm: Unwilling to wait for a couple of
months for each parcel to be tested and the uncertainties to be
largely removed from the market, Mark T. Market insists that the
bank’s balance sheet be adjusted to reflect current market
conditions. At this point, the bank comes back to me to appraise
the current market value of the land, with all the uncertainties
hanging over that particular market. The only sales that have
closed since September 5, when the panic started, were
highly-distressed sales from folks who were just trying to make
one more payroll as they desperately tried to sell their farm
implements businesses to foreign investors.
With distressed sales as the only indicators of “current” market
value, I conclude that the value of the land on September 30 is
$450,000. Upon receiving my report, Mark T. Market immediately
writes-down the value of that asset on the bank’s balance sheet
by $300,000 (from $750,000), taking the $300,000 charge-off
against current earnings. That $300,000 write-down completely
eliminates the $75,000 of shareholder equity that was dedicated
to this specific loan, as well as another $225,000.
Now, since the 10 percent equity requirement has not changed,
the bank must decrease the total of their outstanding loans by
an additional $2,250,000 ($225,000 “write down” times the 10
percent equity reserve requirement). In this analogy, Mark T.
Market’s strict interpretation of “current value” results in a
net decrease of the bank’s potential total loans outstanding by
$2,250,000, even though the farmer has not missed a payment and
any loss of value in the land remains purely speculative.
Credit Death Spiral
Once the bank stops making loans available to
well-qualified borrowers on typical terms, to reduce their total
outstanding loans by the required $2,250,000,
there is a radical decrease in demand for farm land, all
else being equal, since many potential buyers are taken out of
the bidding market. This radical decrease in demand causes a
further drop in overall demand for farm land, which results in
the next distressed sales of similar farm land to support a
market value of only $300,000, an additional charge off of
$150,000 by Mark T. Market as of December 31, 2008, and an
additional loss of bank lending capacity of $1,500,000 as per
the 10 percent equity reserve requirement. At this point, even
though the farmer is still paying as agreed, with a very
attractive yield of 25 percent based on current book value, the
bank’s lending capacity has been reduced by a total of
$3,750,000!
With that $3,750,000
no longer available for, say, the folks who want to buy
the retail shopping center up the pike, and with other banks hit
with similar lending restrictions, demand for retail shopping
centers drops dramatically as well, resulting in additional
charge-offs by Mark T. Market and additional restrictions on
available lending capacity to other sectors, causing a sharp
drop in durable goods orders, mass layoffs in the manufacturing
sector due to decreased demand for the durable goods, another
round of Mark T. Market charge-offs, causing another round of
credit tightening, and so on to the bottom.
Accounting Rule as Suicide Pact
Once such a deflationary spiral gets started, it is damned
difficult– some would say impossible, to stop until we devolve
back to a cash-only economy. Unfortunately, some would say, the
modern incarnation of cash has no intrinsic value and
hyper-inflation of the currency will likely result from the
deflation of assets, as politicians hit every button at their
disposal to try to arrest the downward spiral.
As the cascade spreads from the analogous farm land sector to
virtually every sector of the world economy, hyper-technical
adherence to the mark to market accounting standard creates a
feed-back loop, with the accounting rule itself causing a global
deflationary spiral that cannot be arrested through any of the
available levers of fiscal or monetary policy. That is
definitely a worst-case scenario but there are many levels of
recession and depression between here and there, none of them
particularly attractive.
While the analogy presented above is
highly-simplified, I suspect it is very close to a version of
the scenario which Secretary Paulson and Chairman Bernanke have
portrayed for our politicians in their closed-door meetings. To
their credit, our political masters finally understand the
concept, at least enough to see that something drastic must be
done in the very near term to short-circuit the growing
feed-back loop. The Treasury and Fed have already pumped
something like two trillion dollars of liquidity into the
markets through various means over the past month but that
indirect approach has proved futile in stopping the market’s
panicky momentum. They tried to take their case to the people
but cannot disclose the most apocalyptic elements of the
scenarios laid out in their private meetings for fear of causing
more panic.
Although the mark to market element of
Sarbanes-Oxley was certainly well-intended, and remains a valid
goal in financial reporting requirements, a technical accounting
rule as mutual suicide pact seems quite foolish at this point.
Hopefully, Congress will take some rational steps very soon to
short-circuit a near-total melt-down of world credit markets.
Mark to market may be a laudable standard but other standards
must be made available when panic is ruling the market and
rational owners of such assets who are not motivated by
desperate circumstances unique to themselves would never sell
them at the temporarily depressed prices.
As all appraisers know, a true indication of
market value requires a willing buyer as well as a willing
seller. The fact that buyers are holding back for an interim
period does not mean that a financial asset has lost real value,
only that it is not nearly as liquid as in the past. Those
owners who choose not to sell at greatly depressed prices should
have some other rational method available (NPV of Cash Flow, for
one), so long as those alternative standards are fully disclosed
and consistently applied across periods.
Editor’s Note: Since this story, the
Securities and Exchange Commission
has eased rules that force companies to devalue assets on their
balance sheets to reflect the price they can get on the market.
About the Author
Fred Holtsberry spent ten years working on the credit side
of large regional banks and is Chief Appraiser of his small
firm, Mid-Ohio Appraisal Services.
Thanks to Appraisal Buzz
>>
Collapse of Credible Valuation
by Mike Read
This current financial crisis is truly a collapse of
confidence in the valuation of financial assets. Of course real
estate has to be included in financial assets as it is the de
facto collateral standard for the largest loans and movements of
money. Also, if independently and fairly valued, it has a
reputation for being solid collateral; more functional than
gold.
This collapse has been exacerbated by the
lenders essentially being in charge of the valuation process.
They hire and pay appraisers or employ their own in-house
appraisers, who are expected to do exactly what they are told.
Independent appraisers have to apply to be on a lender’s
“approved list” in order to get assignments. This is part of a
quality control process that is entirely managed by the lender
and effectively insulates them from a true and independent
valuation. When they “pay the judge,” how can we expect an
independent verdict or value?
For instance, if an independent appraiser
marks a little box with a check mark to indicate “Declining
Market,” he/she is instructed to remove it, put the check in the
“Stable Market” box or they do not get paid their fee, or they
are removed from the approved list of the lender. I’m aware of
at least one lawsuit by an appraiser over this practice and have
had personal experiences that have been previously written about
in Working RE. Two of the lenders involved have since failed,
one being the largest bank failure ever.
The practice of lenders controlling the
remuneration and vendor approval process for appraisers is
directly responsible for the corruption of the system. We have
to build a new system that removes this corrupting link.
I remember well the Savings and Loan crisis
in the 1980s. I was an appraiser back then too, before appraiser
licensing was in effect. The bad valuations got blamed on
appraisers, who as a result became strictly regulated under
FIRREA in 1989. There may have been a few bad appraisers but
they were working directly for the lender involved. No appraiser
was ever convicted of overstating value by billions or trillions
of dollars!
The creation of the secondary market (Fannie
Mae and Freddie Mac) turned portfolios of real estate into
portfolios of paper and digital data that could be moved around
the world on the Internet by computers on Wall Street.
Bond Ratings
Whose job was it to put a valuation on this
newly created paper? It was the job of bond rating companies
like Standard & Poor’s and Moody’s. They are a lot like
appraisers. They examine the collateral underlying the bonds and
rate them accordingly. Their independence is crucial.
When the sub-prime paper came into the
picture and was presented to the bond rating agencies they must
have been initially horrified at the thought of rating these
products AAA. They may have suggested a more appropriate grade
such as A or BAA, which is just above the junk classification.
See Bond Rating Table below.
|
Bond Rating
|
Grade
|
Risk
|
|
Moody’s
|
S&P/ Fitch
|
|
Aaa
|
AAA
|
Investment |
Highest
Quality |
|
Aa |
AA
|
Investment |
High Quality |
|
A |
A |
Investment |
Strong |
|
Baa |
BBB |
Investment |
Medium Grade |
|
Ba, B |
BB, B |
Junk |
Speculative |
|
Caa/Ca/C |
CCC/CC/C |
Junk |
Highly
Speculative |
|
C |
D |
Junk |
In Default |
But no! They apparently rated them in the
Quality range, which of course, had a higher price and was
easier to sell for their Wall Street clients. How did Wall
Street persuade the bond raters to overlook the higher risk of
the Collateral Debt Obligations (CDOs)? All you have to do is
follow the money trail. Let me suggest this scenario.
Stock broker warns bond rater that if he
issues a lower rating on the CDOs, it results in a lower income
for the broker and thus lower income to the rater. A lower
income for the rater, acknowledged by the broker, would
necessitate the lowering of the rater’s company stock value and
thus a reduced company market valuation. Does this remind you of
something we were discussing earlier about appraiser
compensation?
The rising popularity of Appraisal Management
Companies (AMCs) seems, at first blush, to create a system where
appraisers are not in direct contact with the lender.
Unfortunately the trend here is for the big lenders to buy a
controlling interest in the AMC, then gain control over the
process and access to the appraisers’ data to form its own
Automated Valuation Models (AVMs). The independent valuation
process is corrupted again.
The corrupting link again is the paying of
the judge and allocating the judge’s “caseload.” There has
to be a better way.
Fixing It
Here’s a suggestion. Create an association of
valuation professionals to act as a clearing house for valuation
requests. The request orders are paid for up front according to
a sliding scale or bid system and the assignments and results
are anonymous to the requestor. Such an association would be
like the old Craftsman’s Guilds but could operate on the
Internet and be accessible to everyone 24/7. This company’s
stock would not be on the “Big Board.’
About the Author
Mike Read is an independent real estate appraiser and
consultant operating in the Puget Sound area for the past 21
years.
>>
About
Lee Hess
"Lee was always friendly, professional and easy to work
with, even as an opponent. He had a great sense of humor,
and would always look for the positive points in people. He
was a well respected expert, and I worked with him both as
an associate and opposite him as an expert on numerous cases
as well. I found him always to be a gentleman, courteous,
objective, and thorough. He was a man of deep moral
personal conviction, very active in his church and community
activities." – Winston Elton
"Lee Hess was a good man. In the appraisal world, he
was dedicated to teaching others. His reputation was that of
a good man and a great teacher trying his best to mimic the
teacher from the shores of Galilee." - Roger Durkin Boston
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