As readers of this blog know, we have been arguing since September that improperly applied accounting dogma caused the current financial crisis to go viral. Literally trillions of dollars in capital have evaporated because banks and other holders of esoteric mortgage-related securities were arbitrarily forced to write down the value of their holdings. I am convinced that history will judge the panic of 2008 as the financial equivalent of the Salem witch trials--an emotional reaction to false accusations fueled by ignorance and an unyielding orthodoxy. Fortunately, the Financial Accounting Standards Board (FASB)-the official arbiter of accounting rules in the U.S.-is beginning to wake up.
Tomorrow (April 1) marks the end of the public comment period for a proposed new accounting regulation called FAS 157-e. Approval from the Financial Accouting Standards Board (FASB) could come as early as the following day. FAS 157 generally establishes the rules for determining the fair value of a security. As you might expect, FAS 157 focuses primarily on recent market transactions. But what happens if the market stops working and there is no reliable transaction to use as a benchmark? Hmmm...nobody seems to have thought of that!
Well, now they have. According to FAS 157-e, under conditions that indicate a broken market (i.e., one in which transactions occur only at prices that indicate a "distressed sale"), the reporting entity has more flexibility in determining what the fair value of the asset really is. Of course, they need to demonstrate some rational basis for the value they ascribe. They can't just pull a number out of the air. But the big news is that the reporting entity is no longer subject to the auditor's whim. If it can justify the higher value, it can report the higher value.
This is a very exciting development, but it is also fraught with problems. For example, in an open-end mutual fund investors are supposed to be able to buy and sell shares at the fund's net asset value (NAV). But what if the NAV is not based on the market price of the fund's underlying securities? If the investor sells her shares at an NAV that is set too high, she is getting a better price than she deserves and her windfall comes at the expense of the other fund investors. Likewise, if she sells a price that is arbitrarily too low, her lower selling price effectively serves to enrich the investors who did not sell.
There are several fixed income mutual funds in this position. Western Asset Management's Core Bond Fund is a good case in point. It holds about 21 percent of its $1 billion in assets in what are called "non-agency mortgage-backed securities." These are the same as the assets that are causing the problems at the banks. Largely because of these holdings, the NAV of the fund has dropped more than 17 percent since January 2008. This is a huge decline for what was supposed to be an investment grade bond fund. (To help put this in perspective, the Barlcay's Aggregate Bond Index actually rose 1.4 percent in that same time period.)
What is a portfolio manager to do? I'm not sure and I don't think Western Asset Management knows either, but it certainly bears watching. In any case, I am beginning to breathe a bit easier. To me, this speaks of an approaching end to our current financial crunch.