The price floor will be put in with the worldwide, coordinated focus on the problem, including the U.S. Treasury’s new focus on direct recapitalization of U.S. banks with a voluntary program of government-sponsored equity investments and world-wide guarantees of interbank lending. The U.S Treasury’s direct equity approach not only avoids the politically awkward “socialization” of private bank losses by allowing potential government equity participation in a recovery, but it also allows the banks to exercise some discretion in terms of selling assets into a fire sale market. However, the treasury is also moving forward on its program of purchasing both mortgage backed securities and whole mortgage loans.
There were numerous other news items this morning, but few as relevant to beleaguered REIT investors as the staff position rushed out by FASB entitled “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”. The guidance was rushed because regulators and policy makers wanted it out in time for companies to use in computing third quarter earnings, which should make this earnings season incredibly interesting – yet AGAIN!
The FASB staff position clarifies the application of FAS 157 where there are limited or no observable inputs for marking certain assets to market. The guidance does not eliminate Fair Market Value Accounting, but it does provide management with much more discretion with respect applying the convention when pricing illiquid assets. This discretion includes ability to use internal assumptions with respect to future cashflows, which would mean employing generally more benign estimates than what the “market” is currently imposing (see Is Commercial Real Estate Really Dead?).
The guidance specifically allows management to use internal cash flow models and assumptions to estimate fair value when there is limited market data available, or market data that is characterized by extremely wide “bid-ask” spreads.
“When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable,” according to the FASB.
Determining whether a market is or isn’t active requires judgment based on factors such as the spread between buyers and sellers. It provides that transactions in inactive markets “may be inputs when measuring fair value, but would likely not be determinative.”
Another issue addressed by the guidance is how much weight to give to distressed sales when estimating the fair value of holdings. The guidance specifies that distressed sales or forced liquidations “are not orderly transactions” and “are not determinative when measuring fair value.”
The guidance emphasizes transaction-level analysis, allowing performing transactions to be marked according to the value of that particular asset. Accordingly, these performing deals will no longer be considered “stressed” simply because the entire market is stressed. For commercial mortgage assets, including whole loans and CMBS, this allows management to consider overall default rates (still at historical lows), collateral characteristics and the underlying obligors on each underlying mortgage. Applying this discretion to portfolios that have few, if any, defaults and high quality collateral will obviously result in meaningful increases in GAAP earnings this quarter compared to previous quarters as previous distressed marks are reversed.
This amendment is huge for financials and for REITs in particular. The wholesale elimination of Fair Market Accounting would have removed a critical component of transparency from our markets, which obviously would have been detrimental. But amending it in such a way as to prevent portfolio valuations from being held hostage by a “market” that refuses to function is a constructive step. Now more than ever, management quality will be key in evaluating REIT investments. But for those REITs that make the grade, we could very well see a Mortgage REIT melt-up that could rival the melt down that has been in progress for so long.
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