Saturday, November 10, 2007

Govt accounting regs pushing CDO writedowns

Via Naked Capitalism, I read about two new developmental regulations essentially forcing more clarity and re-evaluation of CDOs. Combine that with marketplace changes and this is what you get:

The first is that new accounting rules gives companies far less latitude in how they value this paper. As the Financial Times explained it:
They are the “buckets” into which financial statement preparers must classify financial assets under FAS 157, a new US accounting standard for financial years beginning in November...

At the top of the bucket hierarchy is Level One, involving assets with prices quoted in active markets, such as mainstream stocks. Level Two contains less-traded securities and uses prices for assets very like the one being valued.

At the bottom lurks Level Three, assets with “un observable inputs”, meaning their value is calculated via a series of assumptions. Most collateralised debt obligations end up here.

While these categories may be familiar to many readers, what is not as widely know is that another rule, FASB 159, pushes institutions to put positions into the lowest bucket possible. Thus, no phony-baloney Level 3 valuation if there is a way to come up with a gridded or extrapolated Level 2 value.

The second development is that markeplace changes are forcing the revaluation of CDOs. Having first gone through re-rating subprime bonds, they are now tackling CDOs, and downgrades will force commercial banks, investment banks, pension funds, and other holders to recognize losses.

In other words, the first regulation allows less papering-over of hugely different credit ratings of different tranches within a collateralized debt obligation. The second fights artificial valuation.

Then, the market comes in, with CDOs now having to have more transparency, and says, “These ain’t worth shit.”

Yves Smith goes on to say that CDOs have a lot of leverage over other, tangentially connected, financial issues. In other words, “You ain’t seen nothing yet on fallout.”

The good point about the regs is they should help prevent future CDO excesses. Bad point is they should have been on the books years ago.

Bit of history from another Smith post: CDOs were created in 1987 by Drexel Burnham Lambert, home of junk-bond king Michael Milken. That alone is reason why we should have had more regulation of them years ago.