How Much?

I think part of this problem we face is due to overly conservative GAAP accounting rule changes by FASB which are forcing firms to mark down their mortgage assets to nearly zero which I do not think is realistic. I think once the write-offs are done then banks will guide EPS higher and stock prices will recover sharply.

I am just kicking myself that I did not find out about this rule change (FAS 157) in November because clearly stocks started to move down as it was implemented. Basically what FAS says is that the owners of bank debt have to write down that asset based to the lower of the last trade are estimated value. Since that market is illiquid the estimated value will always be a steep discount to the last trade which for most instruments is issue price. Prior to 157 firms could mark to market, mark to estimated market value or hold the debt on the books at historical price just like any other asset.

An analogy to how this works is as follows.

Let’s assume you bought your house for $500K (20% down payment) and months later a similar house on your block just sold for $495K.

In the past it would have taken banks months to identify this lower price whereas today that data is kept in an electronic data base and is immediately posted to a bank's risk management system. Due to the lower sale price your lender would have to under FAS 157 will have to write down the value of its loan to your from $400k to some estimated number below $395K. I does not matter what the real value of your home is it will be written down. For example by banker recently wrote down the value of my house to $360k despite the fact three houses on my block sold for 1,000,000, made capital improvements of roughly $35,000 and my credit score is well over 760.

I think a “disconnect” exists between FAS 157 and reality because FAS 157 mandates are too extreme. The problem is if you are an average American the value of your mortgage is most likely greater than what FAS 157 dictates, which is reasonable because as the average American make payment, lets assume at 7%, the Future Value of that 30 year mortgage is roughly $2.7 million. True some loans are worth less due to short term market conditions but in my view short term market home price values should not be used to price thirty year instruments -short term prices should be used for short term loan and vice-versa. Moreover that house you bought will probably be worth roughly $4,000,000 in thirty years (or 2038) based on a real return of just 2% over inflation. Thus the present value of that mortgage asset and house are roughly more like $394k and $656k respectively and not zero and $150K which is what FAS 157 says.

This explains why the private equity guys are raising billions to buy distressed morbtage debt and why the banks are not selling any of their paper as yet.