Impact of the Credit Crisis

Emily Hollis
March 9, 2009 | COMMENTS

The present credit crisis is going to get worse and although government actions will help, unless there is a change in FASB rules, the secondary markets will not improve anytime soon. Without a modification to FASB rules and subsequently a return to normality in market valuations, institutions cannot sell loans. Without loan sales, liquidity will continue to be tight, which means fewer loans can be made, which will result in a slower economic recovery.

The FASB Other than Temporary Impairment (OTTI) requirements are significantly impairing capital levels of financial institutions. Strict rules are the result of the market's past sins and deceptions and theoretically were put into place for disclosure. However, they are just not working.

As a point of clarification, ALM First has on occasion been criticized as being too conservative. In the history of our firm, only the most senior AAA-rated securities have been purchased. Non-conforming securities represent a small fraction of our aggregate $8 billion under advisement and therefore OTTI is not a major issue for ALM First or its advisory clients. I therefore believe that these concerns as they relate to our clients are unbiased.

Undoubtedly some mortgage-backed securities will lose a significant amount of principal. However, institutions that hold senior credit bonds and can prove the ability to hold them to maturity are being pushed by auditors to take brutal write downs in OTTI. As an example, suppose a high quality bond given conservative assumptions is projected to lose five percent of principal in years five through fifteen. Accounting rules require a write-down of the security to its current market value, which in most cases is at least 50 percent of original value. Forget for a moment that this five percent principal loss is more than compensated with incremental yield. Put aside the fact that these securities could be safer and higher yielding than any comparable loan made in the market today. Therefore, why should accounting rules require an institution to make a 50 percent loan loss provision immediately as opposed to holding the loans outright, when a provision can be accumulated over time?

True, the investor has to write down the value of these securities by 50 percent. However, if in the next year, markets improve, with the current accounting rules, the gain is amortized over the life of the bond, which might take 30 years. An institution holding $100 million of these securities would be required to take a $50 million hit to net income even though losses might not occur for 10 years if at all. As you might imagine, investors are not purchasing these types of securities because the accounting penalty is too high.

It is my opinion that these rules will also cause future havoc in the markets. Over time as actual losses do not compare to those realized and value is returned to most investment grade securities, capital will return in strides. Some economists are then projecting an inflationary nightmare. Interest rates will shoot up and institutions will be ladened with 4.50 percent 30-year mortgages on their books.

We presently find great value in certain fixed income sectors and have a few clients that are dabbling in double digit yields purchasing super senior non-conforming securities. Our questions to them are can you hold to maturity and can you take the heat?

Emily Hollis is a CFA and president of ALM First Financial Advisors in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com.