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Large financial firms have discovered that it’s easier to get unmarketable securities on to
their balance sheets than it is to move them out. FASB 157 will force disclosure of these assets.

Roach proofing your portfolio…


In the first week of November we were greeted with announcements of multi-billion dollar losses related to
these firms’ interests in or guarantees of securitized assets. The process seems to be happening in slow motion
as one company after another confesses to problems related to the mortgage market.

From the size of the percentage declines in these stock prices, it is obvious that these losses were not
anticipated. There is also a general unease that problems in the mortgage market are only the tip of the iceberg.

In recent years the financial engineers at these firms have created a wide array of asset backed securities:

  • Securitized credit card receivables
  • Collateralized debt obligations (CDOs)
  • Leveraged buyout bridge loans
  • Asset backed commercial paper

The losses appear to be coming from four areas:

1. Fee based commitments without adverse change escape clauses
This has all to do with these companies acting as financial intermediaries.

When a firm collects fees in exchange for underwriting a transaction, they are making a commitment to
purchase the securities of the issuer and hopefully can resell these to long-term holders. However, market
conditions may change significantly from the time when the commitment was made to when the securities can
be sold. If material change conditions are not in the underwriting agreements, the investments banks are left
holding the bag if markets move against them.

2. Quick changes in the markets for securitized assets
In early summer when two Bear Stearns hedge funds investing in mortgage backed securities crashed in value,
the market took notice. Fearing losses, buyers balked, leaving the investment banks with a large inventory of
these securities on their balance sheets.

3. Performance guarantees
Underwriters can make guarantees as to performance. If the security has a loss rate that exceeds a certain
percentage, the underwriter (or mortgage insurer) indemnifies the losses.

4. Liquidity guarantees
The New York Times reported on 11/17/07 that:

“some banks also handed out liquidity puts, giving buyers of CDO securities the right to sell them
back to the bank if there was no other market for them . . . . . . . In a new quarterly report from Bank of
America, we learn that it had $2.1 billion of such puts on its books at the end of 2006, a figure that rose
to $10 billion by the end of September. In other words, as the subprime market was starting to falter, the
bank stepped up the issuance of such puts. Presumably, that was necessary to “sell” the paper. This
week Bank of America announced a $3 billion write-off. A large part of it came from these puts.”

The performance of these asset backed securities is reminiscent of the Roach Motel of the 1980’s. The
advertising tagline was “Roaches check in, but they can’t check out.” These firms discovered that it was easier
to check the financial roaches on to their balance sheets than it was to check them out.

All these financial firms would like to check these securities out of their balance sheets, but it’s difficult when
all the potential buyers want to make sure the market has bottomed before diving in. There is an old saying that
bad money drives good money out of circulation. Good money won’t come out of hiding until the quality of
underwriting improves.

Looking for Unrecognized Losses

Management of these large financial firms was clearly caught with their pants down holding mortgage backed
securities. Now investors are looking into other areas, trying to anticipate the next shoes to drop. Keep in mind
that these loss announcements were made by publicly traded companies that have to make quarterly
earnings releases. There are a number of other owners of these securities that haven’t disclosed anything about
their losses:

  • Hedge funds
  • Pensions
  • Insurance companies

There are complex rules governing the timing of loss recognition, but the general approach is to mark
securities in trading accounts to market, and to carry long-term investments at cost. However, long-term investments
are subject to impairment tests. If these assets have experienced what is deemed to be a permanent
impairment in value, losses are recognized. There has always been a fair amount of wiggle room in determining
both the amount of the loss and its timing.

Enter the Financial Accounting Standards Board. One of its accounting pronouncements, FASB 157, is about to
be implemented, and will indirectly accelerate the process of loss recognition for these exotic securities.

Under FASB 157, the investment assets of a company are divided in to three classes:

1. Level 1 assets
These are assets where there is an active market, and market prices are readily available. Examples would be
listed common stock and bonds. These are assets where there is high level of confidence in the carrying value
on the balance sheets of financial firms.

From FASB 157, Section A22—

“Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets and Liabilities the
reporting entity has the ability to access at the measurement date.”

2. Level 2 assets
These are assets that may not be actively traded, but the information needed to estimate their value is publicly
available from independent sources. An example would be a bond issue that isn’t actively traded, but can be
valued in reference to similar bonds that do.)

There is no direct market information, but an independent valuation of these securities should be possible.
There is only limited wiggle room on the part of management to value these assets. These are mark-to-model
securities where valuation estimates are considered to be reasonably reliable.

From FASB 157, Section A24—

“Level 2 inputs are input other than quoted prices included within level 1 that are observable for the asset or
liability, either directly or indirectly through corroboration with observable market data (marketcorroborated

3. Level 3 assets
These are assets with no active market where the information needed to value them is not publicly available.
According to the language of FASB 157, the inputs required to value these securities are not observable. These
are ”roll your own” valuations when there is no independent verification. It’s like running a scientific experiment
with no control group. If there are impaired assets on the balance sheets of these financial firms that are
being hidden by management, they will be in the Level 3 category. With all the write-offs that have taken place,
it’s no wonder that investors are suspicious of management.

From FASB 157, Section A25—

“Level 3 inputs are unobservable inputs for the asset or liability, that is, inputs that reflect the reporting
entity’s own assumptions about the assumptions market participants would use in pricing the asset or
liability (including assumptions about risk) developed based on the best information available under the
circumstances.” (emphasis added)

(In other words, if we have no objective data to support our valuation, we’ll make assumptions about how we
think everyone else will be doing the valuation. Do you think there is a lot of wiggle room here?)

The approach of FASB 157 is to require disclosure of the amounts of assets in these classes. This should allow
investors to draw their own conclusions about the potential for surprise losses in these companies.

The best measure of exposure is to compute Level 3 assets as a percentage of the market value of a company’s
owners’ equity. The following publicly traded companies have made FASB 157 Level 3 asset disclosures:

Clearly not all Level 3 assets are created equal. For example, if these securities were created several years ago
before lending standards went in the tank, they likely have real value. Compare that to securities backed by a
pool of subprime mortgages issued in 2006, or LBO bridge loans made in 2007. Having only 38% of capital in
Level 3 assets did not save Merrill Lynch from a major write-off.

Changes in market conditions may dictate whether assets end up as Level 2 or Level 3. If trading dries up,
assets could be moved from Level 2 to Level 3. Yesterday’s Level 2 asset may become tomorrow’s Level 3
asset. It would not be inconceivable for financial companies to try to game the system and put as many assets as
possible in the Level 2 bucket as a confidence-building measure.

Only one thing is certain. It is far beyond the capabilities of any outsider to be able to determine the haircut that
needs to be applied to Level 3 assets. The companies themselves are having a difficult enough time in
estimating these losses. How are outsiders with little or no information to do the analysis?

Timing of FASB 157 implementation

FASB 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and
interim period within those fiscal years. This means that for calendar year companies, the disclosures will start
in April 2008 when the first quarter’s results are reported. For entities not reporting publicly, the first
disclosures won’t arrive until financial statement auditing is complete in the first quarter of 2009.

Common sense things for investors to think about

Exercise financial awareness
Prospering in this environment is all about awareness. It’s about being tuned in to what’s happening in the real
economy and financial markets and staying out of obvious problem situations. It’s about anticipating problems
before they occur.

Here is a glaring example of non-awareness: Rating agencies (Standard and Poors, Moodys, and Fitch) were
grading mortgage backed securities based on historical performance at the same time underwriting standards
were going in the toilet. Only after the foreclosures starting ramping up did the ratings change. This can best
be described as looking at life through the rear view mirror. No one could connect the dots and anticipate that
bad underwriting would lead to asset quality problems.

Exercise prudent risk management
If you have imperfect information about the companies you invest in, take only small helpings of risk any one
place. (Anyone willing to bet we have seen the last of these write-offs related to securitized assets?)

Don’t make the mistake of thinking that holding the stocks of different financial companies represents
diversification. Based on the pervasiveness of the write-offs, these companies tend to run as a crowd and engage
in similar risk taking.

Don’t assume that problems with one type of securitized asset won’t spill over to other classes. (Does anyone
want to bet that problems in the mortgage market that inhibit refinancing won’t affect securities backed by credit
card receivables?)

Build in a margin of error when making purchase decisions.

Use leverage moderately.

Be persistent

When you are making a large financial commitment to a single company, ask questions about their exposure to
these exotic securities. Don’t take assurances at face value.

The FASB 157 disclosures are one tool that investors can use to increase their awareness of potential problems.
You should know that this information will be widely available starting in 2008. Using this information is a
preventative measure to keep the roaches out of your portfolio.