THE CURMUDGEON CHRONICLE - #258

THE CURMUDGEON CHRONICLE ©

AN IRREVERENT VIEW


Time Line: March 16, 2009
Date Line: Flemington New Jersey

The dictionary defines toxic as “poisonous” or “deadly”. The term toxic assets should refer to cyanide inventories or explosive devices, not to mortgage portfolios.

The “toxic” mortgages issued during the housing bubble are performing as expected: the default ratio is slightly under 20%; the yields to maturity on performing loans will more than offset reductions in cash flow caused by non-performing loans; losses in value are negligible if foreclosures yield about 50% of their original values.

The things affecting holders of sub-prime mortgage portfolios adversely are derivatives based on the credit of their originators. The value of those obligations is problematic if they are considered current assets. They are anything but current assets. Over time, as underlying mortgage debts pay off, the derivatives are designed to self liquidate without loss to anyone.

The current pressure results from the requirement that these long term assets be “marked to market” and treated as current assets. I asked Abraham Levine, (the CPA who solved the UK financial crisis after World War II) about the “mark to market” rule.

After a sip of Dr. Brown’s Celery Tonic he explained: “If you tell an accountant to write rules that govern his liability he will design the rules so that no one can ever blame him. That is why a long term security that no one wants to sell is valued on the basis of the immediate demand for it by people who have no interest in buying it at any price.”

An accountant defending himself in a world of potential plaintiffs who rely on his opinion doesn’t care if they go broke, become homeless, lose billions, or suffer ignominy as long as the accountant is blameless under the rules he wrote. The reliance on certified financial statements has created an unnecessary class of ubermenchen.

The rules they write are designed to keep them safe by becoming industrial yardsticks of performance. “Mark to market” is an invalid test for long term assets. There is usually intent to retain such assets to maturity, and the market for them is not the kind of public auction market one finds for commodities and shares.

The mark to market test was adopted as an accounting rule to protect accountants by applying a standard over which they had no control and exercised no judgment. In effect it gave the accountants “clean hands” never mind the fact that the rule is not applicable to long term assets.

Mortgages due after twenty-four months should be valued on the basis of cash flow or net income, adjusted quarterly for defaults or other impairments. That was the rule for more years than I can remember and should be the test once again. Every bank that was forced to write down its mortgage portfolio would show immediate profits, realistic balance sheets, and could lend to its customers without government support. (No one condones banks that issued derivatives without the necessary financial strength to justify the guaranty they embodied.)

After I got my degree in accountancy I took a summer job with a Chartered Accountant in Montreal. On my first day at work I met M. Dubois, wearing green and yellow sleeve garters. He held up a pencil, and said, “This is the tool of your trade.” He indicated the point and said, “With this end you write, (and then to the eraser) and with this end you erase. If you use (pointing to the eraser) this end more than the other you will be fired.”

I took the next train back to New York; went to Law School, and have never trusted an accountant’s judgment.

Howard Stamer