Asset Pricing Solution and Its Impact on Banks' Capital

I am a strong proponent of the market and its mechanism of pricing what something is
worth. But we probably need to think through what a market price is in regard to the
current financial crisis. Not all things can be easily marked to market. This is especially true of the current subprime mortgage backed securities, which are illiquid.

It is one thing to require that you mark your stocks or bonds to market values every day. It is another thing entirely to require all mortgage backed securities, which are extremely complex and require a lot of time and effort to value.

FASB 157 requires that all securities, inclusive of the illiquid mortgage backed securities, need to be priced. One solution would be to have FASB figure out a better way to price illiquid securities, such as mortgage backed securities? Before you respond, read the following item: FASB 157 summary statement at http://www.fasb.org/st/summary/stsum157.shtml.

Of course, we know that the “Genie” is out of the proverbial bottle. I don’t see how FASB can rescind 157, because everyone knows that these assets on the books are toxic. If anything, rescinding FASB 157 would prolong the problem. Valuing these assets at historical cost is not the answer. Since these mortgage back securities (Alt-A and subprime mortgages) are securitized and have been sold as a security, I have a problem in “not” pricing these assets like other securities that trade on security markets at fair value. Financial institutions should simply “bit-the-bullet” and value these assets at fair value and take the responsibility for their errant ways by reducing their capital accounts by the size of the write-downs of these securitized assets. Of course, the $700 billion bailout would allow the Treasury to purchase these toxic assets and replace them with an infusion of capital.

I want you to focus on a possible solution to the mortgage backed security debacle. The problem is a pricing issue with the consequences on a firm’s capital if these assets have to be written down.

We know that a large percentage of Alt. A and subprime mortgages, which have been securitized, are currently on the books of financial institutions at historical cost, probably at par ($1,000 per bond). We, also, know that FASB 157 requires these assets to be marked-to-market. The pricing of these securities is extremely difficult. Are they worth $.20 on the dollar, $.35 on the dollar, or what? No one seems to know what these securities are worth. That is the dilemma for financial institutions. If they write down these securities, say to $.20 on the dollar, they will have to charge $.80 on the dollar against their capital accounts, assuming they booked these assets at par. Some institutions have already done this and for all practically purposes have wiped out their capital. That is why we have had all these acquisitions and mergers in the past few weeks.

What is your solution? (You may want to address what impact the $700 billion bailout will have on your solution.)