Sometimes it's hard to see the answer clearly when the proposed solution is more complicated than it needs to be. That's the problem with the mark-to-market accounting concept. In an economy that continues to decline, this rule has forced the devaluation of a performing asset class that was never intended to be treated like a security.
It's not about hiding a true value; it's about not being able to determine a fair value. Investors who need long-term assets shouldn't be forced to devalue those assets based on fire-sale prices.
The demise of Wall Street has proven one long-held belief: Investment bankers are — or were — first and foremost good salespeople. After years of consideration and largely failed attempts, they saw an opportunity in the early 1990s to step into a market that they had been excluded from — the sale and delivery of investments in real estate loans. Mortgages became a part of the larger evolution of asset-backed securities.
Specifically, they came to the marketplace with a profitable new idea that converted the commercial mortgage asset class from a hold-to-term investment with value based on performance to a trading investment with value based on the market. Their idea was to sell a product with promised liquidity and a high percentage of investment-grade ratings, allowing investors an easy investment opportunity into this asset class.
These two fundamental characteristics converted a class of investments from whole loans to securities. The beauty of this concept from the investor's perspective was that someone else would do the underwriting and due diligence, and rating agencies would stamp their approval. All investors had to do was buy.
Whole loans fell out of favor and demanded higher spreads. But fundamentally, we were dealing with the same asset that historically filled an investment need for long-term, fixed returns. There was no intention to change the nature of the investment or how it was accounted for, or to hide the true value. There was an intention to sell a product and to make a profit in the process.
Pitfalls of mark-to-market
One unintended consequence was that instead of holding a portfolio of well-underwritten, performing mortgages that met the investor's own guidelines and were treated under hold-to-term valuation rules, those investors received a commercial mortgage-backed security (CMBS) that required fair value or mark-to-market accounting treatment. This idea worked fine, as long as a market for the paper existed; it does not work at all when the market is illiquid.
Mark-to-market accounting attempts to develop a formula that answers a hypothetical question: “What is the real value of an asset when no one is buying?” In the process of defining this accounting rule, we have created confusion and fear.
And fear is now preventing the risk-taking implicit in trading, thereby adversely affecting the value we are trying to determine. Ironically, as the accountants and regulators struggle to solve the value question, they force devaluation. In turn, this concept is causing a lending freeze and the consequent devaluation of the underlying asset — in this case, commercial real estate.
We need to treat these long-term, fixed-income investments as such. Unlike the majority of CMBS, when you hold a portfolio of whole loans, you reserve for actual or reasonably expected losses based on the characteristics and performance of those assets. If the mortgages are all paying as agreed and the rent roll is stable, you have a fairly low reserve requirement. That reserve offsets your value and accurately reflects the effective performance.
Unfortunately, with mark-to-market, all that matters is the price someone else is willing to pay for your paper. Or more to the point today, the value is determined by a third party without the benefit of actual market trades. It's no longer what the market thinks, it's what your auditor thinks. Some argue that hold-to-term accounting is akin to ignoring fair value.
Japan made this mistake when its economy collapsed. However, there is no analogy to the mistakes made by the Japanese as long as we include the actual performance of the underlying loans in our analysis. Others argue that we need transparency, so investors can tell what the underlying assets are. But hold-to-term treatment will allow and encourage the disclosure of the underlying assets since reserves will be directly connected to the performance of those assets.
We effectively converted an asset class from a performance-based valuation to a trading value system. In fact, today commercial mortgages largely continue to perform with very low default rates.
A flawed premise
So why don't they trade? Because no price makes sense if we are arbitrarily setting a value and that valuation process makes every investor more fearful. One life company executive recently told me, “If I pay 50 cents today, someone will be in my office tomorrow saying it's worth 40 cents. Or worse, I'll actually try to buy at the advertised price of 50 cents. But if I try to buy a material amount at the offered price, the price goes up.”
Here is the issue: The premise of liquidity for this product is flawed. The ratings bestowed upon CMBS were at best compromised or maybe misunderstood; at worst, incompetent and conflicted. Were investors in this asset class really in need of liquidity, or was it just convenience? The premise of converting an asset class in the interest of the investor was incorrect. There's no transparency of value issue, only confusion and fear.
Wall Street sold, investors bought. Even when a new buyer needed to be found to buy the lower-rated tranche, Wall Street created solutions that were usually highly leveraged, and with sophisticated structures: collateralized-debt obligations (CDOs), structured investment vehicles (SIVs) and funds.
There was no question Wall Street could create it and sell it, but did they intend to convert an asset class? No. Did they intend to misrepresent value? No. They just wanted something to sell.
The point is that this asset class needs to be treated financially as we have always treated long-term mortgage loans: as long-term investments. We have approximately $800 billion of CMBS held by many of the finest institutions that had the need to invest in fixed-income assets to match fixed-income liabilities.
Why do we insist on bankrupting these institutions by creating an accounting tool that will require another public financial bailout? It's time to understand that liquidity is just one element of value. There are endless examples of valuable private investments that are not liquid — art, collectibles, antiques.
What's the need to devalue the CMBS investments by anywhere from 20% to 50% or even more, when the underlying asset is performing? This is not about protecting firms that intend to make money in the trading environment.
If a firm doesn't have corresponding long-term liabilities and is subject to a capital call at any moment, then it should not have purchased illiquid investments and it should be subject to a valuation based on mark-to-market value. Those firms fail because they don't have sufficient liquidity and did poorly matching asset terms to liability terms.
Call to action
Do we understand that if we proceed down this road, we will not only bankrupt these institutions, but also ultimately choke off capital to the commercial real estate sector? No matter how much cash we believe is in the system, it's difficult to lend and transact when the threat of devaluation is so arbitrary that hoarding cash is the only defense. The three-point solution is so simple it defies any argument:
Allow companies with long-term liabilities and sufficient liquidity to move any currently performing CMBS into the “hold-to-term” classification.
Reserve for anticipated losses based on actual performance of the loans supporting those investments.
Enforce restrictions on sale requirements and potential penalties if the company moves the asset out of this hold-to-term classification with the intent to sell.
Ultimately, financial health will relate to the performance of the asset and the ability of the company involved to actually match those assets and liabilities.
We are in the worst financial crisis in over 70 years. These simple steps will go a long way to calming the marketplace, and may resolve the institutional financial picture to the point that capital will begin moving again.
Most importantly, taking these steps may avoid the pending, unintended consequence of totally shutting down liquidity and destroying the commercial real estate market. It is critical to avoid further delays in addressing this issue.
Edward Padilla is CEO of NorthMarq Capital, a commercial mortgage banking firm with a $37 billion servicing portfolio. He can be reached at [email protected].