Mortgages, Commercial Real Estate and Mark-to-Market
The unintended consequence of “fair” valuation accounting and the failed
promise of liquidity
By
Edward Padilla, CEO, NorthMarq Capital
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 the economic climate 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 being unable to determine a fair value.
The demise of Wall Street has proved 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: Someone else would do the
underwriting and due diligence, and rating agencies
would stamp their approval. All the investors had to
do was pick up the phone and buy. Whole loans
ultimately fell out of favor and actually 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. There was an
intention to sell a product, and to make a profit in
the process.
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 piece of paper (a
commercial mortgage backed security or “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. Fear in
turn is preventing the risk-taking implicit in
buying real estate, 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. The
outcome is financial hardship compounding the need
for major recapitalization. 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.
"We effectively
converted an asset class from a
performance-based valuation to a trading
value system."
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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. 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.
“If I pay $.50 today, someone will be in my office
tomorrow saying it’s worth $.40, or worse I’ll
actually try to buy at the advertised $.50 price but
if I really try to execute at a material amount, the
price goes up,” said one life company executive.
“The market is dysfunctional.”
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 is 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 and they were usually
highly leveraged, with sophisticated structures:
CDOs, 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 commercial
real estate mortgage backed securities held by many
of the finest institutions in our
country…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 phenomenon
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 is the need to
devalue these CMBS investments by 20, 40, 50 percent
or even more, when the underlying asset is
performing? Do we understand that if we proceed down
this road, we will not only bankrupt these
institutions but ultimately choke off capital to the
commercial real estate sector and drag that down
with it? 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 solution is so simple it defies any argument.
- Allow companies to move any currently
performing mortgage-backed security into the
“hold-to-term” classification.
- Reserve based on actual performance of the
loans supporting those investments.
- Restrictions, sale requirements and potential
penalties could apply if the company moves the
asset out of this category with the intent to
sell.
- If necessary, value could also be connected
to market interest rate movement compared to the
portfolio effective rate. 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 more than 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 it
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.