Reasonable Valuation of Illiquid Mortgage-Backed Securities
An unprecedented wave of home mortgage defaults has triggered a widely publicized fallout in the subprime lending market in recent months. As a result, uncertainty has dampened investor enthusiasm for all mortgage-backed securities. While such securities trade in a dealer market that was relatively liquid just a few months ago, bids are now rare for many issues, making it difficult for companies to estimate and report relevant and reliable values for accounting purposes.
CONCEPT OF FAIR VALUE
Current accounting rules require companies to report such securities on the basis uf fair value, which is defined in SFAS 157 as "the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date." Two elements of the fair value definition - "market participants" and "an orderly transaction" - specifically pertain to the determination of the fair value of suddenly illiquid securities. In SFAS 157, a market participant is defined as 1) an unrelated party, 2) knowledgeable of the subject asset, 3) able to transact, and 4) motivated but not compelled to transact. When liquidity drains from the market for a given asset (in other words, when there are fewer market participants), "real-world" market evidence becomes more scarce and the fair value presumption of an orderly transaction necessarily becomes more hypothetical. In other words, fair value is not always exactly the same thing as the widely-held notion of "current value" espoused in the popular business media.
To minimize input risk and increase "consistency and comparability" in fair value measurements, SFAS 157 introduces a fair value hierarchy that prioritizes fair value measurement inputs into three broad levels, giving highest priority to quoted prices in active markets for identical securities (Level 1) and lowest priority to unobservable inputs (Level 3). Level 2 inputs include observable inputs that require some adjustment for the fair value measurement'. When a security is traded in an active market, its fair value is the current observable market price, a Level 1 input; however, the process of fair value determination becomes trickier when there is no active market for a given security.
MARKET INDICATIONS OF VALUE
In the United States, there is no centralized exchange for mortgage-backed securities; the secondary market is comprised by a network of brokers dealing in a particular security, and therefore is not as transparent as the public equity or corporate debt markets. When securities are actively traded in orderly transactions among a large number of market participants, these markets provide reasonable indications of fair value. Unfortunately for financial managers charged with reporting fair value, the markets for many securities have become illiquid.
The recent market illiquidity has exacerbated the structural opacity of the mortgage-backed market, rendering many market-based indications of valuations unreliable at best, meaningless at worst. A Wall Street Journal article from August 2007 quotes one vexed manager: "Someone says they're worth 50, and someone else says 90, and you can't sell at 30 because there aren't any bids." The valuation problem born of the current illiquidity is not that the markets are reliably providing low indications of value, but rather that they aren't reliably providing any indications of value.