Mortgage-Backed Asset Valuation and Mortgage Investment Risk

In a prior post (here), I noted that one of the scarier aspects of the subprime lending mess is the widespread dispersion of mortgage investment risk across the economy. While companies holding mortgage-backed assets might well want to avoid recognizing any diminution of these assets’ valuation, an audit industry group, the Center for Audit Quality, has made it clear that companies should recognize the asset valuation at current market prices, regardless of the depressed state of the market for those assets.

The Center for Audit Quality’s commentary is contained in three memoranda, which can be found here. Of particular interest is the October 3, 2007 paper entitled "Measurement of Fair Value in Illiquid (or Less Liquid) Markets" (here), which addressed the question of how to value mortage-backed assets in the current market environment. The paper expressly asks (and answers) the question whether the current market of mortgage-backed assets is functioning sufficiently to produce a market based-price for asset valuation purposes, or whether the current conditions are more indicative of distressed sale circumstances, in which case other specified valuation methods should be used.

Essentially, the paper states that if trading is taking place, even if at a much reduced level, the trading is sufficient to produce a market price appropriate for valuation purposes: "Notwithstanding current market conditions, there continues to be, for many mortgage-backed securities backed by subprime mortgage loans, quotable prices and observable transactions for identical assets, albeit at volumes far less than in the recent past." These trades, the paper comments, provide the most reliable evidence of fair value.

As I have noted previously (refer here), mortgage investment risk is not limited just to financial services companies; a wide variety of other companies are carrying mortgage-backed investments on their balance sheets. The Center for Audit Quality’s valuation commentary makes it clear that these assets must be valued at market prices, at least where market prices exist, even if the prices are depressed. The application of these valuation principles to companies carrying mortgage-backed assets could require companies to recognize losses in the securities investments, which potentially could cause unrest if investors believe the risks have not previously been disclosed.

One particularly ominous aspect of the Center for Audit Quality’s report is its assessment of the likely longevity of the current liquidity crunch; the report notes that

It is not possible at this tie to predict how long investors will stay on the sidelines or which markets will be most affected, but it is not unreasonable to expect – especially for subprime mortgage-related assets – that current conditions could persist for an extended period of time until the uncertainty is reduced, that is, when it becomes clear that defaults have peaked and real estate prices have bottomed out.

In light of these comments about the likely duration of the current marketplace conditions for mortgage-backed assets, the justification for valuing these assets based on current market prices is all the more compelling. The more interesting question is the impact that these valuation considerations will have on the balance sheets of companies that carry substantial mortgage investment risk.

An October 17, 2007 Wall Street Journal article entitled "With New, United Voice, Auditors Stand Ground On How To Treat Crunch" discussing the Center for Audit Quality’s valuation statements can be found here. The article comments that auditors are being more disciplined in their approach than perhaps they were at the time of the corporate scandals earlier in this decade, or during the savings and loan crisis.

Subprime Mortgage Litigation: Regular readers know that I have been maintaining (here) a running tally of subprime mortgage-related litigation. The Stanford Law School Securities Class Action Clearinghouse has now added a separate web page (here) to its site, with its own running tally of the subprime lending related class action litigation. The Stanford website’s count of 18 lawsuits differs slightly from my tally of 17, but the difference is that the Stanford site included in its tally a lawsuit that has been filed against a home builder. I have been tracking the lawsuits that have been filed against the residential construction companies separately.
By my count there have been four lawsuits filed against residential construction companies, in addition to the 17 lawsuits in my general tally. In addition, there have also been two lawsuits that have been filed against the credit rating agencies based on subprime lending allegations.

The Stanford website not only identifies the lawsuits, but also helpfully identifies the court in which they are pending and identifies the date on which the case was first filed.

Speaker’s Corner: On October 29-30, 2007, I will be co-Chairing (with my good friend Matt Jacobs, from the Jenner & Block law firm) a Lexis/Nexis seminar entitled "Mealey’s Subprime Mortgage Litigation Conference," to be held in Chicago. The program agenda can be found here.