Wednesday, December 12, 2007

Subprime Disclosures and Accounting

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Among the more disconcerting aspects of the unfolding subprime crisis has been the unseemly spectacle of major financial institutions taking dramatically increased asset value write-downs shortly after having disclosed smaller write-downs on the same assets. UBS became the latest company to follow this pattern earlier this week when it announced (refer here) an increased $10 billion asset write-down, only three weeks after taking a $4.4 billion write-down in connection with the same assets. UBS’s increased write down following the more or less same sequence of events as were involved with write-down disclosures at Merrill Lynch (about which refer here) and Citigroup (about which refer here).

In its December 10, 2007 press release explaining its most recent write-downs (here), UBS said it was making its move “in response to continued deterioration in the U.S. subprime securities market,” as a result of which, the company “revised assumptions and inputs used to value U.S. subprime mortgage related positions.”

Perhaps due to the deterioration in the market for U.S. mortgage-backed securities, but also likely in response to the undesirability of the pattern of piecemeal asset valuation disclosures, SEC Chairman Christopher Cox reportedly said on December 10, 2007 (refer here) that the SEC will be sending letters to approximately two dozen financial service firms, including banks and insurance firms, urging them to disclose “more information about their exposure to potentially problematic loans in light of the massive number of gargantuan write-offs caused by the subprime lending crisis.”

Underlying these developments is the fundamental difficulty companies are facing in valuing many of these mortgage-backed assets. The asset valuation difficulty is apparently of particular concern to the Public Company Accounting Oversight Board (PCAOB), which on December 10, 2007 released an Audit Practice Alert entitled “Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists” (here). The Alert is written in light of the circumstances that may “make it difficult to obtain relevant market information to estimate the fair value of many mortgage-backed securities,” which is likely to “increase audit risk.”

The Alert’s purpose is to draw auditors’ attention to certain areas of the new fair value accounting standards under SFAS No. 157, which is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. In other words, these new standards are about to start applying to many companies for the first time in the reporting period that is currently underway. The PCAOB is clearly worried that there may be problems as the new fair value standards are applied to many mortgage-backed securities.

According to a December 11, 2007 CFO.com article (here), the PCAOB issued the Alert “over concerns that the subprime mortgage crisis will increase the volume of fair value recalculations companies will be forced to make after accounting for losses from the subprime collapse.” At the heart of the Alert is a discussion of the hierarchy of inputs to be used in determining whether a company’s financial statement disclosures are complete, accurate and in compliance with GAAP.
Under SFAS No. 157, as the reliability of the inputs decreases, the company’s disclosure obligations increase. (UBS’s recent increased write-down is in effect a practical example of these principles in action, as the company said that its increased write-down was the result of the results derived from changing the inputs used in its asset valuation.) The Alert observes that this hierarchy creates some obvious, potentially unhealthy incentives: “Because there are different consequences associated with each of the three levels of hierarchy, the auditor should be alert for circumstances in which the company may have an incentive to inappropriately classify fair value measurements within the hierarchy.”

The PCAOB’s encouragement for auditor attentiveness to these issues clearly reflects a concern that in order to avoid certain adverse disclosures, some companies may not come clean. The PCAOB’s alert is obviously intended to ensure that auditors are fully engaged in their critical audit function in assessing the valuations companies assign to mortgage-backed assets. While time will tell how these changing standards and audit processes will play out, the Alert implicitly assumes that auditors may be forced to challenge their clients’ valuation assumptions, which in turn could lead to additional financial statement disclosures (and, potentially, asset valuation write-downs).

These accounting issues not only directly affect financial statement disclosure issues, but they may also be at the heart of future subprime related litigation. Many of the subprime-related lawsuits that have already arisen are built around accounting-related allegations, including, for example, the adequacy of loan loss reserves; the failure to properly account for the allowance for loan repurchase losses; and the failure to properly account for the residual interests in securitizations. But more to the point for purposes of this blog post, many of the subprime-related lawsuits have contained allegations related to the failure to timely write down impaired assets. An excellent, detailed discussion of the accounting issues that have arisen in subprime-related litigation can be found in NERA Economic Consulting’s December 6, 2007 publication “The Subprime Meltdown: Understanding Accounting-Related Allegations” (here).

The piecemeal process by which many companies have disclosed their valuation write-downs on mortgage-backed assets has already engendered litigation. The PCAOB’s alert suggests that it is concerned that in connection with their implementation of SFAS No. 157, auditors may also be called upon to reassess asset valuations, a process that could lead to further disclosure and even write-offs. These circumstances certainly present the possibility for even further subprime-related litigation following adjusted asset valuation disclosures.

One final note is probably worth emphasizing. As I have previously discussed at greater length (here), these asset valuation problems are not restricted to the financial sector. The mortgage-backed assets at the center of these valuations are broadly dispersed in the economy and can found on the balance sheets of a wide variety of entities. The potential exists for the asset valuation issues discussed above to affect some unexpected companies, which, in turn, could further spread the growing subprime litigation wave.

The December 12, 2007 Wall Street Journal has an article entitled "A Subprime Gauge, in Many Ways?" (here), discussing problems that many companies (including, for example, UBS) are having with one of the inputs that might be used in subprime-mortgage backed asset valuations, the ABX index, which tracks the value of securities backed by subprime home loans. The article underscores the difficulties that companies are having in determining the approriate asset valuation inputs.

Mortgage Professionals’ Litigation Exposure: As this blog has noted before (most recently here), the subprime-related litigation wave is likely to hit a wide variety of professionals. Among the professionals that have already become involved in subprime-related litigation have been those in the real estate industry (as discussed here). According to a December 2007 report (here) prepared by reinsurance broker Guy Carpenter, real estate professionals’ susceptibility to litigation may vary by state, depending on a set of possible variables.

According to the report, real estate professionals “may have more cause to worry depending on the states in which they practice,” according to the “convergence of a variety of legal and business conditions” that “create an overall climate of risk.” The report ranks the various states based on an index of factors (such as the percentage of mortgages in foreclosure, the number of litigation attorneys, and the frequency of Truth in Lending lawsuits). States ranked as having a high risk of mortgage professional litigation according to this index includes Alabama, Connecticut, Georgia, and Illinois. The lowest ranking states include Wyoming, Vermont, South Dakota and Oregon.

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