SUBPRIME WRITEDOWNS: BLAME IT ON FAS 157!

In case your not sure what FAS 157 is, here’s a quick primer:

The US Financial Accounting Standards Board Rule 157, which became effective for fiscal years that began after November 15, 2007, makes it harder for companies that must assign pricing to those securities considered the hardest to value – Level 3 assets. Essentially, firms are now forced to “mark-to-market” and determine a current fair value rather than use historical cost figures to value assets on the their books.

In the fair value hierarchy, Level 1 assets are simply “mark-to-market” whereby an asset’s value is determined with quoted prices for identical instruments in an active market (ie., an equity security traded on the NYSE).

Level 2 assets, known as “marked-to-model” instruments, are based on an estimate of observable inputs. In estimating value, firms can use pricing models based on net present value of future cash flows and directly observed prices from exchange traded or OTC derivatives. While Level 2 assets are a bit more complex than Level 1, measurement can be rendered with a fairly high degree of confidence. However, Level 3 assets are not so simple.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability. Ultimately, Level 3 inputs, which assist at deriving the underlying asset’s current value, must include information based on extrapolation or interpolation of observable market data.

In the case of Lehman, this sits at the very core of their recent writedown and massive losses. In the last quarter, the firm sold $3.5 billion of Level 3 assets which consisted mostly of mortgage-backed securities. And despite these sales, the firm still has approximately $38 billion in Level 3 assets sitting on the books as of their most recent 10-Q filing. Selling into a weak and uncertain market environment have made matters even worse. And while the firm works to decrease their exposure in Level 3 assets, Lehman makes these sales even more interesting by acknowledging that some of their transactions have taken place with an entity known as R3 Capital Partners.

R3 Capital Partners, launched this past May, is a hedge fund run by an ex-Lehman executive named Rick Rieder. Sounds fishy doesn’t it? I would say so.

Oh and did I mention that Lehman is an investor in this hedge fund. In fact, it currently maintains a "non-voting, minority ownership stake" in the fund.

With that said, I think a few good questions would be:

1. How much did R3 pay for Lehman’s Level 3 assets?

2. Were there any assumptions/conditions built into these deals that actually make these transactions simply a temporary transfer of risk?

3. Could you discuss in further detail the $4.5 billion in assets sold and/or transferred to R3 during Q2?

4. Do any of these executives that run R3 hold Lehman stock? And if so, doesn’t this present a conflict of interest? (The hedge fund’s disclosure documents states that it is possible that R3’s executives “could” be holding restricted stock in Lehman.)

Unfortunately, we probably won’t get the answer to any of those questions. The truth is: they don’t have to.

And so we come back to that darn FAS 157 – it’s forced firms to report market values and not assumed values. Shame on you FAS 157. Look at what you have done to this market.

Comments

[Concerned Citizen]

I certainly hope that the SEC investigates this crew during the aquisition of Lehman. I have strong reason to believe that Lehman and R3 were engaging in related party transactions and have seen it first hand where Lehman has assets on its books that it is allowing R3 employees to directly manage. Very curious and I wonder why the US Government does not do anything about it.

[Agustin Gonzalez]

Sadly we probably won't hear much about it since Lehman is in pure crisis mode. It will get "buried" underneath all the takeover news.

Thanks for reading!