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WASHINGTON, DC-Over the past few months there have been few, if any, trades of toxic or troubled debt securities in the public markets. Given the economic environment, this should come as little surprise except to those expecting a change in accounting rules made earlier this year to have made an impact.

That rule is the mark-to-market component of FAS 157. It requires companies to value assets on their books at the current market price. Earlier this year FASB relaxed the standard to assist holders of securities that, while healthy, had to be valued at zero because market trading had ceased. It also assists holders of securities that may have declined in value to the point of being toxic.

Now holders of these instruments can use an alternative procedure, such as discounted cash flow, for valuation, according to Mark Grinis, a partner in Ernst & Young’s Assurance and Advisory Business Services practices.

There were others reasons for the change. By relaxing the standard in this current environment, holders of real estate-backed paper have a more transparent and level standard by which to calculate prices. That would, lawmakers hoped, prompt sellers to come to the table because they have some expectation of selling an asset at what would otherwise be a fire sale rate.

The opposition’s arguments against the move ranged from the possibility of investment accounting tricks to concerns that holders of these securities will in fact not sell but wait out the market.

It was, and still is, unclear whether the bid-ask spread for these securities would narrow by relaxing the rules. Also if the holder has the capacity to keep the security on its books until the market changes it will likely do so, especially if it doesn’t have to write it down to zero.

Fast forward to today and the market is still unsure of the impact these changes will have. This is largely due to the fact that there have been few if any trades by a company subject to these rules.

One reason, according to Andrew Lance, a partner with Gibson, Dunn & Crutcher’s real estate practice in New York, is that regardless of the changes a few months ago, companies “are still reluctant to pull the trigger on transactions in part because if the market declines further they will still have to show a further loss on assets recently acquired. The relaxation does not relieve them of that burden.”

The bid-ask spread has not narrowed despite the change; and that is the primary reason why toxic debt is not trading.

Often the banks are offering the sales at a 40% or less discount for nonperforming debt and buyers are looking for an 80% plus discount. “The banks aren’t willing to sell and take another hit to their liquidity. They will keep them on the books instead of recognizing an additional 40% loss, which then sets the market and potentially causes them to be forced to mark to market the remaining debt at the same ratio,” says David Akeman, director of Capital Markets for Stan Johnson Co. “The only offerings that may make sense are from the failed institutions, and we really haven’t seen many of these reach the market yet. It is still to be determined how the FDIC will respond to offers on these assets.”

Akeman suspects that many of these institutions are holding out for an additional rescue by the government. “Hope seems to be a business plan these days.”

The new rules also appear to be undercutting the government’s initiative to roll up and sell off toxic debt. That initiative is the Treasury Department’s Public Private Investment Program, or PPIP. There has been doubts raised recently as to whether this program will ever launch – but it is still officially an upcoming option and clearly a factor for at least some sellers of these securities.

The relaxation of the Mark-to-Market rules of FAS 157 may turn out to be a curse disguised as a gift for the banking sector, says Ron Borod, a partner with DLA Piper. “It has already provided an incentive for banks with large exposure to toxic securities to opt out of the PPIP Legacy Securities Program, although larger banks which have already taken aggressive marks in their trading accounts may actually realize reportable gains from participation in PPIP.

“But the uncertainty over the banking sector’s exposure to toxicity which has plagued the sector remains, despite the success at raising new capital over the past two months; and in the long run it may delay the return to health of the banking sector as a whole if banks retreat behind the veil of revised FAS 157 and, just as importantly, if the public begins to get the impression that the fix is still in.”

Momentum for these sales will eventually develop and on a timetable that has little to do with the accounting change or PPIP, Grinis says.

The real estate cycle is only just now starting to provide a glimmer of price visibility, he continues. “The [still wide] bid-ask spread on security sales will continue for a while,” he predicts. Sooner or later, though, buyers and sellers will come to agreement on where the value lies. “Eventually holders of these securities that have to sell, will do so and thus start to set the foundation of market-clearing pricing.”

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