Credit Suisse has a note out urging caution on Citigroup shares due to regulatory hurdles.  Their logic bears noting as it can be useful for other U.S.-based banks.

On Monday the CS analysts met with Citi management, who were somewhat cautious. The CS note indicates that regulatory changes in the U.S. are likely to mandate higher capital ratios and this necessarily will constrain returns on capital, not just at Citigroup but elsewhere in banking.

Another question involved deferred tax assets (DTAs), which I brought up last week. Citi said only $13 billion of the $38 billion in DTAs were counted against Tier 1 capital, meaning any writedowns to capital will have much less affect on Tier 1 capital. About $14 billion in DTAs were related to Citi’s burgeoning loan loss reserves; so the tax losses have not yet been triggered. This may give Citi time to earn money in order to use the DTAs. Again, the key with Citi’s DTAs has to do with how much it earns going forward. If it does not earn enough money, the deferred assets will have to be written down.

In general, banks are now entering a less favourable regulatory environment.  Moreover, in March, many bank stocks were trading below tangible book for the first time since 1990, at the height of the last major credit crunch in the U.S.. After a more than doubling in bank stocks from March lows, this is no longer the case and it will be harder to beat now elevated earnings estimates.

Meredith Whitney has said she expects the large cap bank stocks to underperform due to some of these hurdles and sees a relative value play in regionals.  However, a lot of CRE and loan construction exposure remains at regionals and the continued seizure of 3 or 4 banks every week by the FDIC points to distress.

I continue to believe upside in bank shares is limited all around.

Related posts:

• How well capitalized is Citigroup?
• How is Citi going to deal with $38 billion in deferred tax assets?
• The Citigroup Bailout: a blogosphere post-mortem
• Citigroup and Redecard: shedding international assets
• Rubin resigns from Citigroup

A friend sent me the following presentation earlier in the week when I was feeling a bit ill. So I neglected to post it.  But, I want to return to it because it is in keeping with my recovery/depression theme. These are the issues that were complicit in the latest financial crisis and almost none of them have disappeared.  They will most certainly rear their heads again precipitating or worsening the next downturn.

We’re talking about:

1. Duration mismatches (borrowing short and lending long)
2. Accounting (Mark-to-market, deferred tax assets and a lot more)
3. Conflicts of interest (no Chinese walls, ratings agencies)
4. Regulation (especially given poor risk controls)
5. Risk management (is Meriwether a leading indicator?)
6. Investment Banking vs. Utility Banking
7. Too big to fail (they must be downsized)
8. Heads I win, tails you lose (socialization of losses is crony capitalism)
9. Quantitative easing (QE has costs)
10. Hedges instead of capital

My baseline thinking at the moment is that we are seeing the beginnings of a cyclical recovery built on the back of asset relation more than anything else. The underpinnings of this uptrend are tenuous. So, when this latest burst of reflation hits the wall, all of the aforementioned issues will re-appear and policy makers will again do the who-could-have-known routine we saw in 2001 and again in 2008/ But the broader public is increasingly wise to this song and dance. Hat tip Scott.

Jim Chanos Presentation at Darden, 22 Oct 2009

Related posts:

• Chinese officials warn banks about reckless lending
• European banks: still undercapitalised
• The U.S. financial system is effectively insolvent
• Lessons from Japan’s Bank Crisis
• Bank of Canada blames Geithner for financial mess

In a recent post, “How is Citi going to deal with $38 billion in deferred tax assets?,” I pointed to a Reuters article which called into question Citigroup’s ability to earn enough money to prevent its having to take a charge for an incredibly large deferred tax asset. That post generated a response from a Citi representative who emphatically defended Citi’s capital position with a chart comparing Citigroup to other large global financial institutions.

Below is that chart:

As you can see from the chart, based on Citi’s reported public accounts, the company is well-capitalized. Moreover, even hedge fund operators like John Paulson who maid a mint on shorting financials in 2007 and 2008 now think Citi is in much better condition. Paulson was known to be buying shares in August.

You could agree or disagree with Paulson about whether Citigroup is a buy at its present share price. And you could argue that Citi should be taking the charge that Willens suggests. But the fact is, Citi has been recapitalized – at taxpayer expense. And that’s more the point here. 

Citigroup has received more money from the government ($45 billion) than any other bank in the U.S., none of which has been paid back. Moreover, the government was forced to not just forgo dividends on its preferreds but also convert these into common equity and provide debt guarantees for the company. Absent government money, Citigroup is the worst capitalized big bank. Absent government money, Citigroup would not exist.

Even still, Citigroup cannot be nearly as profitable as it once was because it has been forced to sell assets in order to achieve its ratios. Yet, it is an organization with almost $1.9 trillion in assets and is certainly still too big to fail.

I see Citigroup as emblematic of the problems we face in dealing with large systemically dangerous institutions. They insist that we return to some semblance of business as usual after they have received massive bailouts without any clear timeline when those monies will be repaid – if ever. Meanwhile, it is far from clear what these institutions would look like if the collateral they put up for loans received from the Federal Reserve and the rest of their assets were marked to market.

I, for one, think the big banks have made it. I said so as far back as April. I may not like the way they have been recapitalized, but I am in little doubt that they have been.

But Citigroup and Bank of America in particular have gotten there with great help from taxpayers. All of the too-big-to-fail financial behemoths exist because of government largesse. That high-level executives of these organizations show little contrition or remorse for having cost our economy tremendously is the saddest part of this crisis.

Disclosure: I have no financial positions in Citigroup or any other financial services company.

Related posts:

• My take on the latest Citigroup bailout
• The Citigroup Bailout: a blogosphere post-mortem
• Rubin resigns from Citigroup
• Credit Suisse cautious on Citigroup due to regulatory hurdles
• Citigroup and Redecard: shedding international assets

Citigroup has been losing tens of billions of dollars over the past two years as the financial crisis has unfolded. If one considers the government capital that Citi has not paid back, the bank is clearly the weakest of the four largest legacy banking behemoths in the United States. Earnings results this year demonstrate that their raw earnings power is no match for the likes of JPMorgan Chase or Wells Fargo. Moreover, their capital base has been impaired, causing them to have to sell assets, reducing their earnings power further still.

Unless something miraculous happens over the next few years, they are not going back to the glory days of $20 billion yearly net income. That’s why their mountainous $38 billion deferred tax asset is a problem.

Reuters explains:

Citigroup has a roughly $38 billion deferred tax asset, which essentially represents expected cash flow from future tax benefits. Accounting expert Robert Willens said on a conference call late last month that he expects the bank to write the asset down by about $10 billion in the fourth quarter. That would represent about 7 percent of the bank’s net worth as measured by the reported value of the company’s shareholder equity.

What is going on here is a result of the fact that companies keep two sets of books – one for the taxman and one for public statements.  On the tax books, they pay more taxes upfront than we see in their public accounts (I know it sounds dodgy but I am sure a tax accountant can explain). By deferring the tax liability, companies reduce the net present value of the tax charges. Everybody wins except the taxman, right? 

Well, not exactly.  If Citigroup cannot make enough taxable income in future periods to cover these deferred tax assets, they are going to have to take a charge and write down the asset immediately. That is what Robert Willens is pointing to. If he is right, Citigroup would have $10 billion less capital as soon as Jan.1, 2010. And given they are perhaps the least well-capitalized of the stress test 19 except GMAC, that’s a problem.  It would certainly constrain their lending capacity.

But, of course, Citi officials have already come out to put any fears to rest.

"We are comfortable with the valuation," Kelly said, adding that the bank looks at its deferred tax asset at the end of each quarter. About $16 billion of the deferred tax asset must be realized by around 2016, and the rest has a much longer time frame, Kelly added.

Whew. For a second there, I was starting to think Citi needed another bailout.

By the way, Bank of America has a similar problem.  They have a huge net operating loss (NOL) carry-forward from their acquisitions of Merrill Lynch and Countrywide Financial. If BofA cannot make enough taxable income to use all of their NOLs which are now assets on their balance sheet, they too will have to take a ‘valuation allowance’ a.k.a a hit to earnings.  The net deferred tax assets at BofA (incl. NOLs) were $19.6 billion according to their 3Q 10-Q filing.  See the note below (click to expand).

As you would suspect, “The Corporation has concluded that no valuation allowance is required.”

Source

Bank of America SEC filings – BofA website

Related posts:

• Credit Suisse cautious on Citigroup due to regulatory hurdles
• How well capitalized is Citigroup?
• JPMorgan has record revenue and $2.7 billion in profit
• Is Citi being forced to downsize by Obama?
• Are Citi and BofA gaming the Geithner Plan already?

The positive earnings announcement by Wells Fargo on Wednesday was marred by a sell recommendation from Dick Bove and a lot of chatter about credit writedowns and mortgage servicing rights (MSRs). I wanted to add a few words about the report, MSRs, and bank stocks more generally.

First of all, this has been a very good quarter for bank earnings. Many of the big names globally have surprised to the upside. this includes Goldman Sachs, Morgan Stanley, JPMorgan Chase, Wells Fargo, US Bancorp, SEB in Sweden, Credit Suisse in Switzerland and on down the line. As one would expect, most banks are profiting from record low interest rates.

The question for the big banks is whether the huge writedowns they are still taking and the run-up in their stock prices since march limits any upside in valuation. For smaller banks, we should expect weaker results as they are more leveraged to the sectors of the economy like commercial real estate and construction loans which are still suffering.  Goldman and Morgan Stanley should do relatively better as they are really broker-dealers and both investment banking and sales & trading are doing well right now. On the whole, I have said I think upside is limited for the sector, but downside is vast. Hence I am bearish on bank stocks.

Let’s look at Wells Fargo (WFC) as an example of what is happening.

Wells reports record profits

Wells reported net income of $32 billion, a robust operating pre-tax profit of $10.8 billion, and record net income of $3.2 billion. Sounds wonderful. What’s not to like?  That was bank analysts Dick Bove’s initial impression as well. Live on-air at CNBC, he said Wells Fargo “is proving itself to be a standout.”

But, once Bove got a peek under the hood and started to crunch the numbers at Wells, he was significantly less impressed – so much so that he issued a sell rating literally nine hours later. And he took a lot of flak for this about-face.

The Wall Street Journal’s Market Beat reports:

Prominent banking analyst Dick Bove, who caused a stir Wednesday with seemingly contradictory remarks on Wells Fargo, has decided he’ll no longer provide immediate earnings commentary on air.

“I’m not going to do it anymore. I’m going to have to see the numbers before I go on air,” Bove told Dow Jones Newswires Thursday. “It creates an untenable situation.”

Appearing on CNBC immediately after the San Francisco bank’s 8:00 a.m. EDT Wednesday earnings release, the Rochdale Securities analyst included Wells among “standout” banks when asked to name a few. Bove, who appears regularly on business news programs, said the earnings news suggested Wells had its loan losses “under control.” The comments left many with the impression that Bove
favored the bank.

Later in the day, Bove made waves when he downgraded Wells to “sell” from “neutral.” In an interview Wednesday with Dow Jones Newswires immediately after the downgrade, Bove called the bank’s earnings “pretty poor,” and said mortgage hedging and unsustainable tax cuts inflated earnings.

The downgrade sent Wells shares sharply lower, and weighed on the broader stock market. The Dow Jones Industrial Average finished the session lower after spending most of the day in positive territory.

So, what caused Bove to go from calling Wells a standout to telling us to sell? FT Alphaville’s Tracy Alloway has the goods:

Wells Fargo reported earnings of $0.56 per share for the third quarter. This was well above my estimate of $0.41 per share and in line with second quarter results. The earnings forecast for 2009 has been increased to $2.08 per share from $1.94 per share. The estimates for 2010 and 2011 remain unchanged at $1.93 per share and $2.67 per share, respectively. The target price on the stock is being maintained at $25 per share. The rating is reduced to Sell.

• While the quarterly number was higher than the expected, the increase seems to be due to two factors. The servicing fees on mortgages (MSR) jumped by $1.1 billion or $0.15 per share, and the tax rate fell by 2.2% adding another $0.02 per share to earnings.
• The volatility in the mortgage servicing fee is impossible to explain. In the past five quarters this fee has moved around as follows: $525 million, negative $40 million, $843 million, $753 million, and $1.9 billion. Mortgage rates in these five quarters have been as follows: 6.31%, 5.87%, 5.06%, 5.03%, and 5.15%. These rates would argue for a constant decline in the value of mortgage servicing until the third quarter this year.
• This is not what is depicted in the Wells Fargo numbers. The reason is that Wells hedges its servicing portfolio. These hedges are very large. For example in the second quarter, the bank lost $1.3 billion on its MSR hedges. In the third quarter, it made $3.6 billion on these hedges. The swing from quarter to quarter was $4.9 billion. The earnings per share impact was $0.68 per share. This is more money than the bank earned, overall, including the hedge profit, in the third quarter.
• Despite the fact that this is the most compelling earnings event in each quarter, the bank never spends much more than 5 seconds discussing it. It is an unsustainable profit but MSR hedges keep coming through for the company when it needs to bolster earnings.
• The remaining businesses of the bank were very mixed in the quarter. Most disturbing is that loan losses seem to be accelerating on the negative side.

At issue is mortgage servicing rights (MSRs) not to mention loan losses. Let’s concentrate on the MSRs. Wells Fargo has all of its financial statements dating back to 2001 on its website.  I found an explanation of its reporting of MSRs from the Q3 2003 10Q useful (I have highlighted the key points).

The Company originates, funds and services mortgage loans. These activities subject the Company to a number of risks, including credit, liquidity and interest rate risks. The Company manages credit and liquidity risk by selling or securitizing most of the loans it originates. Changes in interest rates, however, may have a potentially large impact on mortgage banking income in any calendar quarter and over time. The Company manages both the risk to net income over time from all sources as well as the risk to an immediate reduction in the fair value of its mortgage servicing rights. The Company relies on mortgage loans held on its balance sheet and derivative instruments to maintain these risks within Corporate ALCO parameters.

At September 30, 2003, the Company had mortgage servicing rights (MSRs) of $5.8 billion, net of a valuation allowance of $1.8 billion. The Company’s MSRs were valued at 1.03% of mortgage loans serviced for others at September 30, 2003, up from .92% at December 31, 2002 and .89% at September 30, 2002. The increase in MSRs was predominantly due to the growth in the servicing portfolio resulting from originations and purchases.

The value of the MSRs is influenced by prepayment speed assumptions affecting the duration of the mortgage loans to which the MSRs relate. Changes in long-term interest rates affect these prepayment speed assumptions. For example, a decrease in long-term rates would accelerate prepayment speed assumptions as borrowers refinance their existing mortgage loans and decrease the value of the MSRs. In contrast, prepayment speed assumptions would tend to slow in a rising interest rate environment and increase the value of the MSRs.

The Company mitigates mortgage banking interest rate risk in two ways. First, a significant portion of the MSRs are hedged against a change in interest rates with derivative contracts. The principal source of risk in this hedging process is the risk that changes in the value of the hedging contracts may not match changes in the value of the hedged portion of the MSRs for any given change in long-term interest rates.

Second, a portion of the potential reduction in the value of the MSRs for a given decline in interest rates is offset by estimated increases in origination and servicing fees over time from new mortgage activity or refinancing associated with that decline in interest rates. In a scenario of much lower long-term interest rates, the decline in the value of the MSRs and its impact on net income would be immediate whereas the additional fee income accrues over time.

Under GAAP, impairment of the MSRs, due to a decrease in long-term rates or other reasons, is reflected as a charge to earnings through an increase to the valuation allowance.

In scenarios of sustained increases in long-term interest rates, origination fees may eventually decline as refinancing activity slows. In such higher interest rate scenarios the duration of the servicing portfolio may extend. In such circumstances, periodic amortization of servicing costs may be reduced, and some or all of the valuation allowance may be released.

What Wells Fargo is saying is that a decrease in interest rates as we have seen recently should lower net income immediately as the loss in revenue flows through the income statement.  Yet, this is not happening according to the latest earnings report.  the question is why? Dick Bove’s answer is the temporary gains from the hedging contracts have more than offset the more permanent loss in MSR income, that is for now. I certainly think Wells will be making boatloads of money on refinancing fees. But, this fee income “accrues over time.” What will happen with these massive hedges is unclear.  What is clear is that the MSR value will have to be written down and that will be a drag to income. So, on the whole, if you strip out the hedges, the earnings level at Wells is misleadingly high.

The troubling thing about this is that these hedges are marked to market and because there are no actively-traded contracts for comparison, there are no reliable marks to mark-to-market. Let’s call these marks mark-to-make believe then.  And Wells is not the only one benefitting from this. Wells, BofA, JPMorgan and Citi, the four largest mortgage servicers, all are benefitting from this.

The four banks wrote up the value of their MSRs by about $11 billion in the second quarter, according to regulatory filings. Mortgage rates climbed by 0.35 percentage point in that period, according to Freddie Mac.

The four banks control 56 percent of the market for the contracts, according to Inside Mortgage Finance, a Bethesda, Maryland-based newsletter that has covered the industry since 1984. Servicers collect payments from borrowers and pass them on to mortgage lenders or investors, less fees. They also keep records, manage escrow accounts and contact delinquent debtors.

Under U.S. accounting rules in place since 1995, banks should report the value of mortgage-servicing rights on a fair- market basis, or roughly what they would fetch in a sale. A bank must record a loss whenever it sells MSRs for a price below where they’re marked on the books.

Because there’s no active trading in the contracts, there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said.

Bank of America held the largest amount of MSRs as of Sept. 30, with $17.5 billion. JPMorgan had $13.6 billion, while Wells Fargo owned $14.5 billion and Citigroup $6.2 billion.

Let’s see where this leads for the next quarters.  Right now it looks a lot like big bank earnings are inflated artificially by hedges. How well regional banks fare on loan losses should give us a better picture of the underlying fundamentals in the sector.

Sources

Wells Fargo 2003 Q3 10-Q (pdf) – Wells Fargo website

Wells Fargo, JPMorgan Benefit From Servicing Hedging – Bloomberg

Related posts:

• Wells Fargo to buy Wachovia
• How refinancing helps the likes of Bank of America and Wells Fargo
• On Meredith Whitney’s Goldman downgrade
• Wells profit forecast is a clear bullish sign
• Goldman crushes earnings estimates

Marshall Auerback here. This is a cross-post from an article I wrote at the finance site New Deal 2.0, a one-stop-shop for current news, sharp analysis and potential solutions of the country’s fiscal crisis.

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts. The anodyne communiqué from last weekend’s Pittsburgh summit makes clear that this is not the case. Western policy makers appear determined to consign us to years of additional economic misery because of the continued embrace of a flawed market fundamentalist economic paradigm.

So far, instead of trying to revive the productive economy, most of the G20’s resources have consisted of mouth-to-mouth resuscitation for a dying financial sector. This has not “worked” to the extent that last weekend’s communiqué advertised. The best analogy to describe the current state of our financial system is that we have placed scaffolding over a decaying building, but done little to repair the underlying structure. What happens when the economic scaffolding is removed via “exit strategies”, as the G20 participants have advocated?

For many generations, we didn’t face the unprecedented financial fragility we are experiencing today. But there are good reasons why we avoided this until recently. We have spent the past quarter century eviscerating what was fundamentally a robust structured originally devised during New Deal, a system which basically saved the US capitalist system and served the interests of its citizens very well until it was hijacked by a bunch of corporate predators under the guise of deregulation and neo-liberalism.

To read the communiqué from the Pittsburgh summit is to gain insight into an ideology which views government, not as a stabilizing influence protecting us from private sector rent seeking monopolists. Rather it’s an unwanted stepchild, brought out on display as a necessary evil, and destined to be shoved away as soon as we get back to a “normal” economic state of affairs, where the government minds its own business and lets the magic of the “free market” operate. Hence, the emphasis by the Pittsburgh summiteers on “sustained, strong and balanced growth“, the usual code words designed to encourage budget surpluses, more private sector savings and shift from public to private sources of demand.

There is little understanding that if households and firms try to net save (save more out of income flows than they tangibly invest) incomes collapse, and desired private net saving is thwarted. The private “excess saving” cannot exist without a budget deficit or a trade surplus. Many people make this mistake. At best, we can talk about planned private saving being in excess of planned private investment, but other than that, we are violating double entry book keeping principles.

And consider this: in 1998, 1999 and 2000 (increasing each year), the US government “virtuously” ran budget surpluses. And guess what happened? The private sector became more heavily indebted than before as the fiscal drag squeezed liquidity and destroyed aggregate demand and incomes. Along with our misconceived embrace of financial deregulation, the combined result was sharply rising unemployment and a major recession in 2001-02 with unemployment rising sharply and the automatic stabilizers pushing the budget back into deficit.

Unfortunately, that was the yellow flag for what was to follow, a warning signal blithely ignored by our economically illiterate policy makers. Instead, we perpetuated a massively leveraged financial system via Frankenstein financial products such as collateralized debt obligations, and credit default swaps. We squeezed private sector incomes via constrictive fiscal policy, thereby inducing the debt-fueled consumption that is now regularly decried by our officialdom and the commentariat.

The bottom line is that if we want habitual private sector savings, we need habitual government deficits.

And government deficits are not an aberration; they are the norm. Our first (and possibly greatest) Treasury Secretary, Alexander Hamilton, called the national debt a “national blessing”. Similarly, Paul Krugman and L Randall Wray have argued that it was World War II and the subsequent cold war that ended the depression, which created the foundations for a significant expansion of government debt, which in turn set the stage for the “Golden Age.” The government deficit reached 25 percent of GDP during the war, providing a massive amount of private sector saving in the form of safe financial assets that strengthened balance sheets. From 1960 onward, the baby boom drove rapid growth of state and local government spending, so that even though federal government spending remained relatively constant as a percent of GDP, total government spending grew rapidly until the 1970s. This pulled up aggregate demand and private sector incomes, and thus consumption.

This is unsurprising: The private sector cannot create “net nominal wealth” because every private financial asset is offset by a private financial liability. Over the long term, the maximum that a government can hope to collect in the form of taxes is equal to its purchases of goods of services. There is no hope of running long-term budget surpluses because the government cannot possibly collect more than the income it has created as it paid out dollars. When the government attempts this, as it did during the Clinton Administration, the public finds that its net financial assets would be less than its tax liability, requiring households to dip into its “reserves” of accumulated savings, which gradually become depleted. In the absence of other factors, demand slows and the government almost invariably falls back into deficit.

If an external creditor is added (such as China or Japan) it merely delays or extends the process, since for a time, countries running current account surpluses with the US can use their surplus dollars to accumulate additional US dollar financial claims. But in the absence of any increase in US government spending (which is the only source of NEW NET FINANCIAL ASSETS), the end result is still a massive accumulation of private sector debt, which is what got us into this mess in the first place. By contrast, assuming a non-convertible, freely floating fiat currency, a government can never be insolvent even if its tax revenue declines significantly. Its balance sheet can never become precarious in the same way that a household balance sheet can.

In the abstract, this always sounds controversial to those uncomfortable viewing the world within a financial balances construct. It also helps to explain the intellectual incoherence at the heart of the G20 communiqué and the Obama Administration’s economic policies, which has been dominated by Wall Street interests.

So it’s worthwhile considering some historic examples, which illustrate the point better. During WWII, the US government generated huge deficits and bond issues. The record expansion of government deficits not only facilitated the war effort, but created full employment. (As an aside, it is always interesting to pose the following question to “deficit terrorists “: if government budget deficits are so awful, and so egregious for the long term performance of an economy, then why run them at all during wartime, when presumably we need the economy to be functioning in an optimal manner?) After the war, the Fed was concerned with potential inflationary pressures and raised interest rates. President Truman, a hard money man par excellence, drastically cut defense spending from $90.9bn to $10.3bn and the US accumulated huge fiscal surpluses. Post war surpluses, combined with Fed tightening, contributed to a recession in 1949. Unfortunately, it took the “military Keynesianism” brought on by the Korean War to shift Truman away from his aversion to deficit spending, which was continued by Eisenhower, and sustained via his national highways building program. During that period, unemployment decreased. Similarly benign effects on unemployment were manifested in the wake of the Kennedy tax cuts and those of Reagan in the early 1980s.

Today, budget deficits are the highest as a percentage of GDP, but they are overstated to some degree, because they include the TARP measures to stabilize the financial system which brought the global economy to its knees in 2007/08. Classic Treasury expenditures deal with the purchase of real goods and services; Federal Reserve functions deal with the purchase and sale of financial assets. And yet, the focus of policy makers is quickly reverting to “exit strategies” and a reduction of budget deficits, where the Pittsburgh communiqué pledged to “prepare our exit strategies and, when the time is right, withdraw our extraordinary policy support in a co-operative and co-ordinated way, maintaining our commitment to fiscal responsibility.”

If only that were true. The only way one could politically justify a government running a sustained surplus would be to make the case that unemployment created a more functional way of ensuring high profits (via wage discipline) than full employment. Put in those terms, it’s not a particularly compelling message, but it has the virtue of being consistent with modern monetary theory.

Oddly enough, the G20 communiqué devotes considerable attention to the government’s “exit strategies”, which came in response to the destructive private sector financial practices which created this catastrophe. There has been less attention directed to the underlying causes themselves. Thus the IMF, in its latest “Global Financial Stability Report”, suggests that restarting securitization markets is “critical” to a wider economic recovery, and that current US and European proposals to force banks that originate loans to hold on to the first 5% of losses in all securitizations, were not sufficiently flexible and might backfire. In the words of Credit Lyonnais Asia strategist, Christopher Wood:

“[The IMF] is yet again doing the world a disservice by acting as a lobbying group for the securitised debt peddlers. It is clearly fundamentally correct that the agents of securitisation should be made to retain some ’skin in the game’ after the terrible damage they have inflicted. It is true that the collapse of securitisation represents a massive deflationary risk for the global economy. But that does not mean that the answer is to allow a new free-for-all in securitisation assuming, charitably, there is demand for the securitised product.” (”Greed and Fear”, 24 Sept. 2009, CLSA, Asia Pacific Markets)

The IMF, the G20, indeed virtually all policy makers — including the Obama Administration — will make themselves far more relevant when they emphasize that full employment and prosperity can only be achieved to the extent that governments are prepared to spend up to a level justified by non-government saving. That does not mean unconstrained government spending. But the spending ought to be set with regard to results desired and competencies to execute plans — not out of some pre-conceived notion of what is “affordable”. Our federal government can afford anything that is for sale in terms of its own currency. And if it spends too much after getting us to a state of full output, it can get inflationary. But let’s get to that state of affairs first before we start worrying about perpetuating the flawed model of the past. That got us transitory prosperity and wage gains. And it promises years of economic misery if we do not move beyond neo-liberal economic fairy tales.

Related posts:

• Minsky: Turning neoclassical economics on its head
• The Cult of Zero Imbalances
• Low savings, high debt and interest rate policy
• Stephen Roach: Americans’ abandonment of overconsumption is a good thing
• UK consumers don’t save

This is a huge deal.  FASB is considering requiring all financial assets be valued at fair values on balance sheets.  Hat tip Andrew. Bloomberg reports (notice my highlighting in bold):

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.

The FASB’s approach is tougher on banks than the path taken by the London-based International Accounting Standards Board, which last week issued a proposal that would let companies continue carrying many financial assets at historical cost, including loans and debt securities. The two boards are scheduled to meet tomorrow in London to discuss their contrasting plans.

Differing Treatment

While balance sheets might be simplified, income statements would acquire new complexities. Some gains and losses would count in net income. These would include changes in the values of all equity securities and almost all derivatives. Interest payments, dividends and credit losses would go in net, too, as would realized gains and losses. So would fluctuations in all debt instruments with derivatives embedded in their structures.

Other items, including fair-value fluctuations on certain loans and debt securities, would get steered to a section called comprehensive income, which would appear for the first time on the face of the income statement, below net income. Comprehensive income now appears on a company’s equity statement.

Expect the financial services industry to fight this tooth and nail.

Related posts:

• The regionals versus money center banks
• A few comments about mark-to-market
• BofA carrying loans on books for $44 billion above fair value
• What Home-Loan Banks reveal about the effects of mark-to-market
• FAS 157 and the significance of distress versus bankruptcy

FT Alphaville is reporting that the credit rating agency Fitch puts credit card losses at 10.4% of outstanding loans.  This is a record.  Bad news if you are a credit card company.  So, what does one do in that situation?  You raise rates on customers that are paying, silly.

Citi’s rate increases emerged on the day the government proposed legislation to create a new regulator with sweeping powers on consumer protection and a week after the bank was attacked by some politicians for raising employees’ salaries.

Holders of co-branded cards who failed to pay their balance in full at the end of the month saw their rates rise by an average 24 per cent – or nearly 3 percentage points – between January and April, according to a Credit Suisse analysis of data from the consultancy Lightspeed Research.

Now, remember, insurance companies do the same thing- jack up rates for those that can pay to make up for the losses on those that can’t pay.  But, the optics here are not good – with Citi being bailed out by government and Obama calling for consumer protection at the same time as Citi is piling on interest.  It should be interesting to see if the Obama people have anything to say about this.

The Alphaville post by Stacy-Marie Ishmael is interesting because it does suggest that off-balance sheet losses are going to be an issue here.

I have two thoughts on the larger issue of credit cards.

1. The banks to watch are Citi, JPM and BofA, and Capital One as they all have huge credit card outfits.  My eyes are on JPM because they are the bellwether of the industry now.  Back in November, I warned that they were highly leveraged to the real economy. So, while they have escaped fairly well to date, let’s see what kind of beating they take going forward.  This will be instructive to the health of U.S.banking.
2. One would normally expect a slew of writedowns.  After all, it was writedowns on marketable securities which blew up the credit crisis in 2007 and 2008.  But FASB has fixed this problem.  So, let’s see how many writedowns result.  In truth, credit card debt used to be discharged in consumer bankruptcy.  But, the credit card lobby fixed that problem in 2005.  Now, the credit card companies may still be able to get their pound of flesh even if one files for bankruptcy. The key is whether you have a job or not due to a new bankruptcy means test.  The long and short for me is this: in the real world, since a high percentage of people defaulting on credit cards have lost jobs, we should expect the recovery rate to be much lower due to debt discharge in bankruptcy.  This should lead to a lot of writedowns at the likes of Citi, PM and BofA.  But, given recent FASB guidance on accounting for mark-to-market, it is anyone’s guess at this point.

Any way you look at it, though, higher loan losses mean less revenue.  How this gets reported over the near term is another matter altogether.

Related posts:

• Consumer loan delinquencies paint bleak picture
• More credit card writedowns are coming
• Amex: paying cardholders to close accounts
• Citi close to selling German unit
• $35 billion in missing writedowns

Yesterday, I argued that allowing banks to repay TARP funds meant a continuation of overcapacity in financial services, which was a direct contributor to the credit crisis through its dampening impact on unlevered returns.  Some of the banks now free of the TARP restrictions are arguably still undercapitalised, but have been made to look better through various mechanisms like the relaxing of mark-to-market rules.

It stands to reason that these firms will reach for yield i.e. take on more risk in order to generate enough profits to reduce lingering capital shortages.  Remember, we still have a lot of writedowns in areas like commercial property and credit cards which have yet to be taken.  Moreover residential property prices are still falling. Just because these loans and securities are not being marked to market does not mean the losses are not there.

Below is a good video from Bloomberg News in which Boston University Professor Mark Williams argues along similar lines.  He goes as far as to say that allowing repayment now could sew the seeds of bank failures down the line.  It is very understandable that these banks want to pay back the $68 billion, but it is the job of government to regulate so as to prevent systemic risk.

Certainly, it would be a black eye for regulators if any of these banks have to come back later and ask for more money.  Irrespective, my fear is that some banks paying back or looking to pay back TARP money know they are undercapitalised and will be willing to take enough risk to ‘solve’ this problem. Think ‘savings & loan.’

Related article
The S&L Crisis: A Chrono-Bibliography, FDIC

Related posts:

• Mark to market is beside the point
• Some banks not paying TARP dividends
• Ten big banks receive approval to repay TARP funds
• Goldman: Quote of the day – “Leopards change spots”
• Will banks exiting TARP take back their toxic waste now?

I have had a number of posts on mark-to-market accounting in the recent past.  Most recently, the posts have suggested that accounting is going to be favourable to banks and their quest to present a well-capitalized face to the world (see the post “JPMorgan’s $29 Billion windfall”).

A reader who deals with accounting issues has seen fit to send me an in-depth reply to a recent article on the issue, “What the stress tests reveal about Obama’s thinking on banks.”  Below is his excellent commentary in full.  This is a very technical analysis, so if math and accounting is not your thing…

FSP 157-4

I unfortunately disagree with your assertion of my opinion, but I do hope you will consider my positions on your thoughts, which I will try to outline from here, addressing them in the chronological order of your post. I do apologize for the length and slight rambling (I have attempted to break it into sections), but you did give me a chance to try and summarize my thoughts and think about the other various aspects which I had not previously considered, so thank you for that. I am warning you though, this is not short, it came out to almost 4,000 words. I hope it makes sense.

I understand what Kyle is saying: FAS 157 guidelines will have no impact on reported earnings.

Foremost, I want to be clear that this is not what I am attempting to say. I am saying that it will impact reported earnings for exactly the reason you state, but the overall financial situation of the entity does not change (subject to some hypotheticals presented below). My point is simply that the writedown is broken into two places, the earnings/income statement portion, and the OCI portion reflected in Stockholder’s Equity portion. Furthermore, this is not due to the 157-4 change, but due to FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, which was issued concurrently with FSP 157-4. So, if you’re looking at the Balance Sheet, the effect is null. Instead of Retained Earnings being lower by the amount of the change, OCI is lower by the amount of the change. The end result is lower equity by the same amount. The 157-4 revision does not lessen the total writedown in this case, it lessens the portion reflected in earnings, and increases the portion reflected in OCI. The net effect is the same.
I. HTM vs. AFS

A bank only has to attribute its actions to 157-4 if it is amending prior accounting to reflect a change in asset designation to ‘holding to maturity.’ However, if it marks assets today as ‘holding to maturity’ and then is later forced to write down those assets, these writedowns will not be attributed to changes in the FAS 157 guidelines.

I believe this statement is somewhat incorrect, but please allow me to expand on that.
First, the 157-4 change does not require a firm to acknowledge a change from AFS/T to HTM. That has always been a GAAP requirement, and would be reflected somewhere in the F/S, either as a footnote, or as a change in the Significant Accounting Changes portion of the Notes to F/S. The FSP 157-4 change primarily reclassifies when price quotes from inactive markets should be considered for fair value changes. That does not allow a firm to change the asset from AFS/T to HTM, it just means that an asset that was designated as Level 2 is now designated as Level 3 due to use of different inputs. This is a change in accounting estimate, and would be disclosed on any quarterly statement. (I will attempt to provide an example with WFC later on.)

It is absolutely true that if a firm decided to move said asset from AFS/T to HTM, any future write down would not be attributed to a FSP 157-4 change, but I am unclear as to your point in the text quoted above. If the security is moved to HTM as in the situation you presented, it is carried at the FV as of the change, and is then carried at amortized cost, so any market value price changes would not be reflected subsequent to the reclassification. A firm trying to utilize a change via 157-4 to write-up previously marked down assets would lose all ability to exercise that right if they moved the security to HTM, be locking in heavy losses, and I think have a very difficult time getting their auditors to go along with it in the first place.

Furthermore, if they wanted to kill off any fair value losses from this type of accounting treatment, I would think they would have done it in like 2007, before suffering all those previous writedowns, or at any point in time since then. Again, emphasizing this point, FSP 157-4 does not make moving securities from AFS/T to HTM any more likely or feasible from an accounting standpoint. As I said before, I suspect their auditors would not let them just off and dump their entire portfolios like that to begin with, for obvious reasons.

I think people (not necessarily you, I’m generalizing for the sake of generalizing) have a misconception that firms have these gigantic holdings of HTM securities in their portfolios, so moving stuff in and out of them at will is an easy way to hide stuff, and that is simply untrue. (Note: I picked these examples pretty much at random, but tried to get a big money center, a regional, and an I-Bank in there for diversification purposes.) Regions has $45 Million total in HTM Securities [LINK]. JPM has $31 Million total in HTM Securities[LINK]. State Street, on the other hand, has a non-trivial $15 Billion worth of HTM Securities (pre-consolidation, noted below), and it is primarily made up of ABS and CMOs [LINK].Kind of scary.

However, all three banks present (and are required to present) these HTM portfolios at amortized cost [their carrying value], and then at their comparable fair value in the notes. Accordingly, in the event that they had the ability to, and subsequently did, move any material amount from AFS to HTM to hide further writedowns from 157-4 adjustments to fair value measurements, aside from the fact that they would have to explicitly disclose the move, you would see an enormous jump in those balances to begin with and it would be immediately obvious to anyone looking at their F/S. Again, this would not be a result of 157-4 explicitly, it would have to come from another interpretation or a new FSP regarding this. As I stated earlier, if they intended to do this, they probably would have done it already. I tried to outline why I thought this would be unlikely from potential consolidations in the previous section.

On the other hand, an accounting change which did give further clarification or manoeuvrability in this sense [of moving to HTM from AFS] would have enormous material effects on recognized [but not disclosed, which could be affected by FSP 157-4, as outlined next] losses to be sure, and would probably render current balance sheet reporting all but entirely useless, in my opinion. The point I am trying to make is that the entire premise of any firm being able to hide changes due to 157-4 in a HTM reclassification rests on the ability to move the security from AFS/T to HTM, which has not occurred at all thus far, despite obviously having plenty of available motivation to do so. If that indeed does become a common practice, it will be due to another accounting change, because 157-4 does not address this issue in any respect, and as I just stated, would be an unbelievable fold on the part of FASB. I hope that made clear why I do not think firms will have the ability to hide losses related to FSP 157-4 by simply moving them to HTM from AFS.

II. Writedowns of Unconsolidated OBS Securities

Given that only one firm (that I am aware of) actually re-marked-up assets in applying FSP 157-4 during Q1, the only way it could give rise to further markups (or the ability to reclassify under FSP 157-4 at all and thus lessen future writedowns) would be if markets currently considered active became considered inactive, as this is the reason that WFC chose to re-mark their assets, and is the crux of FSP 157-4. It is unclear to me, however, to what degree this would result in a write-up though, and to what degree any number of markets that are currently considered active have the possibility of becoming inactive. I do not know of any specific accounting literature to specify one way or the other. To what degree does the security get revalued in the event of a market becoming inactive? If WFC is the standard setter for this treatment, it could definitely be bad news, but it’s hard to know the answer without knowing the assumptions versus observable market prices for various assets, how much those might diverge between now and the time of any change, and what exactly an auditor requires in order for a market to explicitly become inactive.

In my view, it is future credit card, jumbo loan and CRE exposure which will be most affected by this. These are areas where you should expect heavy pressure from securitized assets on bank balance sheets due to deterioration in income from credit card receivables,prime mortgage loans, and commercial real estate loans. What mark-to-market guidelines effectively mean is that banks will not have to reduce capital by nearly as much as had they not marked these assets as hold to maturity.

I definitely agree with you on this premise, Ed, aside from the HTM part. Per the previous section, I do not think firms moving currently held as AFS/T securities to HTM is a likely scenario, outside of another fundamental accounting change, and certainly not directly due to FSP 157-4. I would, however, expect that those areas which you just highlighted to start seeing very heavy pressure starting in Q2. You’re already seeing this effect, as per State Street’s decision to consolidate some conduit assets last week.
But, going back to my previous point about inactive markets, in the event that those markets became inactive, there is a chance that those securities could be marked down less than what they would have been subsequent to FSP 157-4. But in order for this to even be relevant from a HTM standpoint (AFS standpoint next), they would also have to consolidate those assets back onto their Balance Sheets first as per STT, which almost unilaterally would result in immediately realizing previously unrecognized losses, unless they revalued them upwards before consolidation. But again, they report the change in fair value on a quarterly basis, so you would know if they did indeed consolidate them at a higher value, and I think that is highly unlikely per the reasoning below.

This is just an opinion, but I find it difficult to believe that an auditor would allow a company to mark up an unconsolidated asset exclusively based on 157-4, then consolidate it, and avoid having to recognize any of the losses due to changes in fair value. At the very least, they would have to recognize some OTTI, which is likely a material amount. Most of the assets in those conduits are already valued on a level 3 basis to begin with, as I doubt they have very many observable inputs. The only example of this that I have is STT, which explicitly states in the 8-K that all of the assets they consolidated were carried on level 3 valuation basis, and that of course resulted in a realized after tax loss of $3.6 Billion. If the treatment STT gave to its conduits is the norm (the conduits are almost all abs of various sorts), then it appears unlikely that any firm would take the above mentioned approach of a write-up pre-consolidation.

Of course, STT only has to recognize the OTTI on those assets from now on since they just suffered the realized $3.6 Billion A-T loss on the conduit in order to bring it onto the B/S, but they weren’t recognizing any impairment prior to consolidation [stating the obvious, I know]. Those are toxic assets somewhat de-toxified, to the extent that you now know exactly what kind of losses were lurking Off-Balance Sheet, and what FV might still be unrecognized per the disclosures.

So I guess if you were being really “proactive” about it as an organization, you would re-consolidate now while the market is jubilant, take the current loss including fair value markdown, (which may be a lot less than it will be in a year, although that may already be more than substantial in some cases, and would absolutely require massive capital raising for most firms that decided to do that; see STT, which had to do a CS offering and a debt raising to keep them above water from the consolidation) then only recognize OTTI and avoid having to mark down any fair value changes in the future. No one else has done this thus far that I know of [aside from C last year, which I am sure you recall], and they would still have to disclose the difference between fair value and carrying value on those now consolidated-HTM securities. Again, if firms started consolidating left and right prior to those assets really nosediving (or prior to December, when they likely won’t have a choice due to FIN 46(R), where there is currently a debate as to whether to bring those on at FV or BV), it would be pretty obvious. In the event they have to bring those OBS vehicles on at fair value, we will probably have another legitimate meltdown, as I’m sure you’re well aware.

Anyway, if they did consolidate some OBS vehicles pre-November (at amortized cost and net of any OTTI or FV write down) and then just had billions of unrecognized losses sitting around that everyone knew about as per the disclosures in the notes, I can’t imagine they would be able to raise any capital. This is also primarily why they will probably be up a creek in November, when they have to bring those assets on book, either at fair value or net of OTTI (as I don’t see the above mentioned scenario happening). It would be the same effect as if they had been allowed to just throw everything into HTM 3 years ago, and then only had to recognize the OTTI since, but had to disclose the massive fair value losses in the notes. The B/S would be pristine, with a nasty disclose of “Fair Value losses on HTM portfolio of whatever billion dollar figure you would like to use.” The FSP 157-4 change could allow the FV presented on those disclosures to be different going forward, but it would really be irrelevant from a recording standpoint [but not a reporting standpoint]. It would be sneaky, and I’m unclear as to whether they have to or will have to disclose that information in the future. I suspect they will.

.III Effects on AFS Securities
From the other side of the table, and I apologize if this is what you were initially referring to, if a firm isn’t subject to consolidation of an obs vehicle, but instead is a holder of a securitized receivable carried as an AFS/T security, they could start revaluing them on a Level 3 basis as per the FSP 157-4. It would not hold true that they would be able to hide these potential losses, because, as previously stated, that would require a transfer from level 2 to level 3, which needs to be disclosed along with the relevant accounting interpretation for that treatment, a la 157-4, and highly unlikely that they would be allowed to just move it into HTM as per Part I of this email.

I admit there is a gray area here and room for chicanery to an unknown extent going forward [as I tried to note above]. Depending on the asset class backing the security, they may still rely on L2 inputs, so incorporating L3 inputs might reduce the writedown significantly, or even result in a writeup. Again, if this is the crux of your argument, I do not disagree, and I apologize for the long letter. Still, those are not losses they can necessarily hide, and I think its impossible to accurately know what kind of writedown to expect in one situation versus another as for the reasons noted above (lacking information about L3-related assumptions vs. the here-to-fore observable market prices). They could be huge, they could also be minimal, there’s really no way to know as per above. I’ll defer to your expertise on that, and if you’ve got specific projections for writedowns that you expect (as relates to your comment about the future losses to be “less than what you expect”) pre-157 change for CC/CMBS/etc., I would love to see them just as a gauge against what actually ends up happening.

I have not seen any documentation of any expected losses on those areas for the upcoming quarter on a firm-by-firm basis, just expected declines in underlying assets on an industry-wide basis from various ratings agencies. I am also skeptical of this happening to the degree that it has not been adopted and applied retroactively to previous writedowns. In any case though, you would know that they were trying to do reassess losses because of 157-4, as it would be reflected in the change from L2 to L3 valuations, and not be able to be hidden by moving from AFS to HTM, as previously tried to outline.

.IV Example of FSP 157-4 Effect (to Date)

I will use WFC (because they are the only example) to demonstrate what the 157-4 change does mean, how it has been used thus far, and to further provide evidence of why moving an asset to HTM from AFS/T is not related to FSP 157-4 and is purely a function of valuation change inside the FV hierarchy. Here is the copy/paste from the WFC 10-Q (bold emphasis mine):

FSP FAS 157-4 addresses measuring fair value under FAS 157 in situations where markets are inactive and transactions are not orderly. The FSP acknowledges that in these circumstances quoted prices may not be determinative of fair value. The FSP emphasizes, however, that even if there has been a significant decrease in the volume and level of activity for an asset or liability and regardless of the valuation technique(s) used, the objective of a fair value measurement has not changed. Prior to issuance of this FSP, FAS 157 had been interpreted by many companies, including Wells Fargo, to emphasize that fair value must be measured based on the most recently available quoted market prices, even for markets that have experienced a significant decline in the volume and level of activity relative to normal conditions and therefore could have increased frequency of transactions that are not orderly. Under the provisions of the FSP, price quotes for assets or liabilities in inactive markets may require adjustment due to uncertainty as to whether the underlying transactions are orderly. For inactive markets, we note there is little information, if any, to evaluate if individual transactions are orderly. Accordingly, we are required to estimate, based upon all available facts and circumstances, the degree to which orderly transactions are occurring. The FSP does not prescribe a specific method for adjusting transaction or quoted prices, however, it does provide guidance for determining how much weight to give transaction or quoted prices. Price quotes based upon transactions that are not orderly are not considered to be determinative of fair value and should be given little, if any, weight in measuring fair value. Price quotes based upon transactions that are orderly shall be considered in determining fair value and the weight given is based upon the facts and circumstances. If sufficient information is not available to determine if price quotes are based upon orderly transactions, less weight should be given to the price quote relative to other transactions that are known to be orderly.

The provisions of FSP FAS 157-4 are effective in second quarter 2009; however, as permitted under the pronouncement, we early adopted in first quarter 2009. Adoption of this pronouncement resulted in an increase in the valuation of securities available for sale of $4.5 billion ($2.8 billion after tax), which is included in other comprehensive income, and trading assets of $18 million, which is reflected in earnings.

As you can see, FSP 157-4 provides no relief to companies in their discretion of deciding whether or not to carry any asset at fair value or HTM, it only gives them discretion at deciding what prices to use in determining FV. The overall lack of revision industry-wide suggests that WFC’s claim that “many companies” were using the lowest common denominator as fair value is likely overstated in my opinion. Now, you could certainly suggest that firms are lying about their self-admitted belief that they do not anticipate the change to have any future effects (as is presented in the notes under the statement of significant accounting principles); but in the event that it did affect the aforementioned currently active and soon to be potentially inactive markets, they would still be required to disclose any change in estimate, which is what this is, as this is a requirement of GAAP. It is located under the “Significant Changes in Accounting Estimates” portion of the Notes.

Here is the table attached to the previously quoted portion of the WFC F/S:

The following table provides the detail of the first quarter 2009 $4.5 billion (pre tax) increase in fair value of securities available for sale under FSP FAS 157-4.

(in millions)
Mortgage-backed securities:
Residential		$	2,311
Commercial			1,329
Collateralized debt obligations			492
Other (1)			394
Total		$	4,526

(1)		Primarily consists of home equity asset-backed securities and credit card-backed securities.

That example was supposed to show what the effects of FSP 157-4 have been, and what any changes going forward would resemble, from a reporting standpoint. That resulted in a change in the OCI portion of the Stockholders’ Equity statement. It is not a change from AFS to HTM.

.V Stress Tests and Summary

I do not disagree with anything you said regarding the stress tests; I think you are absolutely correct. I do think that TCE will be effected by FSP 157-4 to the extent that a firm can move an asset to L3 and recognize less of a writedown; I do not think they will be able to move it to HTM and hide the fact that any potential decreased writedowns from FSP 157-4. I think the biggest issue financial firms face is the upcoming consolidation rules of OBS vehicles, as well as the writedowns of CMBS/CC/Prime securities. I think the potential effects of FSP 157-4 on those securities is inconclusive at this point, but I do think there is room for potential abuse as per the above examples. Essentially, I think most firms (despite the claims of WFC above) have already been discounting the observable inputs affected by the change of FSP 157-4, which is why you have seen little to no restatement of prior writedowns. If that is indeed the case, I see no reason why that same accounting logic has not already been applied to the other potential areas mentioned, thus my feeling that the actual language issued in FSP 157-4 is null.

Again, it’s not that I don’t think FV accounting matters, because it definitely does. I just don’t think FSP 157-4 specifically matters. I apologize for the length, but I hope it makes sense.

Related posts:

• A few comments about mark-to-market
• Mark to market is beside the point
• Mark-to-market is dead
• What Home-Loan Banks reveal about the effects of mark-to-market
• A reminder about new mark-to-market rules in Europe

The following Bloomberg article points out why I have repeatedly argued that banks will be earning a lot of money, Meredith Whitney’s counter-arguments notwithstanding. It also points out why the likes of John Hempton believe that the FDIC ‘stole’ Washington Mutual from shareholders and awarded it to JPMorgan, a view I have not supported (hat tip Marshall Auerback).  For those of you who don’t think accounting matters tremendously in why banks are going to fare much better than anticipated, you need to read this article.  I have bolded the most significant parts

JPMorgan Chase & Co. stands to reap a $29 billion windfall thanks to an accounting rule that lets the second-biggest U.S. bank transform bad loans it purchased from Washington Mutual Inc. into income.

Wells Fargo & Co., Bank of America Corp. and PNC Financial Services Group Inc. are also poised to benefit from taking over home lenders Wachovia Corp., Countrywide Financial Corp. and National City Corp., regulatory filings show. The deals provide a combined $56 billion in so-called accretable yield, the difference between the value of the loans on the banks’ balance sheets and the cash flow they’re expected to produce.

Faced with the highest U.S. unemployment in 25 years and a surging foreclosure rate, the lenders are seizing on a four- year-old rule aimed at standardizing how they book acquired loans that have deteriorated in credit quality. By applying the measure to mortgages and commercial loans that lost value during the worst financial crisis since the Great Depression, the banks will wring revenue from the wreckage, said Robert Willens, a former Lehman Brothers Holdings Inc. executive who runs a tax and accounting consulting firm in New York.

“It will benefit these guys dramatically,” Willens said. “There’s a great chance they’ll be able to record very substantial gains going forward.”

When JPMorgan bought WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent. Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.

Basically, all of these banks acquired loan books that were marked down tremendously before they went on the books.  Now, they are going to use this to their advantage and run the ‘excess’ cash flow from these assets through the income statement.  John Hempton has been particularly vociferous about the purchase accounting in the WaMu deal.  Because I had puts on WaMu through August 2007, I tend to see Washington Mutual as a bankrupt organization that was destined to fail.  If you read Hempton’s account, he makes an argument for the opposite. It all boils down to purchase accounting.

Purchase Accounting

The purchase-accounting rule, known as Statement of Position 03-3, provides banks with an incentive to mark down loans they acquire as aggressively as possible, said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine.

“One of the beauties of purchase accounting is after you mark down your assets, you accrete them back in,” Cassidy said. “Those transactions should be favorable over the long run.”

JPMorgan bought WaMu’s deposits and loans after regulators seized the Seattle-based thrift in the biggest bank failure in U.S. history. JPMorgan took a $29.4 billion writedown on WaMu’s holdings, mostly for option adjustable-rate mortgages and home- equity loans.

“We marked the portfolio based on a number of factors, including housing-price judgment at the time,” said JPMorgan spokesman Thomas Kelly. “The accretion is driven by prevailing interest rates.”

What about the other transactions: Wachovia, Lehman, Countrywide, Merrill?  I am sure you will find the same dynamic at work.  The article goes on to mention how many of these deals will also be favourable: at least over the short-term – and that  is what matters.  If the big banks can re-capitalize during this recession and we get a recovery, they are going to be able to take the eventual writedowns in stride as recovery will buoy their earnings potential.

Watch Q2 earnings at the banks, because Meredith Whitney and others are expecting a horrendous quarter.  I am not.  I think this accounting swag is going to be a positive for banks and may cause their shares, now under pressure to stabilize or rally.  Key names to watch: BAC, JPM, PNC, WFC, and COF, all of whom have benefitted from purchase accounting.  You should notice that Citigroup is not amongst these names.

The full story is linked below.

UPDATE 3:40PM: Calculated Risk has a story out (Revisiting the JPMorgan / WaMu Acquisition) which suggests that JPMorgan, if anything, under-provisioned for the eventual WaMu losses.  That would suggest a lot of writedowns over the life of the WaMu loans. This is an account that I would tend to believe as the housing market is worse than the baseline case JPMorgan presented after the acquisition (see my post “JP Morgan Chase buys WaMu out“).  Again, I see WaMu as a bankrupt organization that was destined to fail.  Nevertheless, over the short-term, accounting from the transaction can be favourable to JPMorgan’s earnings – and I see that as a net positive for JPM.

Update 540PM: Here is the associated viedo clip.

Source

JPMorgan $29 Billion WaMu Windfall Turned Bad Loans Into Income – Bloomberg.com

Related posts:

• JPMorgan: Beats expectations despite writedowns
• How refinancing helps the likes of Bank of America and Wells Fargo
• JPMorgan has record revenue and $2.7 billion in profit
• Regionals options suffer due to accounting rules
• WaMu on the brink of disaster: has agreement with regulators

Kyle, a long-time reader, recently asked why I think mark-to-market accounting actually matters.  After alI, savvy investors know that accounting does not necessarily change cash flows.  I think his question has a lot to do with not just accounting, but also with the stress tests.

Kyle writes:

My point is that it has really NOT changed, and people are trying to make it seem like it did. To be honest, I’m glad most people do feel that way, because it means those idiots in Congress will hopefully leave well alone. The capital raising that just occurred due to stress test mumbo jumbo has no connection to FSP 157-4. It is a requirement of GAAP to disclose when an accounting change has affected reporting, in order to explain the change. Out of the probably fifty different financial institution 10-Q’s that I’ve looked at, only one, Wells Fargo, indicated that 157-4 had a material impact on their reporting, which it did to the tune of 4B. The other 49 explicitly state, “157-4 had no material impact on our reporting, and we do not expect it to in the future.” It’s in the notes for anyone to read. I just do not understand how an accounting change which explicitly has had no impact on reporting (this is the ultimate point I am trying to make, the rule change was and has been almost completely meaningless), could lead to changes in whether or not a bank is undercapitalized.

Here is my thinking on that issue. I understand what Kyle is saying: FAS 157 guidelines will have no impact on reported earnings. I think it will and that this will alter behaviour. Wells and the Home Loan banks are just two early uses of the 157-4 alterations. Others may follow.

But more important is the affect on future writedowns.  A bank only has to attribute its actions to 157-4 if it is amending prior accounting to reflect a change in asset designation to ‘holding to maturity.’ However, if it marks assets today as ‘holding to maturity’ and then is later forced to write down those assets, these writedowns will not be attributed to changes in the FAS 157 guidelines. So, anticipated future writedowns that would have gone through the income statement from marking to market will now be accounted for as held to maturity. This means the guidelines are affecting accounting and causing the company to report differently. In short: future writedowns for 2009 will be less because of FAS 157.

In my view, it is future credit card, jumbo loan and CRE exposure which will be most affected by this. These are areas where you should expect heavy pressure from securitized assets on bank balance sheets due to deterioration in income from credit card receivables,prime mortgage loans, and commercial real estate loans. What mark-to-market guidelines effectively mean is that banks will not have to reduce capital by nearly as much as had they not marked these assets as hold to maturity.

That is where the stress tests come into play. The stress tests are seen as the make or break for banks i.e. banks that don’t raise enough capital to meet the TCE requirements will be seized by the FDIC and treated to a BankUnited outcome. So the stress tests tell investors what the likely outcome is to be in regards to nationalization. Translation: if you raise enough capital or are well-capitalized enough already to pass the stress test, we’ll leave you alone. You might even be able to pay back your TARP funds. But, if you can’t make the grade in a few months, you will be seized, cleansed, management thrown out, equity reduced to zero, and we will sell you on to private equity concerns or another bank or chop you up into little pieces. This is the IndyMac/BankUnited solution.  Notice that bondholders did not lose any money here.

So, the stress tests and the capital raising exercise have revealed that no one is going to be nationalized unless they can’t come up with the capital.  But since even Citi and Bank of America have been raising capital, few big banks are going to be seized.  You probably saw Huntington (HBAN) and Fifth Third (FITB) coming to market and their shares coming under pressure as a result. But, HBAN said it was going to repurchase $470 million in preferreds immediately after it raised the common equity capital.  Why?  Tangible Common Equity.  This is the measure by which the stress tests are being conducted.  Preferred shares don’t count, so why not issue common and retire preferreds in order to boost your TCE? Remember, pass the stress test and you’re good to go.  Fail and Sheila Bair plays the Grim Reaper on you, your management team, and your shareholders.

My conclusion from all of this building from March on was that bank shares would pop and I said so in April.  Now, the rally has been way over the top and shares have come under pressure as these companies have gone to market for capital.  However, if writedowns from CRE, Prime and Credit Card loans turn out to be less horrible in Q2 and Q3 as I anticipate, shares can rally again and again.  Note, Meredith Whitney takes the opposite view i.e. that major losses are coming for banks – so I am aware of the other side of this argument.

I am left concluding that accounting alters behaviour and has an appreciable impact on share prices, especially when it dictates government intervention.  This is why mark-to-market, tangible common equity, and the stress tests are all significant for the financial services industry.

Related posts:

• What Home-Loan Banks reveal about the effects of mark-to-market
• At least six banks need more capital under stress tests
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• Black: Stress tests and the Big Lie

Back on the 16th, I posted a link to a Wall Street Journal article by James Hagerty which detailed how the Federal Home Loan Banks were able to prevent asset writedowns because of guideline changes to mark-to-market accounting.  I think the implications will be significant.  Here is what the article said (emphasis added):

A change in accounting policies allowed some of the Federal Home Loan Banks to avoid taking big hits to earnings for the first quarter.

Several of the 12 regional home-loan banks recorded losses and eliminated dividends in recent quarters because of write-downs on their investments in private-label mortgage securities. Such securities, packaged by Wall Street firms, don’t carry a government guarantee.

Now, the home-loan banks are benefiting from new guidance from the Financial Accounting Standards Board, or FASB, on the treatment of securities that companies intend to hold until maturity. That guidance allows companies to make a distinction between the portion of any decline in the value of a security they attribute to deteriorated credit quality and the portion blamed on other factors, such as distressed conditions in the market.

Only the part blamed on credit quality needs to be reflected in the income statement; the rest can be put into an account known as "other comprehensive income," which doesn’t affect earnings or calculations of regulatory capital.

The home loan banks say the new guidance allows them to give a more accurate picture of the losses they expect.

The long and short of this rule change is that financial companies will have much greater discretion in how they account for writedowns in asset-backed securities of credit cards, auto loans and commercial real estate (for more on this, see my post “A few comments about mark-to-market”).  In the end, this will bring accounting of asset-backed securities more in line with the accounting for loans.   To the degree that banks believe market prices reflect temporary impairments of assets they intend to hold to maturity, they can decide not to write down these assets.  Moreover, even if those assets wind up permanently impaired and must eventually be marked down, the banks can benefit from earnings in the intervening period between the likely original markdown under previous guidelines and the eventual new markdown under new guidelines.

Therefore, it should now be clear that many writedowns which would have occurred in 2009 will be delayed indefinitely.  In my view, this is a large reason why the financials had rallied so much from the beginning of March.  Moreover, banks are getting new capital from private investors now.  In the Fall and Winter this was unheard of.  Only the best banks had access to equity capital markets.

What this means is threefold:

1. Writedowns will be fewer in 2009 and 2010 as a result of marking assets as held to maturity.
2. With interest margins high, banks are likely to increase large amounts of capital from earned income.
3. Banks also have access to private equity capital and are likely to raise large amounts of capital through those markets.

So, for any given firm with large commercial real estate, jumbo residential real estate or credit card asset-backed security exposure, the stress to raise capital has been greatly diminished.  Overall, this will be a net plus to credit availability.  To be sure, large writedowns are likely to continue.  However, for most banks these writedowns are not going to exceed the capital raised and earned.

Source

Home-Loan Banks Avoid Some Hits – WSJ

Related posts:

• What the stress tests reveal about Obama’s thinking on banks
• A few comments about mark-to-market
• $35 billion in missing writedowns
• The regionals versus money center banks
• Consumer loan delinquencies paint bleak picture

If you read my recent post on How big banks earned so much money this quarter you would see that much of the income at Wells, JPMorgan, US Bank and others came from refinancing old mortgages. While this may be a boon to present income, it is very much a problem for the legacy mortgage-backed securities which contain the old mortgages. Let me explain.

When I was in business school, I took a course on debt markets with Professor Suresh Sundaresan, which was very helpful for me when I later joined a large bank in London. Professor Sundaresan worked at Lehman Brothers in their fixed income and derivatives area in the mid-1980s and was very familiar with all of the debt products we discussed in class.

One thing I found quite useful about the course was its explanation of the mortgage markets and mortgage-backed securities (MBS).  The mortgage market is a lot more complicated than other bond markets because MBS are not like other bonds. There is an embedded option contained in all mortgages, the pre-payment option, which makes valuation extremely tricky. In Chapter 9 of his book on “Securitization and Mortgage-Backed Securities,” which I have just consulted, Sundaresan talks about prepayment risk and what it means to the lower value of MBS.  He says the following in his book:

Mortgages permit the homeowners to prepay their loans. This prepayment provision introduces timing uncertainty into the originating bank’s cash flows from its loan portfolio. For example, if the bank originates a pool of mortgages with a weighted-average rate of 8% and six months later the mortgage rate drop significantly below 8%, say to 7%, then the loan portfolio is certain to experience significant prepayments as borrowers rush to refinance their mortgages with less-costly loans. The lender has a long position in the mortgage loan that entitles him to monthly scheduled payments, but also has sold an option to the homeowners that gives them the right [but not the obligation] to prepay the loan when the circumstances demand it. This means that the bank cannot predict the future cash flows from its loan portfolio with certainty. Clearly, the option to repay will be priced into the loan by the bank and the borrower will pay a higher interest rate on the loan as a consequence.

Here’s the deal. The bank does not want its customers to pre-pay because that means less income from interest payments for the bank. Less income lowers the value of the mortgage. So, pre-payments are bad for anyone holding debt or derivative instruments related to the expected cash flow of those mortgage loans.

As Sundaresan indicates, the originators and MBS packagers understand this and have tacked on a ‘fee’ in the form of a higher loan interest rate to cover their expected pre-payment risk.

Enter the Federal Reserve. To stave off a deflationary spiral, the Federal Reserve has lowered the effective short-term interest rate to zero and it is in the process of buying up shed loads of MBS paper and long-term bonds in order to artificially reduce long-term rates as well. The problem here lies in the term ‘expected’ from the previous paragraph, because the so-called toxic MBS paper now clogging balance sheets are now unexpectedly pre-paying at a record rate. This lowers the expected cash flow from those assets significantly, making the underlying assets worth even less.

Moreover, there is a certain perverse adverse selection at work here because not everyone can get a loan these days. That means that the individuals pre-paying are likely to be the most qualified borrowers. This leaves existing MBS borrower pools significantly worse off.

For example, say you have a mortgage-backed security collateralized by mortgage assets from prime borrowers. We enter a recession and a number of loans in that pool become distressed and a number of the borrowers in that pool default. This means that your MBS asset is worth less.

Simultaneously, interest rates drop unexpectedly and a number of the borrowers re-finance their mortgage meaning they pre-pay the mortgage in your pool. You are not going to get the interest payments that you had expected to receive. Again, this means that your MBS asset is worth less.

What’s more is that because of the recession, credit conditions are unusually tight and only the best qualified borrowers are refinancing. So the borrowers left in your asset pool are net lower-quality borrowers. Translation: you should now expect a higher default rate of those left in the pool. Again, this means that your MBS asset is worth less.

To sum up:

1. You just got the shaft because a recession has meant higher default rates generally.
2. You just got the shaft because of unexpected pre-payment and lower cash flows that result from this.
3. You just got the shaft because your pool of borrowers has been adversely impacted by the Fed’s interference in the MBS market

All of this is very bad for existing or so-called legacy assets.  Moreover, these assets must be marked-to-market to reflect asset value impairment.  So, this will mean massive writedowns going forward.

But, wait a minute, didn’t we just change the accounting rules? Enter new mark-to-market accounting a.k.a. mark-to-make-believe.  Because of the guidance on marked-to-market accounting in FAS 157-e, you can deem these changes to be temporary impairments.  There is no need to mark to market.  Problem solved.

Here’s what Wells Fargo had to say about its marking-to-market last quarter in their earnings release (PDF):

The net unrealized loss on securities available for sale declined to $4.7 billion at March 31, 2009, from $9.9 billion at December 31, 2008. Approximately $850 million of the improvement was due to declining interest rates and narrower credit spreads. The remainder was due to the early adoption of FAS FSP 157-4, which clarified the use of trading prices in determining fair value for distressed securities in illiquid markets, thus moderating the need to use excessively distressed prices in valuing these securities in illiquid markets as we had done in prior periods.

Nice.

And if you think people aren’t fooled by all of this, think again. Bank stocks are way, way up.

Related posts:

• What is a credit writedown?
• The fixed rate mortgage is king again
• Lawsuit: steering mortgage applicants could mean more writedowns
• TALF: A bailout if one reads the fine print
• Alt-A: defaults lie ahead of us, not behind us

I last posted on Thursday before the Easter Holidays in two posts very much at odds with one another.  The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009.  Meanwhile, the later re-post pointed out the continued fragility of the U.S.  economy and banking system and focused on liquidity and solvency as unresolved issues.  I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.

Why ‘Fake’?  This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks’ inherent insolvency becomes a problem.  This means the banking system will remain weak even after recovery takes hold.  The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off.  Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.

The real situation
In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system. Witness a recent post by Nouriel Roubini:

The RGE Monitor new estimate in January 2009 of peak credit losses (available in a paper for our RGE clients) suggested that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding would be at their peak about $3.6 trillion ($1.6 trillion for loans and $2 trillion for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8 trillion; the rest is borne by other financial institutions in the US and abroad. The capital backing the banks’ assets was last fall only $1.4 trillion, leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private sector recapitalization of such banks and after banks’ provisioning for losses. Thus, another $1.4 trillion would be needed to bring back the capital of banks to the level they had before the crisis; and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.

Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.

These constraints, some artificial and others very real, leave the Administration with limited options.

Engineer recovery
With the preceding constraints in mind, we should remember that the first priority of elected officials in Washington is not necessarily to make the best long-term choices for the American people, but rather to get re-elected in order to have the opportunity to make those choices.  It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time – irrespective of whether it is sustainable.

How to engineer recovery is another question altogether.  Here again there are a set of political constraints which make things more challenging.  First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates.  Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.

As a result, the Obama Administration has crafted a plan to circumvent these obstacles.

1. Moderate fiscal stimulus.  The Obama Administration decided not to seek massive stimulus earlier this year because they deemed it non-viable politically.This clears the first obstacle: deficit hawks. Most economists understand that the output gap that has opened up in the American economy is $2 trillion or more whereas the Obama stimulus package was only $800 billion.  That leaves a massive hole in output in the U.S.  Moreover, the immediate effective stimulus is less. Much of this ’stimulus’ will be saved or will not come into play until months from now. Obviously, this is not going to meet the grade (See my comments on this from February).
2. Quasi-fiscal role for the Fed. Having partially assuaged deficit hawks, Obama still needed to close the output gap.  Enter the Federal Reserve.  You will have noticed that the Federal Reserve has added legacy assets as eligible for the TALF program. In effect, this allows banks to slip tens or even hundreds of billions of dollars in so-called toxic assets off their balance sheets. Mind you, these are assets already on the books impairing banks’ ability to loan money.  Under normal circumstances, one would expect the Federal Government to take these  assets out of the system (bad bank, good bank, nationalization) after being given legislative approval to do so.  However, as I have previously stated this approval is not going to be forthcoming.  This is why the Federal Reserve is taking these assets on.  In so doing, the Federal Reserve is taking on a quasi-fiscal role that re-capitalizes the banking system in order to stimulate the economy by increasing credit availability.
3. Quasi-fiscal role for the FDIC. The new PPIP is a similar end-run around Congress.  After all, the role of the FDIC is that it “maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.”  Meanwhile, the PPIP has the FDIC guaranteeing dodgy assets in a massive transfer of wealth from taxpayers to banks and select investors. (See my previous comments on this issue).
4. End of mark-to-market as we knew it.  You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not.  This is one reason that large international institutions which participate in the securitisation markets have taken the lion’s share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets.  But, this should end because of new guidelines in marked-to-market accounting.  However, the new guidelines do have two major implications.  First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses.  Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses.  In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment.  If much of the impairment is real, as I believe it is, we are storing up problems for later.
5. Interest rate reductions. One reason often given for a large increase in writedowns at financial institutions had been the coming reset of Alt-A adjustable-rate mortgages in 2009.  With the subprime writedowns mostly accounted for, a souring of the much larger pool of Alt-A and Prime residential mortgage loans is the real Armageddon scenario. Well, part of this problem has been temporarily relieved because the Federal Reserve has reduced short-term interest rates to near zero and has begun trying to manipulate long-term interest rates lower by buying long-dated treasury securities.
6. Bank margin increases.  Key to the whole program is banks’ ability to earn massive amounts of money and re-capitalize themselves through retained earnings as opposed to shedding assets or receiving additional paid-in capital (see post from last April on these three methods of recapitalising). The market for bank assets is distressed and few banks can get enough capital from private sources or investors.  Therefore, Obama’s plan hinges on the ability to allow these banks to earn shed loads of money as quickly as possible.  If the banks cannot do this, we are going to have a big problem very quickly (Of course, I think they can).

The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other ’stimulus’ has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government’s claims of wanting to increase transparency ring hollow (see my post on Bloomberg’s suit against the Fed as an example of what is really happening).

I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line.

Other positive economic factors

There are a number of so-called green shoots (a phrase coined by Norman Lamont)  of note.

• Jobless claims have plateaued and comparisons to last year are actually declining (see post).
• The U.S. trade deficit is declining significantly as U.S. import demand has fallen off a cliff.
• Inventory liquidation will put U.S. manufacturers in a better position by Q4 and help make quarterly and yearly comparisons favourable.

I linked to the first two bullets of these other factors.  And I wanted to spend a little time on factor number three because I think it is important.  Niels Jensen of Absolute Capital Partners has a very solid write-up on this in his most recent newsletter: (do sign up for his free newsletter because it is quite informative.  Click here to see the newsletters and sign up.)

Turning my attention to the global economy, after a rather muted beginning, manufacturers around the world have now begun to react aggressively to the economic downturn and inventories are falling aggressively. Chart 5 below depicts US manufacturing inventories as published recently by the Census Bureau. Inventory changes can have a meaningful impact on GDP. There is one example from the 1981-82 recession where the inventory correction subtracted 5% (annualised) from GDP in just one quarter. The current inventory correction is very negative for GDP in Q1 and possibly also in Q2, but it is very difficult to quantify the effect it is going to have. We will have to wait and see.

However, as we must remind ourselves, the stock market is not trading on what is going to happen in Q1 and Q2 of this year. Projecting at least 6-9 months ahead, the stock market is probably already looking ahead to Q4 and possibly even Q1 of next year. And the inventory adjustment currently underway is very bullish for GDP growth later this year and into next. The reason is simple. Manufacturers always overreact. Come Q3 or Q4, they will suddenly sit up and realise that inventories have fallen too much and that they need to produce more. There is no reason to believe that this recession will be any different.

Obviously, this means that U.S. Q1 and perhaps even Q2 GDP will be very low due to the subtraction of inventories now being purged. However, when we get to Q3 and Q4, this effect will be gone and quarterly and yearly comparisons will look favourable. So the inventory purge may mean a huge upside surprise to GDP in the second half of the year and early 2010 – potentially enough to see positive GDP numbers.

A brief reminder of what lurks beneath
Despite the positives from the previous section, there are significant headwinds which may even preclude a positive GDP number. They include:

• Rising joblessness
• Increased savings as households rebuild balance sheets
• Spending cuts by local and state governments
• Decreased capital spending by companies
• A calamitous GM bankruptcy

Moreover, credit availability –and hence GDP will be constrained by numerous factors including the following:

• Declining home values
• Increasing foreclosures
• Commercial property writedowns
• Credit card-related writeoffs
• Junk bond defaults

All of this means that a cyclical rebound is not a foregone conclusion at all.

Tying the threads together
You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the ‘green shoots’ because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.

Nevertheless, banks are going to earn a lot of money and that is bullish for their shares – at least in the medium-term. Yes, the stock market is overbought right now.  However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.

Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well.  It is still too early to tell how this will play out over the longer-term.  For now, I am much more positive on financials, and somewhat positive on the broader market as well.

Related posts:

• Discerning a real from a fake, technical, statistical, or partial recovery
• Looking beyond the fake recovery
• The German $400 billion toxic asset time bomb
• Morgan Stanley’s writedowns bring us to a cool $1 trillion
• Seattle Home Loan Bank short of capital

Because I received a message via e-mail that my previous post on mark-to-market was misleading, I thought I would clarify what is happening with FAS 157 and provide some good links.

The long and short of the rule is it gives more specific guidance as to when a market is distressed and an asset must not be marked-to-market as a result.  Moreover, it allows assets which are not permanently impaired to be excluded from mark-to-market and defines the reporting requirement of how to do so.

You should note that only a small percentage of assets on financial companies’ balance sheets are actually marked-to-market, even for money center banks that have written down the greatest amount of assets.  Nevertheless, I do project this rule will reduce the number of writedowns, particularly from residential real estate where bankruptcy and default is not a factor (i.e. temporary impairment).

One other point, I have mentioned before that banks are hiding impaired and distressed assets in Level 3 assets.  This change gives them the ability to do so legally under the current accounting rules (see Buiter’s piece).  You can bet the IASB will soon follow.

The rule change passed by one vote.

Here is what the new rule states (I have highlighted some of the important parts in the beginning):

April 2, 2009 Board Meeting

Determining whether a market is not active and a transaction is not distressed. The Board discussed comment letters received on proposed FSP FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. In response to comment letters and additional feedback received, the Board decided to make significant revisions to the proposed FSP. The Board decided that the final FSP would

1. Affirm that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).
2. Clarify and include additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
3. Eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The FSP will instead require an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.
4. Include an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly.
5. Require an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable.
6. Apply to all fair value measurements when appropriate.

The Board also affirmed its previous decision that the FSP would be applied prospectively and that retrospective application would not be permitted. The Board decided that the FSP would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity early adopting this FSP must also early adopt FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, Recognition and Presentation of Other-Than-Temporary Impairments. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, it must also elect to early adopt this FSP and FSP FAS 115-2, FAS 124-2, and EITF 99-20-2.

The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot.

Recognition and presentation of other-than-temporary impairments. The Board discussed comment letters received on proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments. The Board made the following decisions in response to comment letters and additional feedback received:

1. 1. The Board decided that the change to existing guidance for determining whether an impairment is other than temporary should be limited to debt securities.
   1. The Board decided to replace the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert
      1. It does not have the intent to sell the security; and
      2. It is more likely than not it will not have to sell the security before recovery of its costs basis.
   2. The guidance will incorporate examples of factors from existing literature that should be considered in determining whether a debt security is other-than-temporarily impaired and how those factors interact with the requirement to assert that the entity does not intend to sell the security and it is more likely than not that the entity will not have to sell the security before recovery of its cost basis.
   3. When an entity does not intend to sell the security and it is more likely than not that the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.
   4. An entity will be required to recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses.
   5. The FSP will include guidance stipulating that credit losses should be measured on the basis of an entity’s estimate of the decrease in expected cash flows, including those that result from an increase in expected prepayments.
   6. The guidance will clarify that existing premiums or discounts and subsequent changes in estimated cash flows or fair value should continue to be accounted for in accordance with existing guidance (for example, EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets”).
   1. An entity will be required to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognized in other comprehensive income.
   2. An entity will be required to present separately in the financial statement where the components of other comprehensive income are reported, amounts recognized in accumulated other comprehensive income related to the noncredit portion of other-than-temporary impairments recognized for available-for-sale and held-to-maturity debt securities.
   1. The disclosure requirements of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, will be modified to require an entity to provide the following:
      1. The cost basis of available-for-sale and held-to maturity debt securities by major security type
      2. The methodology and key inputs, such as performance indicators of the underlying assets in the security, loan to collateral value ratios, third-party guarantees, levels of subordination, and vintage, used to measure the portion of an other-than-temporary impairment related to credit losses by major security type
      3. A rollforward of amounts recognized in earnings for debt securities for which an other-than-temporary impairment has been recognized and the noncredit portion of the other-than-temporary impairment that has been recognized in other comprehensive income.
   2. Statement 115 and FSP FAS 115-1 and FAS 124-1 will also be modified to require that major security classes be based on the nature and risks of the security and additional types of securities will be included in the list of major security types listed in Statement 115.
   3. The above additional disclosures, as well as all existing Statement 115 and FSP FAS 115-1 and FAS 124-1 disclosures, will be required for interim periods

Scope

Recognition

Presentation

Disclosures

When adopting the new guidance, an entity will be required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of a previously recognized other-temporary impairment from retained earnings to accumulated other comprehensive income if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery. The cost basis used to calculate accretable yield will also be adjusted to reflect this adjustment (that is, the entity will no longer accrete the noncredit component of a previously recognized other-than-temporary impairment through earnings).

The Board decided that the FSP will be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, or FSP FAS 157-4, it must also elect to early adopt this FSP.

The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot.

Related articles
More Mark-to-Market Myths – Paul Kedrosky
How the FASB aids and abets obfuscation by wonky zombie banks – Willem Buiter

Related posts:

• What Home-Loan Banks reveal about the effects of mark-to-market
• A reader’s excellent comments on mark-to-market accounting
• FASB: Mark all financial assets at fair value
• FAS 157 and the significance of distress versus bankruptcy
• Pre-payments are reducing value of mortgage-backed securities

This comes via Marc Chandler of Brown Brothers Harriman and is an even-handed review of what just happened:

As widely expected FASB modified fair value accounting rules. The key seems to be for assets for which there is not a market. The last traded price does not have to be used. Rather other methods, like discounted cash flows can be used. In essence, previously there was a presumption that if there was not market for an instrument, it is distressed. Within a few hours FASB is expected to make another announcement about the treatment of permanently distressed assets. Financial stocks appear to have led the equity rally in recent days, ostensibly partly on the anticipation of today’s FASB announcement. Although it seems clear that the political pressure was brought to bear on FASB helped expedite the decision, this seemed to be the direction that they were moving. Cynics will claim this is a thinly veiled attempt to disguise the seriousness of the financial crisis and losses being faced. On the other hand, there are many who see the mark-to-market as an unreasonable demand for financial instruments with no markets. Regardless though of the merits or de-merits, the net impact could help boost bank earnings, reduce the need for capital injections and may help encourage participation in P-PIP and TALF programs.

Tyler Durden also has some things to say about the changes in mark-to-market rules:

Well, now that banks are all good in perpetuity, there goes the need for the PPIP. Hopefully this at least means that Bill Gross and Larry Fink won’t make billions compliments of U.S. taxpayers. But don’t take my word for it: the head of the world’s largest hedge fund voices these very concerns. In fact, Dalio is so disgusted by the insanity in equity markets, rumor is he has moved out of trading equities entirely.

It all sounds very much like the S&L rule changes, doesn’t it? Oh, and a reminder of what happened then: S&L’s went on to invest and lend recklessly, making the eventual bailout much, much bigger. Everyone in finance could see this coming from a mile away.

See what I had to say about this in October in my post, “S&L crisis chronology and accounting rules.”

Addendum: I have posted an update called “A few comments about mark-to-market” as the Mark-to-market is dead title was rather misleading.

Related posts:

• A reminder about new mark-to-market rules in Europe
• Paulson’s Economic Patriot Act is about marking to market
• What Home-Loan Banks reveal about the effects of mark-to-market
• S&L crisis chronology and accounting rules
• A few comments about mark-to-market

Marshall Auerback here.

Everyone is talking about marking to market as if its elimination is a silver bullet. So far as the economics goes, I am not sure that mark to market is such a big deal. The whole point of the banks is to make loans and hold them. Look at it this way- why should banks own anything that IS marked to market?

They should only own what they originate, and not buy any securities or other assets, apart from maybe their buildings. They have no reason to have access to any secondary markets. We then give them special protection so they effectively leverage government; they are intermediaries between government and the non-governmental sector. However, I think the objections raised are mostly political: how can the supervisors/regulators resist powerful private interest. And that is why banks must be kept small.

Furthermore, we had ‘mark to market’ when BofA bought Countrywide and Merrill. I don’t think the so-called “transparency” actually helped that much, did it? Banking isn’t a mark to market model, it’s a credit analysis model. You don’t want a banking system that makes a loan to a grocery store based on where it could sell it at 3am on a Tuesday.

The public purpose behind banking is government-insured funding and lending based on credit analysis- coverage ratios, sources of incomes, payment records, etc. etc.- all standards set by the government that does the funding. Banking is a big government loan program that uses private capital with profit incentives presumably to make sound choices to avoid losing their own capital.

When the regulators come into a bank the check all the credit aspects of our loans and if they fall short declare the loans impaired, write them down, etc. etc. If they are not doing that with the major banks that’s a failure of regulation and supervision.

If it turns out the FDIC has been negligent or acting fraudulently by knowingly funding what they have determined to be insolvent institutions as per regulation then they are guilty of what should be criminal activity and get 150 years in the electric chair!

This has nothing to do with gaming the accounting. For an extreme example, we have US Treasury securities that are trading at discount prices of Libor plus 70 basis points. Should banks who hold them take a loss that reflect the price of credit risk for the US government (not interest rate risk- that’s a different story and covered in gap regulation)???

Regulate them like utilities. It will never happen, but that’s the key.

Related posts:

• What Home-Loan Banks reveal about the effects of mark-to-market
• Bradford & Bingley is being shopped by the FSA
• A reminder about new mark-to-market rules in Europe
• Mark-to-market is dead
• Repayments will make banks weaker and could lead to more failures

This news comes via Reuters:

Bank of America Corp is carrying loans on its balance sheet marked at more than $44 billion above their fair value, the company said in its annual report filed with U.S. regulators on Friday.

The bank said it ended 2008 with $886.2 billion in loans, but estimated the fair value — or market price — for these loans as $841.6 billion.

In a related Bloomberg article, an analyst from Friedman, Billings & Ramsey gets right to the point:

“That’s the heart of why these companies are trading where they are,” Friedman Billings Ramsey & Co. analyst Scott Valentin said in an interview. “Technically, if you mark-to- market the entire balance sheet, most of these banks are insolvent.”

Sources
Bank of America SEC Filings
Bank of America Loans Valued at $44 Billion Less Than Books Say – Bloomberg.com
BofA carries loans $44 billion above market value – Reuters

Related posts:

• FASB: Mark all financial assets at fair value
• $35 billion in missing writedowns
• Fannie reports $171 billion in non-performing loans
• JPMorgan’s $29 Billion windfall
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

There is quite a buzz in the German press about Hypo Real Estate.  But, what should really get one’s attention is its massive off-balance sheet exposures (hat tip Ulrich).  The long and short of  reports is that Hypo Real Estate has assets valued at 1 and 1/2 times its entire balance sheet in off-balance sheet vehicles. This would bring total exposure to German taxpayers to a cool one trillion euros (1,000,000,000,000).

While there have been numerous reports of HRE’s imminent nationalization due to the recent law enacted in Germany allowing such, these reports raise the stakes considerably.  If you recall, HRE almost brought German banking to its knees during the Panic in October after Lehman collapsed (See my post “Germany: banking system collapse possible due to Hypo Real Estate“)

At the bottom of this post are a number of media sources in the German and Austrian press on this subject.  Here’s how German blogger Egghat puts it:

So far, here and there, one could read that the balance sheet of HRE was a measly 400 trillion euros. This would make HRE, according to balance sheet assets at the end of 2007, the eight largest bank in Germany. The largest balance sheet total for 2007 belonged to Deutsche Bank, with a little more than two trillion euros.

Yesterday, according to the Hannoversche Allgemeine, several financial experts from the Bundestag confirmed that HRE credit and credit derivative transactions amount to one billion euros, especially in “off-balance sheet activities.” This would put HRE, when we return to the balance sheet rankings fom 2007, basically to 2nd place amongst the largest banks in Germany. Alleluia! Quite amazing that this message has received so little attention in the media so far.

Update 20 Feb 2008 1536EST: Hypo Real Estate has issued a press release in regards to the reports about its off-balance sheet derivatives exposure(hat tip egghat). The text reads as follows:

Hypo Real Estate Group clarifies facts regarding hedge transactions

Munich, 20 February 2009 – Hypo Real Estate Group has clarified facts regarding media reports on its derivatives positions. Hypo Real Estate Group said on Friday that these reports showed a misinterpretation of the Group’s derivatives positions. The Group explained that in fact, the clear majority of these derivative transactions had been concluded in order to hedge against credit and market risks, pointing out that such transactions were regularly disclosed in the annual report.

In line with current practice adopted by other banks and market participants, Hypo Real Estate Group uses derivatives to hedge against credit and market risks arising from fluctuations in interest rates and foreign exchange rates, for example. Such hedges are connected to underlying transactions: the purpose of hedging is to avoid risks, not to enter into additional risk exposures.

Hypo Real Estate Group currently has derivative transactions in its books with an aggregate nominal volume of approx. one trillion euros. In line with accounting standards, the market value (as opposed to the underlying nominal amounts) is carried on the balance sheet. Hypo Real Estate discloses nominal values of derivatives in its annual report. In accordance with accepted market practice, derivatives positions are backed by additional collateral. Only mark-to-market changes in value impact on liquidity; there is no need to refinance nominal amounts of derivatives. “

Sources
Milliarden-Geschäfte stehen nicht in der Bilanz – Standard Austria
Hypo Real Estate erschreckt Berlin: Eine Billion verliehen – HAZ
HRE-Bilanz außer Kontrolle? – ARD Boerse
HRE Bilanzsumme eine Billion? – egghat
Hypo Real Estate Group clarifies facts regarding hedge transactions – Hypo Real Estate, pdf

Related posts:

• Hypo Real Estate need for 10 billion also reveals huge problems in Spain
• Germany: banking system collapse possible due to Hypo Real Estate
• German banks loaded with 816 billion in toxic paper
• The German $400 billion toxic asset time bomb
• The Germans guarantee all savings deposits

Recently, there has been a great push in the United States to ease mark-to-market accounting rules. The financial services industry lobby is putting on a full-court press because it believes that easing mark-to-market accounting rules would alleviate some of the pressure on financial institutions to write down impaired assets.

I will not go into the specifics here, but the crux of the lobbyists argument centre on the pro-cyclicality of marking-to-market. Essentially, in good times, asset values are high. Marking them to market gives financial companies a false since of capital strength. However, in bad times when asset prices fall, depressed pricing can lead to phantom capital shortfalls for institutions.

This argument is also one used to dismiss nationalization as an option for banks and to support the Geithner plan. The view here is that recapitalizing banks and buying up bad assets will reduce the pro-cyclical nature of mark-to-market and make it abundantly clear that banks are suffering illiquidity and not insolvency.

That is what is happening in the United States. Danielle, a European reader, recently asked what is going on in the European Union regarding mark-to-market. Basically, the EU has already relaxed mark-to-market requirements as an outgrowth of the market turbulence surrounding Lehman Brothers’ bankruptcy. Below is an October article from Business Week highlighting the key issues.

The European Commission on Wednesday (15 October) changed EU accounting rules to help banks avoid sharp drops in the value of their assets at times of market volatility, such as the present financial crisis.

The move on “mark-to-market” accounting—made by the commission’s accounting regulatory committee—has unanimous support from EU member states and will apply for 2008 third quarter corporate results, due to be published soon.

Under current mark-to-market accounting rules, company assets are valued on the basis of the price they would fetch if they were offered for sale on the market right now instead of what they would be valued were the company to hold on to them until maturation.

During the current crisis, banks in particular have seen their assets plunge in value because of mark-to-market valuation of “sub-prime securities”—financial assets based on loans to borrowers at risk of defaulting—with experts saying the banks’ losses would have been much lower if they were valued on the maturation date basis.

The current practice can create a downward spiral in which companies seem to be insolvent.

But under the commission’s new proposals, banks and other companies can optionally reclassify assets from the “held-for-trading” category to the “held-to-maturity” category, avoiding the trap.

“The current financial crisis justifies the use of reclassification by companies,” the commission said in a statement.

“In these circumstances, financial institutions in the EU would no longer have to reflect market fluctuation in their financial statements for these kinds of assets.”

I am not taking a view on mark-to-market in this post, but presenting the information for your benefit.

Source
EU Eases Mark-to-Market Rules – Business Week
SEC rejects bid to suspend mark-to-market rules – San Francisco Chronicle
Robert Rubin Says Mark-to-Market has Done ‘Damage’ – Bloomberg.com

Related posts:

• Mark-to-market is dead
• Paulson’s Economic Patriot Act is about marking to market
• What Home-Loan Banks reveal about the effects of mark-to-market
• Mark to market is beside the point
• Regionals options suffer due to accounting rules

Below is my translation from an excerpt in the Swiss newspaper NZZ:

In 2008, the lucrative business with loans to U.S. students came to an abrupt end. Today, UBS sits on paper that could still be worth $8.4 billion – or less. The collapse of the market for student loanshas increased the barrier to a good education for young Americans.

Sebastian Bräuer, New York
Chris Croteau knows UBS only by hearsay. He has no account with the Swiss bank. Nevertheless, there is a fatal connection between the derivatives operations of UBS and the fact that the young man from New Hampshire was on the verge of interrupting his studies.

In the autumn of 2006, the now 20-year old, began to study Business. In order to pay the usual high tuition fees, he took out a loan. A foundation of his state (NHHEAF) awarded favorable loans to students…..

In February 2008 something happened, which UBS later sheepishly described as a “surprising and unexpected result of the U.S. subprime crisis”: Auctions [for student-loan backed securities] were no longer established. There were no more investors. That has not changed: The ABS market is frozen.

For the students in New Hampshire, this had a direct effect: One month later, the NHHEAF stopped awarding new loans. In the previous year the Foundation had funded $67 million in grants that supported 6000 students. “In 2008, demand would have been just great,” said NHHEAF spokeswoman Tara Paine. Thousands of students have had to seek private loans.

The result of the credit crisis has been two-fold:

1. Students have bee cut off from funds that were previously available.  This makes college unffordable for some. 
2. Banks like UBS are sitting on massive losses in student loans as a result of the downturn in this market and in the economy. Whether these writedowns are excessive because of mark-to-market accounting is hotly contested – hence the abuse of reclassification of assets as Level 3 assets.

I mention this story because it gives one a real understanding of what happens when the credit markets seize up. I first highlighted the implosion of thestudent loan market in May and then again in October. It is not just about over-leveraged subprime borrowers. There are other very real consequences. I think it is tragic that many young people might be denied an education because of this situation.

Moreover, this story highlights the degree to which there are many more credit writedowns which still need to be taken. For a troubled institution like UBS, taking these writedowns here and now could be fatal. In my view, this is yet another concrete example of the fragility of European and global banking.

At the end of December UBS had Asset-backed securities with a market value of $12.9 billion, of which $8.4 billion were based on student loans. The sum is only a vague estimate, because there is currently no demand. What the paper is really worth, is controversial. “The asset-backed securities could be worth 20 to 30% more in value,” says Sean Egan of the independent rating agency Egan-Jones. That does not benefit UBS, however, long as they cannot find buyers. Egan believes interest by private investors will likely return in one to two years at the earliest.

Until then, the ABS’s are a ticking time bomb. In the worst case, they must be written down. How much and how fast is a matter of accounting rules. In the last quarter, UBS reported a writedown of $ 1.2 billion – without a refined reclassification of assets, the bank would have had to report a trading loss of $4.2 billion.

Source
Die UBS sitzt auf Milliarden geplatzter Studentenkredite – NZZ

Related posts:

• Student Loans: New Credit Crunch Casualty
• What is a credit writedown?
• What Home-Loan Banks reveal about the effects of mark-to-market
• Deutsche Bank and HBOS hit by writedowns
• New Writedown Risk: Alt-A

UPDATE 26 Mar 2009: You should note that I have reluctantly gotten onboard with this plan. My motivation is simple: too much time has passed and this is the plan we have to work with. It is a workable albeit unfair plan and there is no time to craft another. So, let’s keep our fingers crossed.

The original post is below.

The title of this post is fairly provocative and categorical. This is by design. For I see Obama’s banking plan as more of the same — not ‘change we can believe in.’ And we all need to be clear about the need for Obama and his team to correct their course of action. Whilst there may be plenty of other reasons to support the President, this is not one of them.

Now, late last year, I predicted that the Obama Administration would not change course significantly on the economic policy front. This was largely due to the make up of his proposed cabinet and their previously stated positions on economic policy. Frankly, they are subject to cognitive regulatory capture and beholden to the same special interests in the financial sector that the Bush Administration were.

Rather than repeat myself, I would like to use today’s commentary from Christopher Wood of CLSA to demonstrate my point. Wood is a well-regarded investment strategist based in Asia who in the early 1990s wrote the book, “The Bubble Economy” about Japan’s own tussle with debt deflation and deleveraging. He now writes a newsletter for CLSA appropriately called GREED & fear. Clearly he knows a thing or two about banking crises. I have highlighted the most interesting bits.

US Treasury Secretary Tim Geithner failed to deliver any hard details on what the Obama administration plans to do about the banking system. This is shocking to GREED & fear because it is such an obvious public relations disaster. If the Obama administration has not yet figured out the best way forward on the banks, it would have been better to have said nothing at all rather than disappoint expectations so much. But beyond the public relations issue, it is also shocking that after so many weeks to think about what should be the key issue for the new Democratic administration, the Obama team has clearly not yet figured out the best way forward. Remember there was an elevenweek interlude between the election and the inauguration. What were they all doing?

The result is that the American policy making establishment is now looking ever more Japanese in its continuing failure to face up to the painful consequences of what is a massive systemic crisis. This is clear from the continuing talk about, and evident desire to resort to, politically convenient “backstops” and “guarantees”. This is also clear from what seems the latest ruse to attempt to jump start securitisation with a massively expanded Term Asset-Backed Securities Loan Facility (TALF). That is to provide sweetheart non-recourse financing to hedge funds and the like to buy asset-backed securities. In GREED & fear’s view this effort to get the game going again is doomed to fail. But it is also a shocking misuse of taxpayers’ funding. Yet, unbelievably, the case for recognising reality and “nationalising” the worst banks is still deemed as way too “radical”.

In a nutshell, Geithner is unwilling to nationalize any banks, preferring to roll the dice on a scheme whereby the Fed and the Treasury buy up toxic assets in order to provide liquidity to the market for those assets. The theory here is that these assets have fallen in value by much more than is necessary. If the market for the assets has more liquidity, these assets would rise in price and the problem of poor bank capitalization would be solved.

But, is that really true? What if many of those assets have a lower real valuation than is presently used on banks’ books? What if the government is creating a market in something that is still overpriced? Remember, we still have a shed load of commercial real estate loan, credit card loan and auto loan losses to writedown.  Add in the leveraged loan, student loan, and prime mortgage loan writedowns and you have a problem.   Under that scenario, FAS 157  – otherwise known as mark-to-market  – comes into play in a negative way. And that would mean everyone needs to mark those assets down, not up.

Now, I am not saying that the ‘toxic’ securities have further to fall at all. The fact is no one knows how much some of these derivative instruments are really worth (in part because the economy has yet to bottom and the scale of credit losses is not yet known). However, while making a market in illiquid markets is a commendable thing, I fear Geithner is playing a very risky game. Moreover, this is the exact same plan that Henry Paulson presented us originally under the TARP (Troubled Asset Relief Program). We have seen this all before.

Let’s get back to Woods’ comments for a second because he makes a few notable additional comments about the politics of this. Again, I have highlighted the appropriate areas.

The result is that GREED & fear’s fears about the dysfunctional nature of Obama’s economics team look at this juncture ever more justified. Hopefully, the US stock market’s bearish response to Geithner’s ill-fated press conference this week will prove a wake up call for a president whose political honeymoon is already over. But for now this looks like a continuing misguided effort to create an economic policy via committee consensus when what is needed is firm leadership from the top. GREED & fear is also beginning to wonder if the new president understands conceptually what is at stake with the banking system. It is natural that he wants to leave the technicalities to the experts. But there is a need here for the president to govern and that means taking responsibility for the most important policy decision. That is not the fiscal stimulus or what to do about the housing market. This is why mundane waffle about the merits of the mostly pork barrel fiscal stimulus is not sufficient. It also does not inspire confidence that Obama delegated the drafting of the fiscal stimulus to House of Representative Democrats.

The other interesting and also troubling development is the news reports over the past week that Paul Volcker, chairman of the President’s Economic Recovery Advisory Board, is upset that he is being sidelined by the Director of the National Economic Council, Larry Summers, in the formation of economic policy. One point would seem clear. That is that GREED & fear finds it hard to imagine that policies based on backstops, guarantees and non-recourse loans to hedge funds and the like would find the wholehearted endorsement of the former Fed chairman. Volcker surely understands what need to be done. That is to get rid of the zombie banks, whatever the cost to bank shareholders and bank bondholders. For this is a problem of solvency, not liquidity……

GREED & fear would also say that offering private investors non-recourse taxpayer-financed financing to buy asset-backed securities is also not in keeping with the times. And indeed it is likely to prompt a hostile response from Joe Sixpack. In this respect nationalisation of the bust banks and separation of good assets from bad assets is the only honest way forward, politically, for dealing with the current escalating mess in the American financial system. In this respect GREED & fear is of the view that ordinary Americans want to be told the truth and are fed up with gimmicky solutions involving adding debt on debt. It is also the case that the Obama administration risks a populist backlash on any policy based on bailing out banks. This is why it is even more amazing that Obama does not understand the political appeal of the nationalisation option.

I would agree whole-heartedly with thrust of this argument. President Obama has a limited window of opportunity here. He will need to decide the correct path and delegate appropriately. Sidelining Paul Volcker for Larry Summers does not leave one with a good tingly feeling. Bailing out banks when populist sentiment is rising shows a tin ear to the shift in national sentiment. On the whole, I am very worried that Obama does not see the poor optics of all of this. Politically, this is not a good plan.

When Obama spoke to Terry Moran of ABC News about all of this recently, he suggested that his plan is actually crafted because — despite rising populist sentiment — Americans will not tolerate nationalization. The exchange went as follows.

MORAN: There are a lot of economists who look at these banks and they say all that garbage that’s in them renders them essentially insolvent. Why not just nationalize the banks?

OBAMA: Well, you know, it’s interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what’s called “The Lost Decade.” They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn’t see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.

And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.

I suggest that Obama try yet more ‘tough love’ because this plan is not going to cut it.

Sources
Fiasco – Christopher Wood, CLSA
Obama: No ‘Easy Out’ for Wall Street – ABC News
No Tough Love for Bankers – Robert Scheer, The Nation

Related posts:

• Roubini: Nationalization “fully on the table” in Geithner’s Plan
• The Paulson plan is not going to make it
• Geithner and Summers consolidate power
• Congress does need to act on the Economic Patriot Act
• FDIC Chairman Sheila C. Bair Statement on the Legacy Loans Program

An issue that has received scant acknowledgment in the media is the likely hole in pension funds books resulting from the recent rout in shares. Pension funds must invest the money they receive today in order to provide pensioners funds tomorrow. The problem is that pension funds have been overestimating the likely returns for years and now that we have hit a rough patch in the economy this poor actuarial accounting is about to catch up with them.

Volatile markets have saddled U.S. companies with a $409 billion deficit on pension plans, reversing a $60 billion surplus a year earlier, and will cut into earnings in 2009, consulting firm Mercer said.

As of December 31, pension plans among members of the Standard & Poor’s 1500 had $1.21 trillion of assets and $1.62 trillion of liabilities, Mercer said in a report released on Wednesday. At the end of 2007, pension plan assets totaled $1.66 trillion and liabilities totaled about $1.6 trillion, Mercer said.

The S&P 1500 is a broad portfolio representing large-cap, mid-cap and small-cap segments of the U.S. equity markets.

The shortfall suggests that more companies will have to pump cash into their pension plans to ensure they can meet their commitments to retirees.

Mercer estimated pension expenses will increase to about $70 billion this year from $10 billion in 2008, reducing overall profitability by about 8 percent.

“The decline in funded status will be capitalized and reflected in corporate balance sheets for many companies,” Adrian Hartshorn, a member of Mercer’s financial strategy group, said in a statement.

He said this will reduce balance sheet strength and could affect companies’ ability to make capital expenses, meet loan covenants and preserve their credit ratings.

Edward here. The fact is that pension funds have systematically used excessive projected returns in order to avoid paying into the fund. In fact, pension funds have been a large source of earnings for most companies.

How does this work? Say, you are an international company called American-British Consolidated. Each year, your workers contribute $100 million to their pension plan. In return, they are guaranteed a certain payout for life. This is called a defined benefit plan — something companies now loathe because they are on the hook for payouts. So they increasingly switch to defined benefit plans, or so called 401K’s.

Now, under Generally Accepted Accounting Principles (GAAP), one must calculate an estimated payout schedule and its net present value after subtracting the employees’ $100 million contributions All of this is complicated and requires assumptions on average life expectancy as well as average pension fund return.

Here’s the thing: if you run the numbers and they come too far short, you MUST cough up more money right now, today, to make the fund whole. What to do? Make optimistic assumptions, silly. If the fund returns 10%, that makes a future payout much less onerous than if the fund returns 7.5%. Everyone knows that.

Only during bear markets do these tactics come to light. Witness the following proposal from 2001 during the last bear market, still accessible on General Electric’s site (I have bolded the most important bits):

The Communications Workers of America Pension Fund, 501 Third Street, N.W., Washington, D.C. 20001-2797 has notified GE that it intends to submit the following proposal at this year’s meeting:

“Resolved that the stockholders request that the Board of Directors take the steps necessary to adopt a policy that future executive compensation will be determined without regard to any pension fund income, so that the compensation of senior executives will be more closely linked to their performance in managing the business.

“Supporting Statement: Accounting rules require the Company to include gains on the assets in its pension fund in calculations of income, even though no money is transferred to the Company. This distorts the principle of pay for performance because the Company relies on net earnings and earnings growth in determining the compensation of executives.

“GE reported $1.7 billion in pension income in 2000. According to a recent study by Credit Suisse First Boston (CSFB), this is the second largest amount reported of all companies in the S&P 500. This pension income amounted to 9.4% of GE’s reported pre-tax income for the year.

“While the impact of earnings calculations may vary, GE’s top five executives were given cash bonus awards of $23.7 million in 2000. They were given restricted stock units worth $89 million. They were given long-term incentive awards contingent on financial performance over a three year period, and were paid $58 million pursuant to the contingent awards that were made in 1997. In addition, they were given options with a potentially realizable value of $422 million if future earnings permit GE stock to appreciate at an annual rate of 10 percent over the option term.

“Executive compensation ought to be based on performance. It should not be distorted by ‘pension income,’ because that item of income does not represent money the Company has actually received, and does not reflect the operational performance of either the Company or its executives.

“As Business Week reported on August 13, 2001, when companies ‘are inflating earnings with income from pension plan assets, … their [reported] results look better than what’s really happening with their business.’ For this reason, a Morgan Stanley Dean Witter report declares that ‘net gains from pension assets do not deserve the same valuation … as true operating income.’

“A related concern, according to The Wall Street Journal (June 25, 2001), is the possibility ‘that companies can use pension accounting to manage their earnings by changing assumptions to boost the amount of pension income that can be factored into operating income.’ According to Business Week, ‘Companies can not only play around with the expected rate of return on assets but also with the value of the assets themselves.’ They can also boost pension income at the expense of employees and retirees by reducing anticipated benefits or withholding improved benefits.

“CSFB identifies several companies that ‘increased their expected rates of return on plan assets in 2000 even though their actual returns on plan assets declined.’ While such increases may well be an appropriate exercise of discretion, the proposed policy would reduce any temptation that senior executives may have to ‘use pension accounting to manage earnings’ for the purpose of increasing their own compensation.”

Your Board of Directors recommends a vote AGAINST this proposal.
This proposal requests the Board to make future executive compensation determinations without regard to reported pension fund income, purportedly to link more closely executive compensation to business performance. As discussed in the Compensation Committee Report at pages 16-19 (Compensation Committee Report), executive compensation is already closely linked to the performance of internal business units and to the appreciation of GE stock – which in turn is linked to GE’s overall business performance. Because your Board believes that senior executive compensation is already closely linked to business performance, and therefore to the long-term interests of the share owners, your Board believes this proposal is unnecessary and recommends a vote against the proposal.

Now, here’s the great thing about pension accounting. If your numbers are good enough, not only do you avoid a shortfall, you actually receive a windfall profit. Just as shortfalls must be topped up, windfalls must also be recorded and fall proportionately to the bottom line of the company. You will notice, however, these are phantom profits because they are non-cash items.

At issue with GE in 2001 was the fact that General Electric received nearly 10% of its earnings from fictitious, non-cash based net contributions from its pension fund. These profits boosted the bottom line and helped executives make a lot of money as their pay was directly and indirectly linked to the company’s profit. Some shareholders did not like this, so they issued the proposal quoted above. Of course, as you saw, the Board of Directors recommended shareholders vote against the proposal. So, the proposal failed.

Now that we have seen another massive drop in market returns, proposals like this are likely to resurface — especially given the $400 billion shortfall that Mercer foresees. We shall see if these new proposals have any more success than the ones in 2001 and 2002.

Source
U.S. companies face $409 billion pension deficit: study – Reuters
Share Owner Proposal No. 6 – GE Annual Report 2001

Related posts:

• Lehman pension shortfall is a foreshadowing
• JPMorgan’s $29 Billion windfall
• What Home-Loan Banks reveal about the effects of mark-to-market
• Chart of the day: social security and medicare
• FASB: Mark all financial assets at fair value

It wasn’t until I read about a massive writedown by a German bank associated with the bankruptcy of Lehman Brothers that I started to connect the dots. But, there is a hidden flaw in our accounting system which accounts for some of the distress associated with the Lehman bankruptcy. And it all leads back to marking to market.

As you may know, marking to market is a practice mandated under a rule called FAS 157 issued by the Financial Accounting Standards Board (FASB). This ruling has been fairly controversial as the fair value accounting instituted has meant large writedowns as asset values have fallen. FAS 157 is pro-cyclical. Basically, it says that any security which is freely traded in liquid financial markets must be accounted for on balance sheets at the price determined by the marketplace.

On its website FASB says:

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).

What that should mean to you is that financial institutions have been and will continue to write down assets on their balance sheet as they fall in the free market except when prices are the result of a distressed/forced sale. That exception is significant because it gives an out to banks which would be writing down their asset values even more right now.

Back in March, the SEC said the following (my highlighting):

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale.

Translation: hide your bad assets in Level Three Assets that you are allowed to mark to make believe if you don’t want to mark to market.

But, what happens when a company is not just distressed but goes bankrupt? What happens to the debt issued by that company? What happens to the Credit Default Swaps associated to that company? A ha, this is the problem.

HSH Nordbank AG’s write-down of EUR450 million unveiled earlier this week is largely due to exposure to the collapsed investment bank Lehman Brothers Holdings Inc., a person close to HSH Nordbank told Dow Jones Newswires on Thursday.

A structured credit portfolio with a nominal value of EUR600 million is composed “mainly” of Lehman paper, the person said. On Tuesday the bank said that the value of the portfolio had to be written down to EUR150 million.

In November, HSH Nordbank said its losses from Lehman exposure amounted to EUR140 million.

You see where this is headed? We’re back to mark to market, essentially. Before Lehman went bankrupt, I’m thinking one could mark Lehman CDS paper to make believe. When they went bust, that game was over because the credit event meant it was time to settle and those writedowns came onto the books.

As I see it, this is another reason why Mssrs. Paulson, Bernanke, and Geithner erred in allowing Lehman to go bankrupt in the way they did. If any other company were to go bankrupt the way Lehman did — and if there is a huge volume of CDS paper associated with that company (think General Motors, Citigroup), then…..Bang!

Sources
HSH Nordbank EUR450 Million Write-Down Mainly Due To Lehman Source – CNN Money
Summary of Statement No. 157 – FASB Website
Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements) – U.S. Securities and Exchange Commission

Related posts:

• The regionals versus money center banks
• A reminder about new mark-to-market rules in Europe
• I got my answer on homebuilder bankruptcy
• Level Three Assets: banks are hiding the ball on credit writedowns
• Paulson’s Economic Patriot Act is about marking to market