When genius (finally) gets wise

Aug 19, 2009 17:33 UTC

The people who brought you the Long-Term Capital Management debacle want banks to get serious about cutting their own leverage, applying fair value accounting to a wider range of assets.

Writing with two colleagues in the Financial Times on Tuesday, Nobel Laureate Robert Merton said banks, their regulators and legislators are conspiring to conceal depressed asset prices in order to avoid dealing with the consequences of insolvency. He wants wider adoption of fair value accounting to force banks to fess up to losses and raise more capital.

Speaking on Bloomberg radio, Merton’s long-time associate and fellow laureate, Myron Scholes, concurred.

This is very refreshing, an honest appraisal of the disease still infecting the financial system—leverage—from two prominent economists who learned the hard way that leverage kills.

These days it’s de rigueur to declare that the worst of the recession has passed, that we’re on our way to “recovery.” Never mind that big banks remain insolvent. Take away the government guarantees that provide them cheap financing and protect the value of their assets and many would be at risk of collapse.

As I argued earlier this week, the fall in real estate prices implies huge losses for bank loan portfolios, losses that could wipe out what’s left of their meager capital.  We got another reminder on Monday of just how bad the losses might be. BB&T said it marked down loans acquired from failed Colonial Bank by 37 percent.

A loss rate half again as large, if applied to Citigroup, Bank of America and Wells Fargo, would wash away what’s left of their equity capital. In other words, despite recent capital raises, their leverage remains way too high.

Merton and Scholes know about the risk of leverage. Their hedge fund,Long Term Capital Management, was levered 25 to 1 before losses wiped out capital, pushing leverage to 100 to 1. It took a bailout from Wall Street firms to make up LTCM’s capital deficit and prevent a systemic collapse.

Even after the stress test, big banks are still levered more than  20 to 1. Far higher when you consider losses they are hiding and off balance sheet assets they have not recognized.  FASB has already instructed them to recognize off balance sheet assets beginning next year and their fair value proposals would, if adopted, kick in a year later.

True, it won’t be easy to put into effect. Banks’ existing fair value estimates are highly questionable. It’s not clear what assumptions they’re plugging into internal models in order to arrive at them. That’s why Merton argues estimates should be “independently validated by external auditors.” If that’s expensive or difficult –  well, then that’s a price banks should bear for investing in hard-to-value assets.

One legitimate criticism with fair-value accounting is its procyclicality. Marking assets to market can inflate capital during bull markets and deflate it during bear markets, exacerbating market swings.

But not if regulators respond dynamically to market conditions. As bubbles inflate, regulators should increase capital requirements so that leverage doesn’t get out of hand. That way when markets turn south, banks will be well-capitalized to handle them.

Unfortunately, regulators don’t have the flexibility to be forgiving right now. Banks didn’t build up reserves during the fat years, so regulators must force them to do so during lean ones.

The first step in solving a problem is admitting you have one. Fair value accounting would force banks to admit they still have a leverage problem and, hopefully, inspire regulators to jack up their capital requirements.

COMMENT

Hi Rolfe,Interesting, but a bit late. Removal of mark to market allowed more ‘willful unconsciousness’ of the insolvency of banking and the tsunami to come.As I’ve posted before, I’m a forensic loan auditor. I evaluate residential mortgage loans for violations of federal Truth in Lending laws, among others. Presently, I’m working on audits for commercial loans, and what I’m finding is quite revealing.I’ve known that banks use ‘debt’ and somehow ‘convert’ them to ‘assets’–but I didn’t know *how* they did it. I’ve found the law in the UCC that allows them to do that–though it is tricky and involves other factors.Suffice it to say that banks are woefully underfunded–and it isn’t just the naughty ones dabbling in risky exotic instruments. It’s all of them, domino tipped by the bad boys, and the result will be felt everywhere.CiaoLisa

America’s Japanese banks

Aug 17, 2009 16:04 UTC

A banking system loaded down with hundreds of billions of dollars worth of unrecognized bad debt — Japan in the 1990s? No, it’s the United States today.

And where are American banks hiding their losses?  Among other places, in their loan portfolios.

problem-debt-areas1

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Banks have  written down billions in toxic securities, but many toxic loans are still carried at close to full value.  According to data published by the Federal Reserve late last year, banks are carrying $3 trillion of residential real estate loans and $1.7 trillion of commercial real estate loans on their books for a total of $4.7 trillion.  Dan Alpert at Westwood Capital thinks as much as a fifth of that total could be uncollectable.

“We know lots of mortgage loans are underwater,” he says, describing the situation where the value of collateral has fallen below the principal balance of a loan.  “A majority of the loans banks are holding were originated at the height of the bubble, when securitization broke down.”

When securitization markets were fully functional, banks had been able to package and sell their loans to investors.  When those markets buckled, banks were forced to eat their own cooking — much of it rancid.

Banks argue that loans should not be marked down if they’re still “performing.”  As long as borrowers are meeting their contractual obligations, there’s no reason to take a writedown.  The problem is, this gives banks an excuse to extend, amend and pretend. They can make concessions on loan terms or delay foreclosure notices, if only to maintain the fiction that borrowers will make good.

With real estate prices likely to fall, and stay, 40 percent below the peak, borrowers have a big incentive to renege on their side of the bargain.  This is how we become Japan.  Emergency bailout facilities allow banks that otherwise would have failed under the weight of bad loans to hold those loans to maturity — pretending the bad ones will be paid off in full over time.

In reality, many loans will default and banks will bleed capital for years.   Take commercial real estate.  As the Congressional Oversight Panel has reported, few CRE loans that were originated at the peak will qualify for refinancing when they mature. Banks can pretend they will, carrying the loans at values far above what will ever be paid back.

FASB wants to bring some clarity to the issue.  A plan under discussion would force banks to record loans at fair value on their balance sheets.  But it’s not clear how much good that would do.

One problem is that it’s much more difficult to determine the fair value of a loan than it is the fair value of a security, where more liquid markets with more frequent price quotes make measurement relatively easier.  With loans, banks must rely on internal models.what-loans-are-worth

Banks are now required to report fair value estimates four times a year.  But the most recent data raises just as many questions as it answers.

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For instance, what estimates are banks using in their models?   As Jonathan Weil of Bloomberg noted, Regions Financial carries its loans at 34 percent above fair value, Citigroup carries its loans at no premium.   This could mean Regions faces bigger losses down the road, or it could mean Citi’s fair-value calculation is too charitable.  More likely, it means both.

Determining fair value is largely subjective.  So FASB’s proposal, to make banks adjust their balance sheets accordingly, is imperfect.  It could have a positive impact if regulators use the new information to force banks to raise more capital, cushioning balance sheets from the future writedowns we know are lurking.

But will banks raise enough?  Probably not.  Alpert is highly skeptical that banks’ fair value estimates are accurate: “Given the decline in value of collateral backing these loans, it’s very likely banks are underestimating the severity of future losses.”

So what do we do?  We can start by eliminating government guarantees that allow banks to avoid dealing with the problem.  As things stand, the biggest banks have no incentive to write down loans because the Federal Reserve, Federal Deposit Insurance Corporation and Treasury Department have, in effect, promised them unlimited financing to hold loans to maturity.

As the Japanese can tell you, this is just a recipe for stagnation.  Thanks to a debt bubble that authorities refused to deal with decisively, that country is now entering its third consecutive lost decade.

COMMENT

Christian,That would only happen if interest rates stayed the same, *then* you’d see housing prices reinflate. But with inflation comes higher interest rates, and higher interest rates mean lower prices because the interest makes the asset more expensive to afford.A 600,000 property at 5% is relatively the same as a 175,000 property at 23%. It’s what people can afford that drives housing.Interest going up will cause property values to collapse.

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