August 21, 2009

How Accounting Exacerbates the Financial Crisis

Posted in Banking, Finance, investments, Uncategorized tagged , , , , , , , , , , , at 5:58 PM by Robert Barone

In a commentary posted on Bloomberg on August 12th (reiterated in Seeking Alpha on August 16th), Jonathan Weil bemoans the apparent discrepancy between the carrying or book values of some bank loans and their “fair-value”.  Bank of America and Wells Fargo are cited as having large discrepancies ($64.4 billion for BAC with total Tier 1 capital of $111 billion, and $34.3 billion for Wells with total Tier 1 capital of $47.1 billion).  Weil also says that this is true of half of the 24 banks in the KBW Bank Index including SunTrust and KeyCorp.

Banks have a choice in accounting for their loans and can use “fair-value” accounting if they so choose, he says, but nearly all choose not to “on the grounds that they intend to keep them to maturity and hope the cash rolls in”.  He concludes, “the difference between being well capitalized and woefully undercapitalized may come down to nothing more than some highly paid chief executive’s state of mind”.  Sounds foreboding, doesn’t it?

Those who continue to push “mark-to-market” accounting onto bank balance sheets, like Mr. Weil, fail to recognize what “fair-value” means, the nature of bank balance sheets, and the dire consequences that will occur if such accounting is imposed.  Let’s not forget that the low point of the financial crisis passed when the FASB suspended some of the “mark-to-market” accounting rules earlier this year.

What is “fair-value”?

Let’s start by defining what “fair-value” isn’t.  It isn’t what some speculator is willing to pay for an illiquid asset during a financial crisis.  We are too consumed with the bid-ask regimen we see daily in the stock exchanges.  Most transactions don’t work that way.  Shoppers find different prices for the same or similar goods at department stores than they do at Wal-Mart or Target.  When there is no ready or liquid market for an asset, “fair-value” is not some speculator’s low ball bid.  When bid prices for bank loans are ridiculously low, “fair-value” should be measured in some other way.  FASB even says so!

For example, if the loans are current and have been paying consistently and there is an expectation that they will continue to do so to maturity, then “fair-value” is more likely to be measured by their discounted cash flow – unless, of course, we expect Armageddon, which clearly Mr. Weil expects.  But, if that’s the case, who the hell cares about this topic?

Nature of Bank Balance Sheets

Think about what a bank does.  It makes its money by turning fairly illiquid assets (like real estate, autos, receivables, etc.) into liquid assets.  It does so by putting the illiquid assets on its balance sheet and giving the borrower access to cash.  To now attempt to price such illiquid assets at prices which will “blow them out” in a short period of time is pure folly.  Anyone who understands an estate sale or what happens in a forced liquidation of a retail business knows that the prices paid by the buyers are significantly below what “normal” market prices would be.  So why do we want to impose this on our financial system which has worked pretty well for the past 70 years?

To be fair to Mr. Weil, he does acknowledge, at the end of his piece, that “fair-value” estimates in the short-term can be a poor indicator of an asset’s eventual worth, especially when markets aren’t functioning smoothly.”  He also quips that “at least now we’re getting some real numbers even if you have to dig through the footnotes to get them.”  To which I would reply, “why isn’t footnote disclosure enough?”

Consequences

The imposition of marking illiquid assets to a speculator’s bid will have dire consequences for economic growth.  Financial institutions will be forced to significantly lower their loan-to-value ratios (LTV).  The norm for a single family home or a condo is somewhere between 80% and 95%.  With the imposition of “mark to illiquid market accounting”, the LTVs would fall significantly, maybe even to 40% or 50% as banks would be forced to protect their capital from loan mark downs during economic slowdowns.  Talk about a deflationary spiral!

Under this scenario, if LTVs for homes fell from 80% to 50%, the price of the home would have to fall by about 60%.  For example, if a buyer has $40,000 down (most don’t have this much) on a $200,000 home (LTV of 80%), if the LTV were to drop to 50%, this buyer could only afford an $80,000 home.

Conclusion

Already the financial system’s capacity has been significantly reduced.  I’ve seen well researched studies indicating that the existing refinance needs over the next five years cannot be met with current capacity.  Just think of the havoc “marking to illiquid asset accounting” will wreak!

Robert Barone, Ph.D.

August 17, 2009

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

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