I intend to discuss that further in a following post, but in the meantime, I thought that the following two pieces, one by Yves Smith from naked capitalism, Will Banks Start to Walk Their Talk? Don't Hold Your Breath (Mark to Market Edition), and the other by Roger Ehrenberg at Information Arbitrage, Entrenched Managements: Yet One More Reason Why TARP = CRAP, sets the stage by discussing some very relevant points.
The new meme from big embattled banks, starting with Citigroup's leaked Pandit memo yesterday and Bank of America CEO Ken Lewis' declaration that the bank will be profitable in 2009, is that things will be OK and all this talk of nationalization is unwarranted.
I'll reserve judgement till the fat lady sings. The record of financial crises suggests the housing market has lower to go (which is consistent with the notion that prices need to revert to historical norms relative to incomes and rents) and that unemployment is far from its peak (the Reinhart/Rogoff historical comparisions suggest US unemployment will reach 12%).
The flip side is the point made by John Hempton: US banks earn fat spreads, so their earnings power is good (for those who read his detailed post, note some have raised objections to some of his assumptions). That has been enhanced by the Fed's near zero Fed Funds rate. And as we have noted, the fat interest spreads that are good for banks are not so good for borrowers. Yes, some have raised concerns about the requirement that banks participate in various "get the housing market going" programs may work to their detriment, but frankly, we are skeptical that these programs will come close to reaching the number of homeowners Team Obama bandied about.
So the 2009 picture boils down to how much the big banks have in the way of writeoffs, AND let us not forget, how well they do in their trading operations. Ken Lewis seems to still be depicting BofA as a conventional bank, and ignoring that Merrill could deliver losses and further writedowns.
Ah, but relief is coming on that front too. I must confess that I did not watch the Senate hearings, but mark to market looks to be dead. From Bloomberg "Lawmakers Tell FASB to Change Fair-Value ‘Quickly’ ":
U.S. Representative Paul Kanjorski said regulators must act “quickly” to give companies more leeway in applying the fair-value accounting rule that banks blame for exacerbating the financial crisis.
“If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself,” Kanjorski, the Pennsylvania Democrat who leads a House Financial Services capital markets subcommittee, said at a hearing today. Fair-value, which requires companies to mark assets to reflect market prices, has “produced numerous unintended consequences,” he said....
Kanjorski said he isn’t advocating suspending the rule, because such a move would bring back “the very kind of subjectivity and sleight of hand that made mark-to-market necessary in the first place.”
Eliminating fair-value “would diminish the quality and transparency of reporting, and could adversely affect investors’ confidence in the markets,” Herz said. The rule “can help to more promptly reveal underlying problems at financial institutions.”
Guidance being prepared by Norwalk, Connecticut-based FASB will encourage companies and auditors to use their own judgments in valuing assets, Herz said.
You cannot have it both ways. The Senate is trying to pretend it is going to keep fair value accounting in a somehow friendlier form, but friendlier to the industry means the financial statements are no longer reliable. They cannot be trusted. Anyone who thinks so needs to recall the example I keep harping on, Lehman. Even with mark to market accounting, Lehman delivered $100 billion in losses to unsecured creditors on a $600 billion and change balance sheet. That level of misvaluation should be impossible (absent exempted categories like Level 3 assets, which are openly phony baloney). If this wasn't accounting fraud (and I am inclined to believe it was) then the existing rules were so loose you could steer a supertanker through them. Lehman says there is ALREADY too much play in the existing rules, not too little.
You cannot be half pregnant here. Either you have objective standards or you don't. The notion that subjective valuations will be permitted and they won't be abused is utter fantasy.
The reason fair value was implemented, was, to paraphrase Churchill, it is the worst way to value financial assets except all the others that have been tried. Historical cost is misleading in an environment where interest rates can move significantly over the life of the asset. Banks also tended to avoid writing down or reserving against assets until they were clearly impaired. Hold to maturity (which is what is used for loans, and presumably some variant will be the new fair value compromise) has considerable subjectivity.
One bad feature of mark to market is that it it pro-cyclical. That is, as market values in general go up, the value of assets on financial firm balance sheets go up. Say assets formerly valued at 100 are now worth 120. Oh, and guess what? That gain in value increases your equity by 20. If you are a Wall Street firm, you'll pay some to yourself, but you'll lever up the portion you retain. So firms take on more risk even thought their holdings have not changed, merely their valuation. No one had any problems with mark to market when it was making everyone look good. The process operates in reverse on the way down (except those employees still keep paying themselves, funny how that works). Of course, there is another solution, which is to have procyclical capital requirements (higher when prevailing asset prices rise, lower when they fall) and some have been worked out in considerable detail. But that is far too sensible and offers no quick relief to banks desperate to slather lipstick on the pig of their balance sheets.
Some have contended that the death of mark to market is no biggie, such as David Reilly of Bloomberg, who argues that, based on his analysis, it applies only 29% of assets the 12 biggest banks in the KBW Bank index.
First, if you look at the index, it excludes Goldman and Morgan Stanley. Second, Merrill was purchased by BofA AFTER its latest report date, so its inclusion might boost the total a tad. Looking at mark to market and reaching conclusions based on figures that exclude many of the systemically important global trading firms is silly.
Second, 29% is still vastly in excess of their equity. If the elimination of mark to market allows banks to make their valuations of these assets more flattering by, say, 10%, that would exaggerate their assets by roughly 3%, which goes straight to their net worth. For instance, on a quick and dirty pass, Citi's balance sheet (conveniently excluding its roughly $1 trillion in SIVs) is $1.9 trillion and shareholders' equity is $142 billion, or 7.3%. An additional 3% would be an over 41% increase.
So yes, the banks may look just ducky soon. They are going to continue to get plenty of subsidies from the authorities, via super low interest rates. the fancy new facilities that will boost their profits, such as the new $1 trillion asset backed facility (I think TABSF, but I can no longer keep them all straight, which is no doubt part of the point).
In the meantime, the taxpayer will continue to subsidize banks, the banks will get to keep the upside, and (as in credit cards) charge fat spreads. Ain't capitalism wonderful?
If the banks were really doing as well as their PR suggests, they would not need to use the to be launched public private garbage barge operation. Do you think there is a snowball's chance in hell of that happening?
We are going straight down the Japan path: propping up banks rather than forcing them to recognize losses, and providing the same sort of accommodative accounting to boot. All it did for them was kick the can down the road a few years, at considerable cost to its society. But that's what you get when the executive and regulators are unwilling to challenge the primacy of the banking class.
Update 3/13. 12:30 AM: You gotta love Floyd Norris:
If mark-to-market accounting is to blame for the current financial crisis, then the National Weather Service is to blame for Hurricane Katrina; if it hadn’t told us the hurricane hit New Orleans, the city would never have flooded....
Sadly, a victory for the bankers would not help them much. Even if it were true that banks would be held in higher regard now if they had not been forced to write down the value of their bad assets — and that is, at best, debatable — changing the rules now would be counterproductive. Would you trust banks more? Would other banks be more inclined to trust banks?...
Although you would not know it from the angry complaints, the accounting board’s Statement 157 did not require mark-to-market accounting. That was already required under earlier rules. What it did do was clarify how such values should be determined. That stopped banks from defining “market value” as meaning whatever they chose it to mean.
Conrad Hewitt, who was chief accountant at the Securities and Exchange Commission when it conducted a Congressionally mandated review of the issue late last year, said at a recent Pace University accounting forum that he asked all the complainers if they had a better way to determine market value than the one prescribed by Statement 157. None did
Now for the second post:
Citigroup is up almost 80% over the past few days, while Bank of America has nearly doubled. Each CEO has come out with a bullish statement, Citi to the effect of "We're raking it in" while B of A has defiantly exhorted "We don't need no more stinkin' money." These words helped set off a frantic rally, as market sentiment has, almost overnight, been flipped on its head. Could things have looked more bleak last week? I don't think so. But today's feeling was downright optimistic. Did we get a plethora of new data to cause this reassessment? Not that I saw. Have we seen credit spreads dramatically tighten in line with the equity markets bullish rampage of the past few days? Nope. So what gives? At least as it relates to the financials, the key message is this: TARP has turned big-time CEOs into traders with losing books swinging for the fences. Not exactly what Congress or the Treasury had in mind when they decided to bail out the biggest, most complicated financial institutions. With our money.
Clearly much of the price appreciation is due to a vicious short-covering rally that Messrs. Pandit and Lewis kicked off. But the fact is, what do they have to lose? If they can fool us long enough, credit spreads will come in and recovery will become a self-fulfilling prophecy. Otherwise, Congress (read: the US taxpayer) will bail them out once again. Citi, B of A and AIG have each had multiple bites of the bailout apple, so what's another bite among friends? They are inclined to do this because their reputations are already severly damaged; in essence, short of outright fraud, they can't get any worse. Therefore, they are motivated to throw caution to the wind, be super-positive and hope for the best. If new management with fresh reputations were on the scene, the would be much less inclined to release bullish statements without empirical data to back it up. This is a major flaw of TARP: letting incumbent managements stay around. It has created perverse motives that serve neither the troubled institutions nor its shareholders very well.
How are buyers of Citi going to feel if they enter at $2, think it's going to $5 because of Vik's words and then see it crater to $0.80 based on deteriorating fundamentals and the need for additional dilutive equity issuances? i'll tell you how - pissed off. Now you can say "caveat emptor," and you'd be right. But wouldn't you rather have new managements with motivations aligned with those of shareholders, instead of old managements motivated to rehabilitate their reputations? Rather than be so focused on capping pay, how about insisting that a new slate of managers take over as well as some new independent directors? I think this would yield far better outcomes for everyone involved. Congress and Treasury have taken their eye off the ball. Time for a little less populist BS and a little more common sense reform.
p.s. the title of the post, if that wasn't clear, refers to the point made also by the Motley Fool, among others, that its all well and good that the banks are generating some nice income right now from some juicy spreads, but the real issue is the value of the legacy assets on their books and whether or not they are solvent
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