The Unintended Consequences of the New Mark-to-Market Rules

By Jeff Harding          

I came across this story from the Naked Capitalism and Zero Hedge blogs about the sudden resignation of Charles Bowsher, the Chairman of the Office of Finance of the Federal Home Loan Bank system. This was reported in Bloomberg by Jonathan Weil who interviewed Bowsher.

The FHLB Office of Finance issues and services all the debt for the12 regional Federal Home Loan Banks. And the FHLB has a lot of debt:

…$1.26 trillion as of Dec. 31, making the FHLBank System the largest U.S. borrower after the federal government. The government-chartered banks, which operate independently, in turn supply low-cost loans to their 8,100 member banks and finance companies. If any of the FHLBanks were to fail, taxpayers could be on the hook.

The finance office’s board also oversees the preparation and auditing of the FHLBanks’ combined financial statements. Some of the banks have run into trouble the past year because of plunging values for mortgage-backed securities they own.

I will tell you why he resigned shortly, but let me set the scene first. As you may know the Financial Accounting Standards Board (FASB) caved under political pressure and weakened the mark-to-market (MTM) rules. There has been tremendous political pressure from banks to suspend the rule that requires them to accurately value assets on their books. The banks claim that all the subprime paper and junk mortgages on their books are difficult to value and if they write the values down it would unfairly impact their balance sheets. They claim that this is only a “temporary” problem and they shouldn’t be penalized because of that. They hammered Congress and Congress intimidated FASB and the rule was changed to accommodate them.

This is bad news. I don’t need to go into the details of the new rule (157-e), but suffice it to say that banks won’t have to mark these assets down and the rule gives them an incentive to hold on to them. This means that you can’t rely on the balance sheets of these banks. Wall Street has already figured this out.

Look at this chart from the Wall Street Journal which shows how much some big banks have of these “toxic” assets:

Banks' Subprime Assets

It’s a lot. If you were investing in one of these banks you might think that their capital is substantially less than they report on their balance sheets. Maybe you would think that the value of their stock should be less because these assets might be inflated in value. If you were lending to one of these banks you might think the same thing. Some banks might even be—insolvent?

This gets us back to Mr. Bowsher. He resigned because he wouldn’t sign off on the FHLB audit. Continuing from the Weil article:

“I was not comfortable as an audit-committee member in signing off on the financial statements, after I became aware of the standards and processes for valuing the mortgage-backed securities,” Bowsher told me. …

Bowsher told me he was concerned, in part, with the methods used for determining when losses on hard-to-value securities should be included in banks’ earnings and regulatory capital. The way the accounting rules work, as long as such losses can be labeled “temporary,” they don’t count in net income. …

Bowsher said the process of valuing such assets was fraught with doubt already. “Now if you think about it, the FASB might be changing the whole thing, and everybody might mark their assets up,” he said. “Who wants to be part of that?” …

Tough stands are nothing new to Bowsher. As comptroller general, he was in charge of the General Accountability Office, the investigative arm of Congress. At his direction, the GAO was among the first to warn the public about the brewing savings-and-loan crisis during the 1980s. He testified before Congress in 1994 that there was an “immediate need” for “federal regulation of the safety and soundness” of all major U.S. derivatives dealers. (How’s that for prescient?)

Most recently, in 2007, he led an independent committee that issued a blistering report on financial missteps at the Smithsonian Institution, whose board of regents included U.S. Chief Justice John Roberts.

Now the question for taxpayers is this: If Charles Bowsher can’t get comfortable with these banks’ financial statements, why should anybody else be?

Somebody ought to give this guy a medal.

I forgot to tell you the title of Weil’s article: Honest Man Emerges From Muck of Banking Crisis.

What does this new MTM rule mean?

1. This whole thing is a big fiction to appease the banks. As I pointed out in my article on MTM, just saying something is worth X doesn’t mean it is. The value of these assets could be valued by putting them up for sale (investors will buy them at a fair market price) or going to Markit and starting there as a basis for valuation. Some of these banks are solvent only because they inflated the value of these assets and that is why they don’t want to MTM.

2. Banks will lend less because they really do know the true value of these assets and they won’t risk lending more than what they think is safe by today’s more restrictive loan standards. Just because the new FASB rule allows them to value these assets higher than they are worth, doesn’t mean they are stupid bankers. They will be afraid of what will happen if the recession/depression continues and their borrowers face more deflation of assets thus jeopardizing their loans.

3. Their stock values will remain depressed despite the new MTM rule because their book of bad loans is still accelerating:

The relaxation of fair-value accounting rules won’t prevent bank shares from falling because growth in bad loans is accelerating, according to Goldman Sachs Group Inc.

“Our core view is that banks will not bottom until underperforming asset growth decelerates,” Richard Ramsden, a New York-based analyst at Goldman Sachs, wrote in a report today. “Loans are going bad faster than banks earn money.”

Delinquent loans are increasing at a 3 percent annual rate industrywide, compared with a 2.5 percent rise in earnings before setting aside money for bad loans, Ramsden said.

He estimated that Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. are all carrying commercial mortgages at 100 percent of face value.

4. This may defeat the Treasury’s Public-Private Investment Program (PPIP) which is supposed to rid banks of toxic assets and get the economy rolling again. As I pointed out in my article, Cash for Crap v.2.0: The Public Private Investment Program, that concept won’t work anyway, but the Treasury believes it will. So, what will Treasury do when banks don’t sell these bad assets because the bids may be far less than what the value is on bank’s books? Will the Treasury force them to sell which is a de facto MTM? Will they juice up the deal for private investors so they will bid more for these toxic assets than they are worth? I guarantee that the bids for these assets under PPIP won’t be as high as the banks and Treasury are hoping. My guess is that investors will be looking for returns north of a 20% IRR because of the risk associated with the underlying mortgages.

5. The banks know these assets are worth less than they report. But now this rule gives them an incentive to hold on to them because it inflates their balance sheets (regulatory capital) to their advantage. They don’t want to have to go out and raise more capital because that’s a tough thing for any bank to do now.

6. It will delay our recovery. All of these subprime assets held by banks are just bad investments. The market always cures bad investments by liquidating them at their real market value. Nothing the government can do will change that fact. However, by trying to delay this, the government is doing everything they can to prevent the economy from recovering. The Japanese tried everything we are now doing and they stayed in recession for 14 years. This is just a bailout of the big banks by the taxpayers.