What Home-Loan Banks reveal about the effects of mark-to-market
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:
- Writedowns will be fewer in 2009 and 2010 as a result of marking assets as held to maturity.
- With interest margins high, banks are likely to increase large amounts of capital from earned income.
- 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
I fundamentally struggle with this issue, because I see so many people posting about it. The only thing that FSP 157-4 changes, is that it effectively splits the unrealized loss between earnings and OCI. The loss is still there, it’s just a direct to equity adjustment, as opposed to flowing through Income and then subsequently Retained Earnings. The end result is the same, you have less equity, and it is displayed there for any one to see. If anything, now you can tell how much of the impairment they think is permanent, and how much is not. If they’re wrong it makes no difference. The I/S says impairment of x% of the writedown, the SE statement contains the rest. The whole loss is still recognized. Do you really think real and rational investors do not understand or are somehow fooled by this, simply because the effect is split between the I/S and B/S? I just have a hard time believing that.
Kyle,
not all investors are rational and the price of an asset is determined by the marginal buyer so these accounting changes have an effect. Look at how bringing option accounting through the income statement changed behaviour in Silicon Valley.
Accounting matters.
I’m not saying accounting doesn’t matter (I’m an accounting grad student, it better matter!), I’m saying that people are making this out to be something that it isn’t. The price of the asset is still the same as it was before. The extent of any writedown is still recognized to the extent it was before. If you have a loss on the security, it still gets recognized, it just gets recognized in two places. I don’t know, I just find it hard to believe people could be so easily deluded into thinking that because it doesn’t flow through the I/S first, it doesn’t matter. The only potential effect I see it having is on various P/E measurements like as-reported/gaap earnings. There might be a psychological/sentiment effect from moving it from the I/S to S/E, I will agree with that, but nothing has changed from a fundamental standpoint. People with real amounts of money can’t possibly be fooled into thinking that because the writedown is in OCI, its no longer important. Or can they?
I would like to take your view that the information remains the same but the accounting has changed and this means nothing materially, but evidence shows that accounting changes behaviour. Look at what we just witnessed as a result of the stress tests, a massive $40 billion capital raising exercise by banks including Citigroup, which were shunned.
At a minimum, the mark-to-market accounting changes mean an FDIC seizure is less likely for most banks and that is bullish for shares.
Ed,
I’m not sure I follow you on that either. 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.
I hope I’m not coming off as confrontational or anything, but I feel as though I might be. I really enjoy your blog and have been reading it for over a year now, and I have learned a great deal from your posts.
It makes sense that if the banks are able to drag out the write-downs until the losses are realized, then they may be able to cover the shortfalls with using the profits they are generating on the huge margins.
But the problem for the economy at large is that if the benefits of the ultra-low rates are being hoarded by the banks merely to minimize capital raising, then the overall economy is not getting the pick-me-up intended.
And that is going to feedback into higher loss rates that banks need to recover…
I think that’s the thinking behind those who say its better to take-over the banks, remove the bad assets at once, and recapitalize them. It’s not that the banks couldn’t otherwise recover if all the advantages of the Fed policy are used by them for that purpose. It’s that those advantages are lost to the rest of the economy to save the stockholders and managers of the banks.
And later, the price of all this easing will be paid by the rest of the economy.
The question is, is the sole purpose of monetary policy to keep poorly run banks afloat?