As financial shares take a beating, it is a good opportunity to highlight the differential treatment of accounting for loans and for debentures and securities because this bodes ill for regional banks.
FAS 157
The crux of the difference in how loans are treated for accounting purposes and how debentures/securities are treated comes from FAS 157. This was an accounting promulgation issued by the Financial Accounting Standards Board (FASB), the body that makes the rules for how U.S. companies can comply with Generally Accepted Accounting Standards (GAAP).
FAS 157 addressed the issue of fair value measurements. And it was designed to mark to market all tradeable securities, so that the balance sheets of financial firms reflected the true state of their financial position. FASB’s own words as to its rationale are as follows:
Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.
The net effect of FAS 157, which went into effect at the worst possible time in November 2007, is that it has forced most institutions with tradeable Mortgage-backed securities (MBSs) and derivatives to write down the value of their assets. If a debenture is trading at $90 when par value was $100, that $10 loss must be taken down and run through the income statement as a credit writedown.
Needless to say, financial companies are getting their clocks cleaned by having to write down massive quantities of tradeable securities to fair value. And there has, therefore, been pushback.
A Financial Accounting Standards Board member encouraged the rule-setting body to consider modifying a new standard aimed at getting financial companies to value assets at market prices in light of investor concerns that firms aren’t disclosing enough about their complex securities.
FASB member Thomas Linsmeier today urged two investor participants to convey their criticism of corporate disclosure to the accounting group’s staff at a Securities and Exchange Commission conference held in Washington.
The investor concerns relate to how the so-called fair-value rule, or FAS 157, has been implemented since it went into effect last November when the collapse of mortgage-backed bonds caused firms like Citigroup and Merrill Lynch to take massive writedowns.
–Financial Week, 9 Jul 2008
Translation: securities firms are lobbying FASB to rescind FAS 157 now. The thesis here is that marking to market leaves the securities firms vulnerable to wild swings in the market value of their tradeable assets and, therefore, makes them more volatile and more risky. There is a lot of truth to this statement. However, what is really hurting the industry is the timing of the measure — right when the housing bubble collapsed and writedowns had to be taken on a gargantuan scale. No one would be crying if they were forced to write up their securities due to gargantuan gains in asset value.
Differential treatment of loans
Here’s where additional writedowns by regional banks come into play. When it comes to Mortgage-backed securities and derivative instruments like CDOs, it is the big global financial institutions that play the leading roles. Regional financial institutions are only bit players in this pool of investments.
Smaller regional and local banks are still involved in mortgage lending and lending too for real estate construction and commercial property. However, they hold most of these loans on their balance sheet at book value. They have not re-distributed the risk of these loans in the securities markets as much as the money-center banks.
What’s noteworthy is that these loans are held at book value meaning that they are on the balance sheet as if there has been no impairment to the loans. So, you ask, how could that be when big players have been writing down hundreds of billions? The answer lies in FAS 157. This rule does NOT apply to bank loans. It only applies to freely traded securities. Translation: there are enormous hidden losses on the balance sheets of most regional and local banks from these loans.
Conclusion
The hope was that as the housing market reached bottom and turns up the regionals and local banks would be protected from the type of massive writedowns that the larger security firms have had to do. On the other hand, what if the credit crisis and housing downturn last much longer? Well, then, we have only begun to see the writedowns and many are to come from local and regional financial institutions.
Oh, and they can’t count on being to big to fail and the Fed bailing them out. Maybe that’s why they are selling off.