It’s been my thesis for a while now that this particular business cycle will be held hostage by the credit writedowns of financial institutions. These writedowns will impair bank capital and restrict lending, which will slow economic growth. The obvious question then is what the heck is a credit writedown and why are they so important.
A credit writedown is a reduction in the value of an asset as it is carried on a company’s balance sheet. As these losses must also be reflected on the income statement, credit writedowns result in massive losses.
I will explain more fully by showing how the asset-backed security (ABS) model of loan origination is riskier than the traditional model and how it has led to credit writedowns. Then I can demonstrate why those writedowns are a problem for economic growth.
(See my Credit Crisis Timeline for the news stories associated with the writedowns and related events during the crisis, the most recent of which you can find here.)
The balance sheet
In accounting, companies use a balance sheet to record the assets and liabilities they have. The difference between assets and liabilities is what remains for shareholders/ business holders. Using double-entry bookkeeping, companies record each asset purchased and sold on their balance sheet twice by offsetting any loss or gain by an equal amounts from assets, liabilities, or equity. This way total assets always equal total liabilities plus equity. (assets = liabilities + equity).
For example, if a company buys a building for $100 million, it would increase its buildings assets by $100 million and simultaneously decrease its cash assets by $100 million. If the company makes a profit of $100 million, it increases its equity by $100 million and its cash by $100 million as well (or marketable securities or other assets, depending on what it does with the profit money).
Loans and Asset-backed securities
So, when a bank makes a mortgage loan at say 6% interest, it gives the home owner the cash, and it receives 0.5% every month for the life of the loan plus one portion of the principal such that at the end of the loan period the mortgage has been paid off. The bank records this loan as an asset on its balance sheet and it debits an equal amount for the cash it loaned out. The profit it should make comes from the interest payments during the life of the loan.
Now, with Asset-backed securities (ABS), what has happened is those loans are aggregated across different mortgage loans in different communities (to diversify risk) and bundled into a large aggregate amount, say $200 million. So, the originator of these loans sells the loans on to the ABS originator, who packages the loan up to sell to investors. The originator receives cash and passes on any risk associated with the loan. So, the loan originator can now record an increase in cash assets and a decrease in loan assets.
Notice, the loan originator is back to where it started before the loan. It’s as if the originating bank never made the loan, meaning it can go out and lend more money to someone else. So, asset-backed securities increase overall credit in the system by freeing up bank capital for more loans. They also put loan risk and loan origination in separate hands creating a dangerous asymmetry.
Loan originators, therefore, are incented to make many more loans because their capital is not tied up in the loans they originate and they now make their money from transaction fees instead of loan interest. In traditional mortgage finance, where the loan originator holds its own loans, the originator only lends to borrowers it believes can repay their mortgage because the originator is on the hook if the borrower does not. In the ABS model, the loan originator doesn’t care about borrower creditworthiness because the originator is not on the hook for credit losses.
In sum, the Asset-backed Model is different from the traditional model in the following ways:
- The loan originator does not hold the loan on its books and can therefore loan out more money to new borrowers again and again. In fact, the number of loans is now not restricted by bank capital, but rather investor appetite for ABS product.
- The loan originator actually has an incentive to make as many loans as possible as its income is now tied to the quantity of loans, whereas in the traditional model it is tied to both the quantity and the quality of loans.
- The loan originator has few incentives to restrict lending to only those it believes will repay because it bears risk only so far as it owns ABS product or keeps its own loans on its books. This means loans are riskier in the ABS model.
Investors
So, we now have $200 million of aggregate mortgage principal to sell to investors as a bond. These particular asset-backed securities are called mortgage-backed securities (MBS). Denominations of our bond will be bought by sundry investors who receive interest every six months which derives from the mortgage payments of the homeowners whose mortgages are collateral for the loan.
Many institutions are MBS originators. The biggest and most important MBS originators are Fannie Mae and Freddie Mac. And investors in these securities include pension funds, mutual funds, banks, hedge funds, sovereign wealth funds, you name it. This is a big market.
What happens if the collateral goes bad because the home owners default on their mortgage? Well, if the collateral goes bad, even for MBSs that have been over-collateralized, losses begin to occur. This means the bonds are now worth less than the original par value of the bond. For example, Merrill Lynch recently sold some $30 billion worth of mortgage-related paper at 22 cents on the dollar to get it off its books. According to FAS 157, tradeable securities MUST be marked to market. Therefore, even had Merrill not sold these securities, they would have to be written down to 22 cents on the dollar — also implying Citibank, UBS, Morgan Stanley and other companies holding the same securities need to do the same — more losses are coming.
In essence, MBSs must be accounted for in one’s balance sheet at market prices. In order to do so, one must run this through the income statement. For example, Acme Bank owns some Mortgage Backed Securities (MBS) that are impaired with a face value of $20 million. If the impairment is 50% so that the market price is $50 instead of $100, these bonds are now to be marked on the balance sheet as $10 million dollars. However, since the balance sheet must balance, this writedown is taken not only from assets but also from equity. Acme creates a loss on investments on the income statement of $10 million that rolls into the equity on the balance sheet as a debit of $10 million in equity.
To repeat, Acme’s $10 million writedown reduces net income by $10 million, which also then reduces equity capital by $10 million and a balancing transaction is recorded in assets by writing down the asset $10 million.
So, what is a writedown? A credit writedown is a reduction in the value of an asset as it is carried on a company’s balance sheet. As these losses must also be reflected on the income statement, credit writedowns result in massive losses. Also, unlike a writeoff, a writedown does not result in a total elimination of the asset from the balance sheet, just a reduction in its carrying value.
Writedowns are bad for the economy
As you probably know, financial institutions have written down $500 Billion globally. That’s a lot of dosh! When securities firms and banks are writing down that much, it turns them into thinly capitalised, fragile financial institutions. They must de-leverage to reduce risk and ensure their own creditworthiness, which means either shrinking their asset base or increasing equity capital or both.
But, there’s no way banks are going to be able to recapitalise enough through asset sales and raising capital alone — the scale of the writedowns is just too large. Banks will have to restrict credit as well. As old credits are repaid at a rate higher than new credit is loaned out, the banks can de-leverage even more. But, this means creditworthy individuals will be turned down for loans they would otherwise get. Just two days ago, I was at a party and a guy there who is a landscape architect told me most of his home builder friends just aren’t getting loans — even for good projects.
Conclusion
So that’s what a credit writedown is and that is also why they are bad for economic growth and it is also why this blog is named Credit Writedowns. The more our banks writedown, the less capital they have available to make new loans. No capital = no new loans = no new business = no economic growth. Until these writedowns come to an end, we are stuck in a low to no growth phase. As to when the writedowns end, that is anybody’s guess.