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Financial Cooking

Posted by Larry Doyle on July 5, 2009 8:46 AM |

When business operations make money, it is due to the brains and intellect of management, correct? When business operations lose money, it is some sort of nefarious measure at work in the marketplace which can be ‘corrected’ by changing the rules, correct? The implementation of the relaxation of the FASB’s (Federal Accounting Standard Board’s) mark-to-market utilizes that thought process. Make no mistake, it is flawed and simply allows financial institutions to ‘manage earnings,’ otherwise known as “cook the books.”

We receive a whiff of this recipe in a report by the Wall Street Journal, Home Loan Banks See Net Income Decline 51%. I have maintained that the basic business model of the FHLBs is flawed and we see evidence of this in the fact that outstanding advances (loans) by the FHLBs to their member banks actually decreased in the 1st quarter of this year:

Total advances outstanding from the banks declined to $817.41 billion as of March 31 from $928.64 billion three months earlier. After surging in 2007 and early 2008, demand for those advances has slackened, partly because of the recession and partly because the federal government has offered alternative funding programs for commercial banks.

Without even maintaining the level of advances, the FHLB system is coming under increasing pressure to generate earnings in the face of increasing delinquencies, defaults, and foreclosures on all of their holdings–advances, mortgage originations, and mortgage-backed securities purchased from Wall Street.

In regard to those MBS holdings, the WSJ shares:

During the housing boom, some of the home loan banks invested heavily in so-called private-label residential mortgage securities, packaged by Wall Street firms and not backed by any government-related entity. As of March 31, those securities, purchased for a total of $64.82 billion, were being carried on the books at $59.53 billion and had an estimated market value of $44.75 billion.

The banks are benefiting from recent guidance from the Financial Accounting Standards Board, or FASB, on the treatment of securities that companies intend to hold until maturity. That guidance, announced in April, allows companies to make a distinction between the portion of any decline in the value of a security that 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 must be reflected in the income statement.

This analysis by the WSJ is totally flawed. The FHLB system holds total assets of upwards of $1.3 TRILLION.  Those holdings are broken down as such:

> approximately 65% advances

> approximately 5% mortgage originations

> approximately 30% mortgage-backed securities (Jumbo loans, Alt-A, pay-option arms, sub-prime).

This data is highlighted in my post Freddie Mac, Fannie Mae Deja Vu?

I can only gather that the WSJ has mistakenly characterized the FHLB systems’ own mortgage originations as their total mortgage securities holdings. In doing so, the WSJ has played the role of sous chef for the entire FHLB system. The fact is the FHLB system holds approximately $400 billion in private label mortgage securities.

The WSJ opines that the FHLB system is carrying its mortgage securities at 92 cents on the dollar ($59.53/$64.83) while the market valuation is 70 cents on the dollar ($44.75/$64.83). Assuming those valuations to be close to accurate, the FHLB system is sitting on embedded losses of approximately $100 billion.

When a chef is trying to whip up something really good, it is great to have an extra set of hands in the kitchen. The WSJ did not come anywhere close to professional standards with this report.


  • Aaron kramer

    Larry you are spot on again. The reality is few want to honestly deal with the problems that we face and they think if we live in denial long enough things will be better. When the music stops we won’t just be short of chairs, all of them will have disappeared. The FASB rule change is a pathetic attempt to keep insolvent banks afloat while holding toxic assets. Additionally the collateral given the Fed rots in possession and is bringing the FED closer to insolvency by the day. The banks are busted and the next leg of the crisis will be when Mr. Market enforces discipline on the FED and unfortunately all of us.

    • Aaron,

      Thanks for the plug. Glad you enjoy Sense on Cents. Please visit and comment often!

      As much as people may want to paint our economic reality in a different light, we are faced with adjusting to the new reality. In that process, losses have to be addressed…..whether we like it or not. You can pay me now…or you can pay me later.

  • coe

    LD – if a tree falls in the middle of the forest, does anyone hear it? are actually tackling two key issues at once – the intrinsic inconsistencies and asymmetry of the accounting model, and the serious position that the FHLB system holds in our “banking” system…I’ve commented before on both in response to your columns, but thought I might try a new angle tonight…have we ever thought that, on balance, most of us in business try to do the rational thing – i.e. something in our own self-interest and in behalf of the better interest of the shareholders if we are a public company…you truly cannot say the same thing about the federal government or the federal agencies..I find it quite curious that the FHLB advance book has shrunk some 12% quarter vs quarter…that speaks volumes on several levels – first of all, it tells us loud and clear that the “members” are either not borrowing as much, and/or have cheaper sources of funds in other directions…I think both of these conditions are true and both are frightening – there just isn’t that much of a demand from corporate America to invest/borrow from the banking system, and, despite all the jawboning to thaw out the credit pipeline, the underwriting criteria are substantively tougher (and, by the way, fully endorsed by the examiners); and the FHLB has been trumped by the flood of liquidity alternatives that the Obama administration is pouring into the banking system..for the most part, the FHLB system is a closed loop – and their own ability to raise cheap funds was quite impaired for awhile…the second point is that the district banks are always searching for a way to make a spread on their own borrowings (liabilities) vs the assets they hold (advances and investments)…look closely – the whole system is awash with cash…last time we checked, the yield curve just doesn’t offer much in the way of return to be in cash…no advance growth/higher funding costs = pressure on the individual banks to invest in higher yielding bonds – sounds a bit like the sequel, doesn’t it! We see this same configuration with the big mortgage GSEs and with the banks themselves…mmmmm, leverage and credit risk – all roads lead to Rome…”Morituri te salutant” is carved into the stone of the Colisseum of ancient times – or to translate the Latin cry of the gladiators, “We who are about to die salute you”…let’s end this madness…ride that chariot, LD!

  • Coe… are truly a wealth of knowledge and enlightenment.

    We who are about to die, salute you !!

    I love it.

  • kbdabear

    A Goldman trading scandal?

    Did someone try to steal Goldman Sachs’ secret sauce?

    While most in the US were celebrating the 4th of July, a Russian immigrant living in New Jersey was being held on federal charges of stealing top-secret computer trading codes from a major New York-based financial institution—that sources say is none other than Goldman Sachs.

    The allegations, if true, are big news because the codes the accused man, Sergey Aleynikov, tried to steal is the secret code to unlocking Goldman’s automated stocks and commodities trading businesses. Federal authorities allege the computer codes and related-trading files that Aleynikov uploaded to a German-based website help this major “financial institution” generate millions of dollars in profits each year.

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