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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.


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