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Banks Want to Continue Rope-a-Dope Accounting

Posted by Larry Doyle on August 21, 2009 8:04 AM |

If a financial position is hidden, disguised, or in some manner unreported, does that mean it does not exist or is not impactful? Will the American taxpayer continue to bear the burden of unsafe and undisciplined lending and investment practices on behalf of our banking system without being able to demand truth and transparency? Make no mistake, these very practices have brought our economy and financial system to its knees and if the banking system continues to get its way, we will remain subject to the massive risks connected with them. Let’s navigate this corner of our economic landscape and see what the implications are going forward.

CFO Magazine highlights the growing pressure from within the banking industry to delay the implementation of  accounting rules requiring banks to bring investment positions onto the balance sheet and raise sufficient capital to support them. In short, these accounting rules would strike at the nexus of the off-balance sheet vehicles which crippled many banks. CFO reports:

Bank regulators are set to discuss accounting standards next week, with an aim toward determining the potential affects that off-balance-sheet rules may have on some financial institutions. During the past year, bankers have fretted about new accounting rules that would force them to bring back on their balance sheets billions of dollars worth of assets — a move bankers have argued will throw regulatory capital ratios into chaos.

Bankers may fret, but taxpayers are picking up the tab on an ongoing basis. If these bankers really want to see ‘fretting,’ then they should start talking to the American public.

Why are the bankers concerned about implementing these new accounting rules? They believe it will force them to raise new capital, dilute their stock value (which will most likely negatively impact their own personal wealth), and increase the potential of a takeover or some other form of business transfer, including potential liquidation. The bankers would prefer to continue to operate in an undercapitalized fashion while they ‘hope and pray’ for a turnaround in the housing market which is at the very core of their investment holdings and overall franchise.

CFO addresses these points in writing:

The new standards revise older accounting rules — specifically FAS 140 and FIN 46(R) — changing the way, for example, companies define control over financial assets and liabilities, thereby causing some off-balance-sheet transactions to be consolidated back on to company financial statements. The rule would likely have a large impact on banks, which frequently package up loans into securities.

The impact of the accounting rules on banks came to a head in May, when the Federal Reserve Board released the results of its so-called stress tests, which were performed on the 19 largest bank holding companies in the United States. The unprecedented stress testing, officially dubbed the Supervisory Capital Assessment Program, incorporated several accounting changes into its modeling, including the potential effects of FAS 166 and FAS 167. In its summary report, the Fed concluded that the new FASB rules would require banks to reconsolidate off-balance-sheet assets tied to securitizations and SPEs.

So far, the estimates of how many billions of dollars would have to be reconsolidated vary, with the Fed guessing that an aggregate $700 billion worth of assets would be brought back on the balance sheets of the largest bank holding companies. News reports have estimated the impact to be closer to $1 trillion worth of assets.

What are the practical implications of these past accounting practices which promoted off-balance sheet activities, as well as the FASB’s relaxation of the mark-to-market? We need look no further than the lead article in this morning’s Wall Street Journal, In New Phase of Crisis, Securities Sink Banks:

U.S. banks have been dying at the fastest rate since 1992, mainly because of bad loans they made. Now the banking crisis is entering a new stage, as lenders succumb to large amounts of toxic loans and securities they bought from other banks.

The WSJ is inaccurate in stating the banking crisis is entering a new stage. The problems embedded in the investments and securities held within the banking system (whether on balance sheet or off) are not new. The accounting rules and games played by the banks merely allowed them to be covered up.

We are way past the point when these games should be allowed to continue.


  • Randy Bowman

    Shall we take the blue pill and go all the way down the rabbit hole to the nitty gritty truth about our banks without all the sugar-coating?

    Truth #1) The global banking system is still in operation today, ONLY because the public has faith that their respective governments will step in and stem the tide on any problems that might endanger its health;

    Truth #2) The global banking system is mired in an unconscionable amount of loans and derivatives that are largely uncollectible or worth just a small fraction of their stated values, caused by virtue of the greed in spawning them without proper growth controls, the lax standards in granting them to anyone still breathing hard enough to fog a mirror and the collapse of the credit bubble and housing values bubble that the banks and their respective central banks created (with the help of the government)all in the name of growth and prosperity.

    Truth #3)In order for this game of musical chairs to continue, the governments and central banks will continue printing money in efforts to reinflate the declining asset values and keep the system afloat and….despite the ugliest underlying economic results to the contrary staring us all in the face, they shall claim in voices too loud and clear to ignore that the worst has been averted and all is on the mend… and they will be doing so solely in hopes of swinging consumer sentiment back to the positive side of the ledger and getting us to resume our spending whether we have jobs or not.

    As seen today, it must be time for Uncle Ben Bernanke to campaign for the future continuation of his job title, as he is now claiming to have saved the World. It sort of brings to mind the story of the little Dutch boy Hans Brinker who stuck his finger in the dyke all night long to avert a flood of disastrous proportions, does it not? The only trouble with that story and with Bernanke’s claim is that neither of them are the least bit true… they are both pure fiction. Also, in Ben’s case.. he has in reality worked feverishly to put all of our collective fingers in the dyke. What happens if we lose patience with the charade and begin to remove our fingers (translate this as stop spending and continue to save for a rainy day)? I think that’s a really good question worth asking…

    The fiction version says all is just fine and just ignore all those job losses and the inability of families to survive on meager unemployment checks from the government, etc. which citizens now fear will stop any day anyway.

    Reality on the other hand suggests we had better take action on the real underlying problems, begin to take action on creating more jobs and work to wean ourselves off oil in the next 20 years by starting right now, etc.

    Or alternatively I guess we could continue to wave goodbye to our children’s and grandchildren’s futures by letting the current Administartion continue to squander our time and our tax monies in ridiculous attempts to mis-manage the sick care industry. That’s right it is not the health care industry. Health care is about prevention of disease through sensibile lifestyle, proper nutrition and exercise. What we have now is nothing more than expensive sick care that makes us lifelong slaves to the day to day management of symptoms via the toxic products of the big pharmaceutical companies who fund the coffers of the FDA and of key members of the AMA so that they have a clear path to continue raping the public. Ahhh but that is a story for another place and time.

    • Larry Doyle

      Randy…I have often thought of that little Dutch boy as the perfect analogy to our current economic morass.

      In regard to the wealth and wisdom of your other comments, I could not have said it better myself….nor could I have been as eloquent.

  • coe

    LD – this isn’t the first time rules have been arbitraged, nor will it be the last..isn’t it a part of the human condition in all walks of life to try to finesse the letter of the law – I did it with my parents’ rules, and my children did it with ours..what I am implying is that many constituencies are always incented to find ways to work between the lines, stretch the boundaries, and restructure around the perhaps what this tells us is that we need to break down and rebuild the accounting and regulatory “rules” in a way that makes sense and helps prevent a replay of this recent debacle while also promoting transparency…you have been beating the drum about leadership and ethics – I say throw the bums out, reconfigure the Boards of Directors and rationalize regulatory and accounting standards with simple truth and teeth (of course nobody can read nor understand a thousand pages of legal gobbledygook in the health bill nor in the arcane FASB and FDIC/OCC handbooks – get real and write in plain English) ..having bank exposures in the zip code of $1T “off to the side” really doesn’t pass the common sense test – just because this “conduit” activity was funded by CP and other short term liabilities under 365 days shouldn’t have made it invisible, particularly because the assets funded in these same off-balance sheet vehicles were certainly longer duration, and absolutely proved to carry both credit and interest rate risk! Who were the geniuses that were at the epicenter of this scam – well, the Wall St “solutions” teams, the investors who bought the CP, and the leaders of the banks, who were paid handsomely to create spread out of thin air – i.e. off-balance sheet safe harbors. Once the CP markets seized in ’07 and refunding risk became all too real, the jig was up. Would the burden of reconsolidation and fair market accounting tax already strained capital positions and create more problems – you bet…but it is quite disingenuous to look the other way and suggest that a problem delayed is a problem solved…and for the record for the umpteenth time, why aren’t banks allowed to mark their deposits to fair value…I maintain what is good for left side of the balance sheet is also good for the “right” (in both senses of the word) side as well…this would provide some offsetting benefit as well as more transparency – and I have to believe it is just as easy to “mark” a deposit as it is to model and value a mezzanine tranche of multi-issuer CDO backed by bank and insurance company trust preferreds – don’t you?

    I am also coming to believe more firmly that the other really big misconception is that our economy is so big and complex, and that it is easy to shout that the “sky is falling” and that pressure on the banks will derail any shot at a recovery – that we are hostage to “the cure is worse than the disease” principle..tough to refute on some levels…but the last time I looked, somehow the world survived with the disappearance of Salomon Brothers, WAMU, Bear, Lehman, Kidder, Wachovia, Bank of New England, OptionOne, SecPac, great Western, Continental Illinois and thousand of others – maybe the visionaries that ran these companies into the ground have scarred legacies and bruised egos, but I suspect they have plenty of wealth to seek personal grief counseling at the expense of their shareholders, customers, employees, and yet again the taxpayers…

    it’s Saturday morning at 530am, and you already have me fired up…

  • J. Edward

    LD I agree with most things you say but not this one.

    Banks buy assets with the intention of holding to maturity. They are not trading houses. If market prices determined the market cap of banks in the 80s ALL major commercial banks would have failed ( Bill Isaac, former head of the FDIC ).

    To assert that market prices at any given time alone determines cap ratio of the banks you must also believe the markets are effecient. I think 2008 has emperically proven effecient markets are a myth. Portfolios designed on that premise imploded.

    The call for mark to market accounting is to bring integrity to the transparency to the financial world.

    That can be done by having a standard methodology to value assets without basing it on market prices at given intevals.

    Those that think that this would be a whitewash need to consider this… marking to market can also distort the intrinsic value of an asset in the other direction. Consider Las Vegas real estate circa 2006. A house that could be built for $300k and rented for $15k/yr was selling for $550k. Rental equivalant and replacement cost says that this house should be valued close to $300k, mr. market said $550k. Who was right ? And which methodology should we use ?

    • Larry Doyle

      J.Edward…thanks for the comment. If everybody who reads my work were to agree with me on all the topics, this would be a fairly dull site. In that spirit, I thank you for being direct in sharing your view.

      I do believe our area of common interest is in gaining increased transparency to the financial world.

      The fact is the banks have a horrendous track record in this area. These SPEs were truly designed to allow for greater leverage. The lack of transparency was crippling.

      A few other comments. Not all investments are intended to be held to maturity. I am not an accountant, but I do believe banks categorize investments as either: 1. available for sale, or 2. held to maturity. As such, different marking/pricing practices are utilized.

      Your point about Vegas real estate is a good one. That said, I would assume that bucket of assets would be in the “held to maturity” bucket and marked accordingly. The rub here obviously develops as banks move assets between these categories.

      Do we trust the banks? I am a believer in the ‘Trust, but Verify’ approach.

      Thanks for commenting and disagreeing. It makes for a better site.

  • TeakWoodKite

    They are not trading houses. .

    This maybe a pencil shaving of difference, in that the investment instraments they hold are traded. As an example, can you tell me with any certianty a loan you made for your house if made through a bank is still held by the bank? Or was “sub-primed” and lost to the world for ever?

    What has changed?

    • J Edward

      I’ll answer that with a question

      what would the impact be if home mortgages had margin calls ?
      Most of us would rent

      the difference is we have no intention of closing our the ‘trade’ just because it’s profitable that year and the IRS does not require us to book a positive appreciation as profit until we sell, further proof it is not and should not be a trade.

      BTW if the banks are so unprofitable last year due to declining asset values why did the IRS receive such a huge tax payment from them?

      Bottom line
      market asset values are transient and differ based on where you are in the business cycle. That’s why the great investors ignore mr market and look at cash flow.

      • TeakWoodKite

        what would the impact be if home mortgages had margin calls

        J, thanks for the bottom line. They did have margin calls. or was it that the banks found the bailouts were great for coming up way short?

        Bottom line is most investors are might consider “cash flow”, but perhaps thats why as LD points out the “street” is looking to kick the change in accounting down the road a ways.
        Do you think the banks were not aware of the toxic crap they held? For me the last 2 years has been one big “margin call” and MANY people are renting (or homeless) because of it.

  • Randy Bowman

    The “great investors” mentioned above are capitalized to such a heavy degree to begin with that they are able to play a very different version of the game than you, I and most of the rest of the contributors to this site combined. Unless you wear some extremely deep pocketed pants, you ignore Mr. Market at your own great peril and it could probably go without saing that just as many games are played with “cash flow” these days as any other measurement. Accounting rules allow for a great amount of gamesmanship, totally apart from the outright lying and fraud that goes on regardless.

    Many of the earlier points in this thread of comments were, IMHO quite cogent. Key parties will always try to game the system, regardless of any new rules that are legislated, unless and until the penalties for doing so are quite substantial and unless and until these gaming entities no longer hold great sway/influence over the regulators themselves by virtue of key individuals placed within the government or within the regulating bodies themselves by said entities. Until that day comes, if ever, the majority of activity seen regarding improved regulations, etc will be far more for show to the public. There will always be loopholes left available for the favored few. To think otherwise is simply not consistent with reality, as proven by history.

    Even if regulations are given some real teeth, the examiners and regulators charged with finding the problems seldom ever attract the brightest in the biz and they will thus almost always show up a day late and a dollar short when trying to stay up with the best whom they are attempting to regulate. If you’ve ever been a senior banker explaining away a mess to a senior examiner then you already know what I am talking about. I’ve no idea where they find those folks but they are nearly as clueless about what really goes on as are our elected representatives.

  • J. Edward

    Banks themselves are required to be holders of deep pockets. If not allowed to weather valuation swings with some reasonableness they would need to delever down to 1:1 ratio, which is where we were headed till FASB partially suspended Mark to Market accounting earlier this year.

    If purists had their way the system will have already melted down.

    The problem of the ethical marking of assets as mentioned is and always be a problem no matter the system. But it is the ethics that is the problem not the system that worked fairly well since 1937 when Fair Value accounting was suspended only to be put back in place in the fall of 2007 sending banks towards a death spiral as each markdown in one financial institutions assets reverberated thru the system and accelerated to the point that Senior Debt was trading at .65 on the $1 implying a 100% default rate.

    The real issue as LD has touched on is that those that do wrong must be held accountable. This is fix for the system.

    Name one high profile exec thats going to jail despite the massive securitization fraud.

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