Market fixes clashing
At the end of the fourth quarter in 2008, analysts were reporting that many of the nation’s largest banks were nearly insolvent because of carrying a massive amount of troubled assets from mortgage-backed securities on their books.
Yet at the end of the first quarter of 2009, many of these publicly held banks, such as Bank of America and Citigroup, declared profits to record quite a remarkable turnaround.
Are the earnings real or did recent reporting changes issued by the Financial Accounting Standards Board, which was under pressure from Congress to change the rules, build the banks a paper bridge to profits between the two quarters?
David Weiskittel, a partner at accounting firm BDO Seidman LLP, didn’t think the FASB changes turned the corner.
“I can’t tell you for sure exactly why they’re showing good results. But I think part of it is the interest rates have decreased so much that a lot of banks are going through a lot of refinanced mortgages for those people who are fortunate enough to be able to refinance,” he said of refinancing rates that have fallen below 5 percent.
“My understanding is — and this is just from hearsay — that they’re actually starting to charge more in the way of fees to refinance. So I think those fees are really cranking to their bottom lines.”
Refinancing income, fewer loan losses because they were taken at year end, and less in what the industry would have seen in losses of temporary impairments on their investments are the three factors Weiskittel believes improved the banks’ quarter-to-quarter fiscal picture.
“Did these FASB changes really help them out a lot? It’s kind of hard to say that this early,” he said.
Investors, though, have complained that the new accounting rules mask the true financial condition of the big banks because it allows them to keep declines in their asset values off their income statements.
The Investors Working Group, led by former Securities and Exchange Commission Chairmen William Donaldson and Arthur Levitt Jr., said the FASB changes would “reduce the free flow of transparent and reliable financial information,” would “undermine investor interests,” and would “weaken their ability to make sound investment decisions.”
Investors are interested in paying market value for a security, regardless of the type. But there are different ways of pricing value. One is the traded price. Another is getting a quote for a stock that isn’t listed. A third is creating a price for one that isn’t traded, such as the pooled mortgage-backed securities lenders still own that brought the financial system to its knees last fall.
Weiskittel said the banks favor the latter method and FASB gives lenders a better chance to incorporate that pricing level in those securities. The change makes it easier to claim that the market for these financial products is distressed. And because the market is distressed, the banks have more leeway to make a pricing decision.
“It allows them to put some of their own inputs in, and they can get away from broker quotes and from what these things are actually trading at in the marketplace. It gives them more judgment. What will happen is the prices will be higher under that than it would be under the previous rules,” he said.
FASB helps the banks with their debt securities in another way. Banks can either classify the debt as securities they will hold to maturity and not sell, or they can categorize them as debt they intend to hold but might sell. Securities that are held to maturity are recorded at their cost, while the other grouping is recorded at market value regardless of the purchase price.
If the value of a debt instrument falls below what a bank paid for it, the bank would have to take the loss to its income statement under the previous accounting rules. But FASB lets a bank take just a small portion of a loss to the income statement and put a larger share in its “Other Comprehensive Income (Loss)” column on its balance sheet.
“That’s huge,” said Weiskittel. “The reason why that’s important is that OCI account does not get considered when banks determine their regulatory capital. Regulatory capital for a bank is very important because regulators stipulate that they have to have certain ratios.”
The categories for regulatory capital are “well capitalized,” “adequately capitalized” and “under capitalized.” Falling into that last category can be tough on a bank. Regulators may require it to raise more capital to stay in business and it will see its premiums to the Federal Deposit Insurance Corp. rise. So FASB helps a bank stay out of the under-capitalized group.
“The key is, the OCI does not get counted for regulatory purposes,” said Weiskittel.
Weiskittel recently did a 10K filing for a bank in the region. Before the FASB change, the bank was looking at having to write off $40 million in debt securities, which would have gone onto its income statement and put the lender into the under-capitalized category. But the FASB change allowed the bank to park that unrealized loss in its OCI column and the lender is now categorized as being adequately capitalized.
“So, it’s really important to them, and going forward it will just allow banks to look better,” he said.
In the meantime, the Obama administration, through its Public-Private Investment Program, wants to establish a value for those troubled securities in a distressed market. The plan proposed by Treasury Secretary Timothy Geithner would have, say, a hedge fund pay for 7 percent of a pooled security’s price with taxpayers picking up the rest. Any profits the securities may yield would be split, but taxpayers would be on the line for 93 percent of any losses incurred.
Geithner said the remaining $100 billion in the Troubled Assets Relief Program would be used to purchase those securities, a buy the administration believes would boost prices as private investors bid those debt instruments up, which will encourage institutions to sell.
But are banks now going to be willing to sell? As long as those troubled assets remain as unrecognized losses in the OCI column and don’t count against their regulatory capital, many might be unlikely to do so.
“Investors might bid the price up, but it’s still not going to come up to where the banks would probably like it to be. So a bank has this portfolio and it’s parked in those unrealized losses under the intention that it’s not going to sell it. And now this new program comes along and they do sell it: That sale is going to be run through the income statement as an unrealized loss and it’s going to reduce their regulatory capital,” said Weiskittel.
“So I think a lot of banks are going to be hesitant to participate in the program.”
Weiskittel also said he didn’t think the first $350 billion the Bush administration gave to banks from the $700 billion TARP pot met its goal of getting these lenders to lend again.
“I’m not sure that really worked because I think a lot of the banks looked at that capital they got in as an additional cushion for potential other losses,” he said.
Ironically, the larger banks are in the process of returning those TARP dollars to get out from under the limits tied to accepting those funds. Weiskittel said banks are handcuffed by those restrictions, especially regarding employee compensation issues. Banks that haven’t accepted those funds may be looking at hiring executives away from those that did. And those executives are likely to welcome a chance to leave a TARP-receiving bank because their pay potential won’t be restricted.
“There are some really good people out there that work for these banks that had nothing to do with (the financial collapse),” said Weiskittel.
“I think the banks want to give the money back if they don’t need it and think they can survive without it. They just don’t want the government, which quite frankly doesn’t know what it’s doing, in the way of running their bank.”
So whatever good intentions the administrations and Congress may have had with TARP, FASB and PPIT, the unintended consequences of the three programs may not result in the government achieving its two key intended outcomes — namely, getting the troubled mortgage assets completely off the banks’ books and the banks to lend more money.
“I think so,” said Weiskittel of what may turn out to be unintended consequences. “It will be really interesting to see.”