Streetwise Professor

April 2, 2009

Accounting Follies & Moral Hazard

Filed under: Economics,Financial crisis,Politics — The Professor @ 10:21 pm

FT Alphaville discusses the FSAB’s decision to relax mark-to-market requirements for banks for assets for which the market is inactive, or for which prices are distorted by numerous fire-sales, and the implications of this for bank stocks.  I think this is a bad idea, but being pressed for time, for now I will merely repeat the comment I left on the FT post:

The reason that accounting rules should influence one’s decision on whether to buy banks is different from those you mention in this post. The value of bank stocks right now, especially the dodgy ones, derives from the government put (either formally, through deposit insurance, or informally through the too-big-to-fail bailout possibility). The value of this put is greater, the longer banks have the opportunity to survive, and potentially gamble their way out of insolvency, or catch a break from an unexpected upturn in the economy to save them from receivership. Obfuscating the value of assets, and giving banks more discretion over their valuation through choice of accounting treatment, extends the life of that option, and makes it more valuable.  

So, to the extent you believe that accounting rules or other mechanisms will permit insolvent banks to extend their lives, and exploit volatility (and indeed, increase volatility) and the government put, then yes, it may be a time to buy banks. Sadly, the banks’ shareholders’ gain is not a social gain, as it is achieved at the expense of those underwriting the put. Namely, me and other American taxpayers.  

We saw this before, in the S&L crisis, when in the mid-80s “regulatory capital” and other accounting dodges permitted (a) insolvent institutions to survive, and (b) Congress to avoid appropriating the money to address the problem when it would have been cheap to do so. We all know how well THAT turned out. A manageable, relatively inexpensive problem metastized into a barely manageable, very expensive one. But, those who cannot remember the past etc., etc.

Willem Buiter weighed in a few hours later with similar remarks:

Under FAS 157, the FASB’s standard on fair-value measurements, holders of financial assets recorded at fair-value must state what these values are based on. Three levels of information or assumptions are distinguished, corresponding to   how “publicly observable” the information is. In level 1, the value of an asset or liability stems from a quoted price in an active market. In level 2, it is based on “observable market data” other than a quoted market price. In level 3, which often applies to asset valuations in illiquid markets or in “distressed” sales (or “fire sales”), fair value can be determined only by inputs that cannot be observed or verified objectively.   Typically this means prices based on internal models or management guesses.

Basically, the new guidance allows banks to shift a whole load of toxic and impaired securities from level 2 to level 3.   Up till now, a frequent source of level 2 information were prices achieved by competitors’ asset sales to help determine the fair-market value of similar securities they hold on their own books. Banks are now allowed to ignore prices achieved in competitors’   asset sales when these transactions aren’t “orderly”.   This includes transactions in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements.   This is vague and broad enough to drive a coach and horses through fair-value accounting for most imperfectly liquid assets.

Leaving the valuation of illiquid securities to managerial discretion will lead to systematic and systemic overvaluation.   Banks with significant amounts of toxic assets and plain bad assets on their balance sheet have lied, lie and continue to lie about what they have on their balance sheets.   This has now been made easier.   No wonder bank stocks rose and bank credit default swap rates declined.   Reported asset values will be boosted.

Analysts estimate that, now that banks can mark toxic assets using their own models (which are private information) rather than what they would fetch on the open market, quarterly profits at some banks could be boosted by up to 20 per cent.

. . . .

The official excuse for this egregious pandering to the interests of zombie bank managers and unsecured creditors is that mark-to-market (or fair value) accounting is to blame for exacerbating banks’ capital problems and causes exacerbation of pro-cyclical and potentially systemically destabilising   detrimental feedback loops between lack of market liquidity, distress asset sales, mark-to-market, margin calls, falling asset prices and lack of funding liquidity.

That argument makes no sense.   It is clearly desirable that regulators and supervisors exercise regulator/supervisory forbearance as regards the implications of mark-to-market for regulatory capital requirements and for any other regulatory requirements when asset markets are distressed and illiquid.   They should do the same when asset markets are perfectly liquid but subject to speculative bubbles.

But  given  micro-prudential regulatory forbearance as regards mark-to-maket capital losses incurred on illiquid securities, and  given  sensible macro-prudential responses by regulators, monetary and fiscal authorities when securities markets are illiquid, there is no earthly reason for deliberately lowering the informational content and quality of published corporate accounts.   This impairment of the informational content of the corporate accounts will be the inevitable consequence of replacing valuation using market prices (even illiquid market prices) with the judgment of the deeply conflicted managers of these corporations. Investors will be worse off.   Corporate governance will suffer.   Accountability of corporate executives and boards will diminish.   And, because mark-to-myth is likely to prevent necessary corrective measures from being taken, or at least to delay them, the FASB’s encouragement of marking-to-myth is likely to increase future financial instability.

Conclusion

It really is wonderful how the US political and regulatory establishment is riding out in support of its wonky banks.   First, the Treasury Secretary Timothy Geithner proposes a toxic and bad assets purchase scheme (the PPIP or Public-Private Investment Program) which subsidizes the private parties in the public-private partnerships   bidding for the toxic assets by leveraging the private and public equity involved in the bids through non-recourse loans or guarantees.   This permits – indeed encourages – private bidders for toxic assets to make bids far in excess of their estimates of the fair value of these assets.   Their rents can then be split between the private bidders for the assets and the banks selling them.

Second, in case even this isn’t good enough, banks that would rather not sell these toxic or bad assets, even at these inflated prices, can avoid pressure (from the regulators or from shareholders) to sell by marking-to-model (that is, marking-to myth) the assets rather than marking to market.   This gives the management of the bank more time to ‘gamble for resurrection’ at the expense of the shareholders and other stakeholders, including the tax payers.   Most importantly, banks with large amounts of undeclared crud on their balance sheets will act like zombie banks, engaging in little new lending or new investment in the real economy.   While their managers sit, wait and pray for a miracle, intermediation between households and non-financial enterprises continues to suffer.

The G20 have made many pious statements about the need to recognise the losses that have been incurred, on and off the balance sheets of banks and shadow banks, and to ensure that the dead hand of the overhang of past losses does not act as a tax on and deterrent to new lending and borrowing by banks.   Yet the primus inter pares in the G20, the USA, decides to give its banks another large fig leaf behind which to hide their losses and gamble for resurrection.   This continues and prolongs the zombification of most Wall Street banks.

The FASB, like the rest of the American regulatory and standards-setting establishment, appears to have been captured lock stock and barrel by the vested interests of the large Wall Street zombie banks (management, shareholders and unsecured creditors).   This may well have been another example of cognitive regulatory capture, like that which has afflicted the SEC and the Fed.

No doubt the IASB will wimp under also, and promulgate a new ukase permitting European banks also to substitute managerial judgment/wishful thinking for market valuation. Our accounting standard setters are making terrible and very costly choices.   Paraphrasing Churchill: mark-to-market accounting is the worst accounting principle in the world, except for the others.

Buiter’s capture point is an excellent one, and one that I have been planning to write on for awhile.  Maybe this weekend will provide the time to do it.   I note merely in passing, that the PPIPs program is also severely tilted in favor of big, politically influential real money managers, e.g., BlackRock and PIMCO.  I wonder how that happened.

In related news, Bloomberg reports that Federal regulators are considering forcing major banks to write down assets by $1 trillion:

U.S. regulators may force Bank of America Corp.,  Citigroup Inc.and at least a dozen of the nation’s biggest financial institutions to write down as much as $1 trillion in loans, twice what they’ve already recorded, based on Federal Deposit Insurance Corp. auction data compiled by Bloomberg.

Banks failing Federal Reserve evaluations of loans this month may be ordered to make sales worth as little as 32 cents on the dollar, according to FDIC data. That would be less than half of the 84 cents on the dollar the Treasury Department suggested was a possible purchase price. Some of the bank- insurance agency’s auctions brought 0.02 cent on the dollar.

Regulators are apparently aware that the Achilles Heel of the Geithner plan is the optionality it extends to banks:

“If there’s an issue with the program, it’s going to be trying to get banks to sell assets,” FDIC Chairman  Sheila Bair  said in a speech the same day at the Isenberg School of Management of the University of Massachusetts in Amherst.

“If I have concern, it’s the pricing may not be where seller and buyer are willing to meet,” she said.

Any standoff between investors and banks over loan prices may scuttle Geithner’s plan to segregate non-performing assets and restart lending, said  Bob Eisenbeis, chief monetary economist with Vineland, New Jersey-based Cumberland Advisors and a former Atlanta Federal Reserve Bank research director.

‘Really Bad Stuff’

“It’s hard to believe that the really bad stuff that’s causing all the problems are going to be offered for sale,” Eisenbeis said. “The institutions won’t want to sell them if they get a true price, because their capital would take too much of a hit.”

This is an advance, and one wonders whether Bair, Geithner and others knew it all along, and planned a pincer movement–establishing PPIPs as a mechanism for buying these assets, and then hitting the other flank by using regulatory pressure to force banks to sell.  

But why the indirection?  Is this politically driven?  That is, was this strategy of the “indirect approach” (to borrow a phrase from military writer Liddell Hart) chosen over the “direct approach” (i.e., good bank-bad bank in some variant) because the judgment was made that the latter would crumble in the face of fierce bank resistance?  Is this driven by an assessment of regulatory capabilities, i.e., a consideration of what regulatory weapons the FDIC has at its disposal?  Is it primarily driven by a recognition that Congress would never fund the direct approach, so stealth bailouts are required, and regulatory pressures are necessary to make the purportedly “voluntary” Geithner plan work?  

I don’t know the answers to these questions.  I would prefer the direct, transparent approach.  The indirect, apparently disconnected approach could be attributed to canny strategizing, but it could also indicate intellectual confusion, ad hoc decision making, extemporization, and the dysfunctional consequences of a dysfunctional Congress.  

I would also note that there is incredible tension and inherent contradictions in much of the policymaking.  The FASB action completely undercuts the Geithner plan–as a standalone initiative.  If, in fact, the Geithner plan is part of a pincer strategy in which the government will force banks to participate by forcing writedowns, the FASB action raises the level of government force required to achieve that end.  

My main concern about these indirect, opaque plans to deal with banks is related to a point I made in my FT comment.  Namely, we have been here before, in the S&L mess in the 80s.  Congressional malfeasance then made a bad problem into a horrific one.  Congressional failure to grasp the nettle, and fund a reasonable cleanup of the S&Ls led regulators to resort to all sorts of indirect “fixes” that only allowed the problems to metastasize.  

The most charitable interpretation of the administration’s actions is that it recognizes that the current Congress is likely to commit malfeasance on even a grander scale, and hence feels compelled to disguise bailouts by making vast commitments, unfunded at the present (most importantly, the commitments inherent in non-recourse lending), but which will effectively force Congress to provide funding in the future when the bills come due.  

I would prefer a more direct, honest, and transparent approach.  It would provide confidence that the true problem is understood and is being addressed, whereas the present course leaves considerable room for doubt.  But, being charitable to the administration requires one to believe that even it views Congress as incorrigible, irredeemably unreliable, and counterproductive.  That is perhaps the most sobering, no, disturbing, possibility of all.  

 

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