Reverse Leverage of Mark-to-Market Wrecks Banks: John M. Berry Commentary by John M. Berry Oct. 13 (Bloomberg) -- The world's banking system is caught in a vicious trap, with a forced sale of assets at one institution wiping out capital at others holding similar assets. Think of it as extraordinarily high reverse leverage. You can blame mark-to-market accounting, the advent of new indexes that supposedly track values of a wide range of assets, or a market mind-set that assumes every asset is part of a bank's trading book. Like the old Pac-Man character, this combination is devouring financial institution capital at a voracious rate. The question is whether it will gobble up even the new capital injections into banks by the U.S. and foreign governments. It's way past time to suspend mark-to-market accounting -- or somehow to make investors and analysts understand that fire- sale transactions aren't supposed to be having such broad implications. Of course, suspending mark-to-market would be greeted by screams of outrage by its devotees, including those at the Financial Accounting Standards Board and the Securities and Exchange Commission. After all, the mark-to-market rules are supposed to provide investors with needed information about the true state of a company's balance sheet. In the midst of this financial crisis, mark-to-market isn't necessarily telling the truth. The notion of pricing assets on the basis of what they would bring if sold today -- even if an institution doesn't have to sell them -- creates a paper loss that reduces capital and restricts lending. Federal Reserve Chairman Ben S. Bernanke has expressed reservations about mark-to-market on these grounds. Great Depression Nobel laureate Milton Friedman and his co-author, economist Anna Schwartz of the National Bureau of Economic Research, describe in their seminal work, ``A Monetary History of the United States, 1867-1960,'' how a similar process forced the closure of many banks at the beginning of the Great Depression. ``The impairment in the market value of assets held by banks, particularly in their bond portfolios, was the most important source of impairment of capital'' that caused them to shut down, not ``defaults of specific loans or of specific bond issues,'' they wrote. ``Friedman and Schwartz argue that during financial panics, forced asset sales bring down good assets as well as bad,'' said Lee Hoskins, former head of the Cleveland Federal Reserve Bank. Appropriate Assumptions Instead of this mark-to-market approach, Hoskins said, ``What I would like to see is someone do a present-value calculation on mortgage-backed security holdings at banks using appropriate assumptions about future home prices and default rates.'' For individual loans or groups of similar loans, banks are supposed to set aside loan-loss reserves when questions arise about whether they will be repaid. If the risk of default is sufficiently high, interest payments, which normally are treated as income, are supposed to be booked as payments to principal. However, adding to loan-loss reserves is a far cry from valuing a loan as if it were to be sold immediately -- which is the foundation of mark-to-market accounting. For instance, on Oct. 9, some lists of highly leveraged loans being offered for sale were circulating in Europe. Included on them were assets seized from banks that had just been taken over by the Icelandic government. The news that the loans were on the market caused the Markit LCDX, a benchmark credit default swap index used to hedge against losses on leveraged loans, to drop more than 6 percent over two days. ``This will affect the mark-to-market for all loans,'' Louis Gargour, chief investment officer at LNG Capital, a London-based hedge fund, who is setting up a distressed debt fund, said on Oct. 9. The FASB staff on Oct. 10 issued additional guidance on the fair-value rules that could limit the fallout from forced sales. However, Gargour's view seems to be widespread in the market. Saved by Forbearance Back in 1982, when the world was a simpler place, the six largest U.S. banks -- Citicorp, Bank of America, Chase Manhattan Bank, Morgan Guaranty Trust Co., Manufacturers Hanover Trust Co. and Chemical Bank -- were in deep trouble. Collectively they had loaned more than $1 trillion to Latin American countries, which couldn't service their debts. Had the banks been forced to recognize on their balance sheets how badly their loans were impaired, they would all probably have been declared bankrupt. Instead, the Federal Reserve and other bank regulators exhibited so-called forbearance -- letting the institutions continue in business without recording those losses. Had they done otherwise, it would have crippled the banking system in the middle of what was already the worst U.S. recession since the 1930s. Added Capital At the end of the 1980s, new international standards required banks to increase their capital bases substantially, though the current crisis has shown that the added capital wasn't adequate either. Asset writedowns and credit losses are approaching $600 billion at the world's biggest banks and securities firms, and the $443 billion worth of capital raised to cover them hasn't been enough to reassure investors. I wonder what that balance would be if the world weren't fixated on mark-to-market accounting. According to Bloomberg figures, Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. have all raised more capital than their writedowns and losses. Nevertheless, the stock prices of the first two have been hammered since the crisis began more than a year ago. (JPMorgan Chase has fared better.) So one has to ask: How much capital will the U.S. government have to inject into these and other banks -- along with other actions -- to thaw the world's credit freeze? Given the mark-to-market climate, it may take more than the $700 billion authorized in the recent rescue package. Harvard University economist Kenneth Rogoff said on Oct. 10 that it likely will take much more than that. If it does, the next president will have to demand that Congress provide it. (John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.) To contact the writer of this column: John M. Berry in Washington atjberry5@bloomberg.net
Tuesday, 14 October 2008
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