Month: October 2008

            A number of
respected people have blamed accounting rules for much of the current financial
crisis. “Fair value” or “mark to market” accounting aims to present a more
accurate picture of a bank’s condition and should not be abandoned. The
application of fair value accounting, however, especial to assets like Mortgage
Backed Securities (MBSs) that do not trade or trade in thin, distressed
markets, is flowed and should be improved. The SEC’s recently revised guidance
on valuing such assets is a very positive step in this direction. Accounting
rules should not be perverted to achieve other laudable objectives, such as
moderating the pro-cyclical increases and decreases in bank capital that result
from the pro-cyclical variations in the value of bank assets.

 

Accounting rules can be complicated
but their purpose is simple, which is to provide as accurate a picture as
possible of the financial performance and condition of an enterprise. Business
and other decisions depend on such information. In the case of banks, an
assessment of its soundness is critical to uninsured depositors and investors
before intrusting their funds to the bank. A bank is insolvent if it does not
have positive net worth or capital, the difference between the value of its
assets and its deposit and other liabilities. One of the most important lessons
of banking supervision of the last half century is that it is very unwise to
allow an insolvent (but liquid) bank, i.e. a bank with negative capital, to
continue to operate. Its losses almost always grow larger until it is finally
closed.

 

            Market
participants will do their best to evaluate the soundness of banks before
buying their debt or placing large (i.e. uninsured) deposits there. If they can
rely on accounting statements to reflect soundness to the extent that it is
possible to do so, they will do so. If accounting statements cannot be trusted
or disguise the truth investors will not rely on them, estimating the bank’s
condition as best they can. But not having the best possible statement of
condition increases market uncertainty and the associated risk premiums about
what the true condition really is.

 

            It has long
been recognized that book values of loans or other assets do not generally
reflect the actual market value of such assets. If a borrower is not making its
payments on a loan (mortgage or otherwise) it is obvious that its book value
(the contractual principle and interest payments first entered into the banks
books) to the bank overstates and potentially greatly overstates its actual
realizable value. It over states the resources the bank has with which to honor
its deposit and other liabilities. The best possible statement of its value
would be to record the present value of the expected income to be received from
such loans (discounting the expected income with the prevailing market interest
rate). This requires judgment and can’t be know perfectly, but it is not too
difficult to arrive at a far more likely value than from using its original
book value.

 

            This is
quite obvious and uncontroversial for non performing loans but for some reason
the same truth is not so easily recognize for assets that will be fully repaid
but with interest rates that are no longer attractive. If a bank buys a
treasury bond for $1000 with a 6% dividend per year for thirty years and market
interest rates go up to 12%, its real (market) value is reduced significantly
even though its interest and principal will all be paid on time and in full. If
the bank needed to liquidate the bond now it could only sell it for a bit more
than $500. Holding it to maturity just doesn’t change the fact that it has lost
value. Reporting it at face value (its purchase price) would be a fraud, a
deliberate misstatement of the facts. The S&L crisis of the 1980s reflected
exactly such a phenomenon. Savings and Loan banks lost money and became
insolvent not because borrowers were defaulting on their mortgages more than
usual (as now) but because market interest rates increased dramatically and
these banks were stuck with otherwise good long term mortgages that yielded
much less than they now had to pay to their depositors to keep their money
there—the money that financed these mortgages. These good mortgages were producing
huge loses that bankrupted almost 2,000 banks.

 

Rules for classifying and
provisioning against loans kept on a bank’s books are reasonably well defined.
However, when loans are securitized and resold in the market, different rules
apply. Basically, the prices received or prevailing in the market for similar
loans or pools of loans provide the market’s assessment of current value and
are generally expected to be used to value similar, potentially marketable
loans still held by the bank.

 

            The
movement to mark to market accounting is an attempt to more correctly account
for a bank’s performance and condition (net worth) by valuing its assets at
their current market price. As such it is an important improvement over earlier
book value accounting. Its implementation, however, is not without problems.
Take mortgages and Mortgage Backed Securities (MBSs), for example. Mortgage
defaults this year and last were much higher than had been expected, especially
for Adjustable Rate Mortgages (ARMs) to Subprime and Alt-A borrowers. Banks and
other owners of these MBSs have experienced unexpected losses and this should
be reflected in lower valuations for these assets in their books. Existing loan
classification rules for non traded loans (including mortgages) would require
provisioning against expected losses on these loans (writing down the expected
value) in light of recent experience even if they are not traded. Banks need to
have the best estimate of the likely value of their loans (even if they are
fully performing up till now). But for traded mortgages the secondary markets
in which these assets trade are very thin and currently non existent (frozen)
and thus market prices in this case might not be a fair measure of the expected
return from holding them. Furthermore, unlike trading government securities or
corporate bonds, which are homogeneous within their class so that the market
price of a 10 year treasury bond clearly should apply to an identical bond held
by the bank, MBSs are heterogeneously and not fully comparable.

 

            Criticisms
of fair value or mark to market accounting fall into two main classes. The
first is that the actual application of fair value accounting in some cases
does not actually result in the best valuation of the asset. The second, which
is misguided, is that even if it results in the best measure of actual value it
should not be used because it contributes to undesirable pro-cyclical swings in
bank capital. These are examined in turn.

 

Accounting rules formally define
“fair value” as “the price that would be received to sell an asset… in an
orderly transaction between market participants at the measurement date.”[1]  Peter J. Wallison, Chief Legal Council of the
U.S. Treasury during the Reagan administration, criticized the rules for
applying mark to market requirements to MBSs in a study for the American
Enterprise Institute. “It seems an unavoidable conclusion, however, that the
doubts about the financial stability of these institutions were sown by the
drastic cuts in asset prices required by the mark-to-market valuations of fair
value accounting, instead of a fair appraisal of the value of the cash flows their
assets were producing,” he wrote.[2]  Wallison pointed to many legitimate problems
with valuing MBSs when distressed sales and a lack of market liquidity are
believed by many, including the U.S. Treasury, to have resulted in the
undervaluation of these assets in the market. However, he persistently refers
to the present value of “cash flow” as a preferred basis, when it is the
“expected cash flow” that is relevant. On September 30 when the Securities and
Exchange Commission, in junction with the Financial Accounting Standards Board,
issued guidelines under "fair value" accounting rules for financial
firms trying to value of hard-to-trade assets on their balance sheets, they
correctly referred to “expected cash flow” as a proper bases for valuing assets
that are not trading or are trading in disorderly markets.[3]
The fact that the current (historical) cash flow from a mortgage pool is what it
is does not change the fact that it is now generally expected to be lower in
the future and thus the best estimate of the true value of the pool will be
lower because of that.

 

Earlier SEC FASB interpretations of
the rules for valuing MBSs leaned much more heavily toward current market
prices as long as there were any at all, while the new clarification admits
that current market conditions are not orderly and thus internal expected cash
flow estimates may be appropriate. “Fannie has an underwriting and valuation
shop with models for valuing mortgages that are up and running.”[4] They
forecast default rates for different assumptions about price declines and have
a good track record. They might be deployed to establish valuations in lieu of
reliable market prices until markets return to normal. This new SEC clarification
is welcomed and should increase bank capital in much the way the Treasury’s new
$700 billion TARP program was expected to.[5]  It should also do much to diminish the call
to abandon mark to market accounting.

 

The other criticism, also made by
Wallison, is that “Procyclicality is obviously an unintended consequence of
fair value accounting, but nonetheless an issue for policymakers…. The central
purposes of fair value accounting were good—to make financial statements easier
to compare and to bring asset values more in line with reality—but these goals,
even if they had been achieved, are not as important as avoiding or reducing
asset bubbles, producing steady growth in the economy, and encouraging stability
in our financial institutions.”[6]

 

            The
pro-cyclical behavior of asset values is an economic reality. No good policy
purpose would be served by attempting to hide the fact by corrupting accounting
standards. Full transparency is desirable. However, an honest accounting of the
pro-cyclical behavior of asset values does not prevent taking policy measures
designed to moderate the effect of asset value swings on bank lending or other
behavior. A far better approach to the tendency for raising asset values to
encourage banks to expand lending or risk taking pro-cyclically would be to
vary capital requirements over the business cycle such that banks are required
to hold more capital relative to their liabilities during the up side and less
during the down side of business cycles.

 

            This issue
is reminiscent of the slow evolution of central banks toward acceptance of
International Accounting Standards (IAS) for themselves. Traditionally central
banks rejected the use of IAS they required commercial banks to follow in order
to hid their unrealized foreign exchange valuation gains and losses (“paper”
gains and losses), which can be considerable for a typical central bank. The
banks’ accounts are in their local currency and they necessarily have an
exposure (open position) to foreign currency values through their reserves of
foreign currencies. European central banks resisted the adoption of IAS with
regard to the reporting of these gains and losses because their laws required
them to surrender profits above some minimum to their Finance Ministries and
during the first two or three decades after World War II they generally enjoyed
valuation gains from their foreign exchange reserves because of the tendency
for European currencies to depreciate against the U.S. dollar in which most of
their reserves were held. They did not wish to report these unrealized gains
because they did not wish to pay them to their Finance Ministries. Thus they
hid them by not including them in income. However, in the 1980s the German mark
and some other European currencies appreciated against the dollar for a number
of years causing the famous Bundesbank to become insolvent. The Bundesbank was
recapitalized by the German Government and there after led the field by
amending its accounting standards to reflect unrealized as well as realized
valuation gains and losses.

 

Drawing on the precedent set by the
Bundesbank, I convinced the Bosnian authorities in 1997 (and the IMF’s legal
advisor) to adopted IAS standards for reporting the Central Bank of Bosnia and Herzegovina’s
income. As we all agreed that it would not be desirable as a matter of policy
to remit to the government unrealized valuation gains (what some might call
purely paper profits from changes in exchange rates when no transactions
occurred), the rules for determining income subject to remittance were adjusted
to exclude unrealized gains. This is far more transparent than the traditional
central bank practice of hiding them from income in their financial statements.

 

While efforts to improve the
implementation of fair market accounting are welcomed and should continue, the
gains made in making financial statements a more accurate reflection of
outcomes and conditions are helpful and important to the efficient functioning
of markets.

For the past year, and especially for the past few weeks, U.S Treasury and Federal Reserve officials have cautioned that a credit crunch (significant reductions in normal bank lending to companies and household that regularly depend on such credit for normal business activities and investment) threatened to turn a mild economic slow down into a more serious recession. Sometimes they pointed to a lack of liquidity as the problem and at other times to the lack of capital. What is the difference?

Banks and firms, like households, experience a mismatch of receipts and expenditures day by day, which they manage by investing temporary surpluses in liquid assets (those that can be sold and turned into cash quickly and easily) or by borrowing to cover temporary shortfalls. Problems can arise when normally liquid assets become hard to sell or usual sources of funds become hard or expensive to obtain. Its like maxing out your credit card. If depositors withdraw their funds or investors/lenders fail to renew their investments in a bank, the bank must find other depositors/investors, liquidate assets, or reduce lending. If their assets become hard to sell, requiring a discount, or if new depositors/investors become expensive (require higher interest rates) to attract, banks will reduce lending. If secondary markets for their normally liquid assets (e.g. Mortgage Backed Securities—MBSs) become thin, expensive, and unreliable, banks will tend to shift to more liquid assets such as treasury securities and reserve deposits with the Federal Reserve. In short, they will try to build up (horde) “liquidity” as a precaution. When all banks are trying to build up their liquidity at once, their reluctance to roll-over or extend loans squeezes businesses and households who then must cut back on inventories, employees, investments or purchases. Such credit crunches can cause or worsen recessions. Rather than force a bank to sell assets at a steep discount in an illiquid market to cover deposit withdraws, central banks traditionally accept such assets as collateral for loans to banks to satisfy their need for liquidity.

Normally banks borrow and lend from each other in an interbank money market as part of their day to day liquidity management. The interest rate for three month interbank credits (London Interbank Offer Rate—LIBOR) is normally about 0.1 or so percentage points above the Federal Reserve’s target for the interest rate on overnight interbank lending (the Fed funds rate). In the second half of September this spread (mark up over the Fed funds rate) jumped to 2.4 percentage points. This does not represent a liquidity shortage as banks can borrow large amounts from the Federal Reserve at 25 basis points about the Fed funds rate. Rather it is a risk premium for the risk banks see in lending to other banks (counterparty risk). This focuses attention on bank capital.

Capital means somewhat different things in different contexts. For economists, capital is net worth, the difference between the value of a bank’s (or anyone else’s) assets and its liabilities. There is a closely related but somewhat different concept of “regulatory capital” for banks. Capital absorbs limited losses in the value of assets so that banks are still able to honor all of their deposit and other liabilities. Prudential regulations limit the amount a bank can lend in relation to its capital. Thus even if a bank has all of the liquidity it wants, it can not lend if it does not have sufficient capital.

If a borrower defaults on its mortgage from a bank, the bank reduces the value of that loan on its books (it still expects to recover much of the value of the loan by foreclosing and selling the collateral) and its capital falls by that amount. If losses are larger than its capital it becomes insolvent and cannot pay off all of its liabilities. U.S. banking law requires the FDIC to take over banks when their capital reaches very low levels and to sell off the bank or its assets and operations in whatever manner maximizes their value to pay off the depositors and other creditors.

Before introducing deposit insurance (and sometimes still) when depositors suspected that their bank did not have the money to cover and return their deposits, depositors would run the bank (line up to withdraw their money). However, a bank might be solvent (have positive capital) but not be able at the moment to return deposits because it is temporarily illiquid (not enough cash in the faults). This is exactly when central banks are supposed to provide such liquidity by lending to banks. However, the bank might be insolvent as well as illiquid, in which case the central bank should not provide liquidity and the banks should be “closed” (taken over and resolved by the FDIC). A major challenge is that the ultimate value of assets (e.g., loans and mortgages) is not known and can be difficult to estimate. The value of a mortgage cannot be known for sure until it is fully paid off (or defaulted). Thus a bank’s capital can only be estimated. Experience suggests that when banks are seriously illiquid they are almost always also insolvent (negative capital) as well.

Treasury Secretary Paulson and Federal Reserve Board Chairman Bernanke asked for and got the Emergency Economic Stabilization Act, which included the $700 billion Troubled Asset Relief Program (TARP), in order to improve bank liquidity and capital. This act also increased the size of deposits covered by the FDIC’s deposit insurance while at the same time Ireland and some other European countries guaranteed all deposits in their banks (100% insurance coverage). Deposit insurance improves bank liquidity by removing the reason for bank runs, but it does nothing to improve bank capital. It has no effect on bank capital because it does not change the value of bank assets. Deposit insurance also reduces the incentive for depositors to monitor the soundness of their banks. The purchase of MBSs by the Treasury under TARP on the other hand can increase bank capital in two ways as well as improve bank liquidity by improving the marketability of MBSs. If the Treasury pays their actual value for the MBSs it buys, it will ultimately receive that value when they are paid off and these purchases will cost tax payers nothing (however, it is impossible to know for sure what the actual value will turn out to be). If as is suspected the market is currently undervaluing these MBSs because of its aversion to the risk and uncertainty about their “true” value, the higher price paid by the Treasury will allow banks holding them to mark up their value on their books. This will increase their capital at no cost to anyone because it comes from reduced uncertainty. Secondly the Treasury might pay more than their true value for the MBSs it buys. This would increase bank capital even more as a result of tax payers picking up the tab for the difference.

An obvious question is why not just let insolvent (or seriously undercapitalized) banks fail and accept the punishment free markets hand out for poor or overly risky behavior. After all, the FDIC has developed quite efficient ways of handling such failures. In systemic crisis like the one we are in the longer run costs to the economy can be far greater than the costs that fall on those in the financial markets who misbehaved and would be born by most of us. That cost can be limited with minimal damage to market discipline of economic actors by increasing bank capital generally until confidence returns to the market and its normal functioning can resume with market determined winners and losers. This would require that some existing losses be shifted to tax payers. A government (tax payer) recapitalization of banks should be offered only to those banks rated as generally sound by the banking supervisors and those that are not should be allowed to fail (using the FDIC’s normal bank resolution tools). Accounting tricks that merely hide losses (by abandoning honest mark to market accounting) will not do and are dangerous (a form of capital forbearance).

TARP is a rather roundabout way of improving bank capital. I have describe two better ways in "The Big Bailout–What Next?", CATO Institute, October 3, 2008 and in "The Subprime Crisis–Plan C".

The just enacted $700 billion Plan B to put a floor on the market prices of mortgage related assets may not be enough to restore credit markets to normalcy, though the Treasury has yet to settle on just what Plan B is.  What should Plan C look like?

When the bursting of the real estate price bubble began to dramatically increase mortgage defaults and foreclosures in the spring of 2007 (especially for adjustable rate mortgage loans to subprime borrowers), banks began to horde liquidity and heavily indebted hedge funds and others began to deleverage. The three month LIBOR, the rate at which banks lend to each other, which normally averages between 0.1 and 0.2 percentage points above the overnight Federal funds rate, suddenly jumped starting in August 2007 to more than triple those spreads by mid September reflecting a lack of confidence in the borrowing banks.

In Plan A the Federal Reserve responded quickly to supply the increased liquidity demanded by the market and even introduced new facilities that extended the terms, increased the list of eligible collateral (all Federal Reserve Bank loans are collateralized), and broadened the institutions that could access these new facilities. The money supply (M2) grew above its normal rate throughout this period. Lenders were encouraged to renegotiate the terms of mortgages if foreclosure could be avoided and the lender incur a smaller loss. Plan A included bank by bank interventions and resolutions of failing commercial and investment banks starting with Northern Rock in the U.K, followed by Bears Stearns in the U.S. and later by Countrywide, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia to name the bigger ones. But still the three month LIBOR spread over the fed funds rate persisted in the 0.7 to 0.8 percentage point neighborhood.[1]

Following the September 15^th bankruptcy of Lehman Brothers and the government take over of AIG the next day financial markets panicked and by the end of the month the LIBOR spread more than tripling again from its already extremely large value (to 2.4 percentage points) and credit markets largely froze up. Regrettably more radical intervention was needed. Having largely addressed the “liquidity” problem the Federal Reserve and U.S. Treasury began to focus on the “capital” problem. The write offs of mortgage losses and the prospects of more to come led banks to question the soundness of their counterparties (those other banks to whom they generally lend short term money) and limited what they could lend even if they had the liquidity with which to do it. Thus the rapidly conceived and still unspecified Plan B for Treasury to buy up and insure mortgage related assets held by banks in order to help improve their capital. Plan B seeks to free up the flow of credit to “Main Street” by bailing out “Wall Street.” Depending on the details of its implementation it might succeed, especially if intervention takes the form of direct capital assistance (preferred shares) to all but the weakest banks (which should be resolved in the traditional way if they are not able to come up with enough capital on their own). The best plan would be to immediately guarantee that the government will take a significant, specific share of any actual loss on any mortgage. This plan could be implemented immediately with an immediate increase in the value of all questionable mortgages and of the capital of the banks that hold them.[2] It would share the loss with, and thus reduce it to, lenders but would not eliminate it completely.

Plan B does little to help homeowners unable to meet their mortgage payments. Reducing mortgage defaults is the most fundamental way to reduce Wall Street losses and increase bank capital. It is being called a “trickle up” rather than a “trickle down” approach. The administration and Congress have been rightly concerned not to tax those who borrowed prudently to bailout those who borrowed foolishly or who speculated on increasing housing prices, or to change lending rules in ways that increase the costs of mortgages in the future (such as court order debt restructuring). It has pressed for voluntary loan restructuring with HOPE and beefed up the FHAs assistance programs. However, we now need to carefully consider a radical Plan C that helps home owners with minimum unfairness and moral hazard of encouraging imprudent borrower behavior in the future.

Koppell and Goetzmann recommend that the government “pay off all the delinquent mortgages” by offering “to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent.” [3] McCain introduced a similar plan during the Presidential debates October 7. These proposals are bold but fail on many of the fairness, moral hazard criteria above. McCain’s plan spares the lenders any cost of their misjudgments and fully bails out borrows who can’t or won’t pay. A better plan, proposed by Henry Sanborn, is for the Federal government to offer to pay a share, say 30%, of the existing contractual mortgage payment in exchange for which the lender must pay (write off) a share, say 10% and the mortgagee the rest. The government’s payments would be a loan to struggling homeowners with attractive terms that encourage early repayment.[4] Replacing ARMs with Koppell and Goetzmann’s fixed rate mortgage could be usefully added to this plan. Actual and expected foreclosures should drop significantly to those levels that should not be prevented in any event and the market value of mortgages and mortgage backed securities would quickly increase, the associated losses to lenders decrease, and the capital of banks holding them increase.

To illustrate, a $200,000 30 year mortgage on a house valued at 220,000 with an initial teaser interest rate of 4% adjustable after two years, would require monthly principal and interest payments of $955 per month. After two years the remaining principle would be $192,812. If the interest rate on the adjustable rate mortgage (the category with the largest defaults) increased to 6% (most ARMs cap year to year adjustments at 2%), monthly payments would jump to $1,186 per month (or $1,440 per month at 8%), which might be more than the borrower could afford. Sanborn’s proposal is that if the lender can not agree on a voluntary restructuring satisfactory to the borrowing, the government would pay (as a loan) 30% of the monthly payments ($356) and the lender would eat (write off) 10% ($119) reducing the monthly payments for the borrower to $712. More likely that borrower would choose to borrow from the government the smaller amount needed to keep her payments at the affordable $955 per month. There is no firm data on the extent to which such measures would reduce mortgage defaults but it is likely to be considerable. Even if the market price of the house fell 20% to 180,000 (i.e. below the amount of the mortgage (serious home owners are not likely to walk away from their home as long as they can continue to make the monthly payments)

Let’s start discussing the details of Plan C before poorly designed versions are forced through a panicked Congress and before the unavoidable losses on other credits as the economy slows add to the erosion of capital.