What do Ken Lewis and Jamie Dimon know that we don't? Lewis, the CEO of Bank of America (NYSE:BAC), and Dimon, CEO of JPMorgan Chase (NYSE:JPM), have reportedly spent millions recently buying their companies' beaten-down shares, defying those who seem to think that the nation's banks are doomed.
Ongoing problems at Citigroup (NYSE:C) and Bank of America, as well as write-offs at the venerable State Street (NYSE:STT), Bank of New York Mellon (NYSE:BK), and several regional banks inspired rumors of bank nationalizations and spooked financial stocks again in recent days. Bank stocks led the market sharply lower last Tuesday, a day otherwise marked by the festive inauguration of a new president.
What can President Obama's financial team do to right the banking ship? There are a number of proposals under consideration, including the formation of a "bad bank." One idea that should be reviewed is the elimination of mark-to-market accounting, required by FAS 157, which would go a long way toward stabilizing the banks.
Analysis from an expert
A great new report from Ladenburg Thalmann's Richard Bove, "Views on the Banking and Securities Sectors," details the latest developments at Bank of New York (a stock he is recommending) and puts the absurdity of the current situation into perspective. In short, because banks are scared of future asset writedowns, they are depositing money obtained from the federal government with the federal government, as a safety net. Does this make sense?
According to Bove, FDIC figures indicate that bad loans held by banks as of last year's third quarter were still relatively low compared to historical norms. "Even if one assumes that the banks are about to see these numbers triple," Bove writes, "they are well within the bounds of what can be absorbed."
Demonstrating the impact of mark-to-market accounting, Bove reviews the figures for Bank of New York. Delinquencies on BNY's commercial mortgage-backed securities were 0.88% of its total portfolio; Bove points out that the bank is currently carrying the loans at $0.75 on the dollar, indicating a 25% default rate.
Furthermore, BNY has estimated that it may lose $208 million on securities that are current, out of a total portfolio of $46 billion. Responding to this estimate, management decided to mark down its portfolio by $1.2 billion, which was charged to earnings. This brought the total amount of portfolio markdowns to $7.6 billion; the company is valuing the securities at 83.5% of par value. In response, the company intends to sell off $14 billion of "risky" securities, and to generally lower its risk profile. Consequently, the bank now has $56 billion on deposit with the Federal Reserve.
As Bove says, "One might argue that the bank has withdrawn $70 billion in liquidity from the markets based on a deeply flawed accounting rule."
And this is not a one-off
Bove points out that bank deposits with the Fed have soared to more than $900 billion, a totally unprecedented figure. To put this in perspective, going back to at least 1990, bank deposits with the Fed have never exceeded $100 billion!
Writedowns of assets have rattled investors and obscured the operating results of the banking sector. Criticism of the accounting rule is widespread, with many analysts pointing out that concern about future markdowns has led to a virtual collapse in demand for questionable assets, greatly compounding the losses being taken. Under normal circumstances, mark-to-market may present a more accurate reading of a company's situation, but not when the markets are critically illiquid. Marking assets to "model," in my view, generates as much uncertainty as carrying loans and other hard-to-value properties at cost. At least cost is not a moving target.
One critic of mark-to-market is William Isaacs, former head of the FDIC. Isaacs spoke on an SEC panel last October, saying that FAS 157 "has destroyed hundreds of billions of capital in our financial system, causing lending capacity to be diminished by ten times that amount." As Vince Farrell, Chief Investment Officer of Soleil Securities Research, points out in a note to investors, Isaacs headed the FDIC during the early 1980s, at the time of the Latin American debt crisis. At that time, Farrell writes, "Latin debt was trading as low as $0.10 on the dollar … Isaacs has said that if mark-to-market accounting had been in effect then the banking system would have been insolvent and out of business."
An accounting controversy
This is a controversial issue. Admirers of the new accounting standard argue that eliminating the requirement would crush investor confidence in banks' financial statements. What confidence? As a sector, financials are off 68% over the past year.
Bank statements today are not only misleading, but also nearly incomprehensible. If you don't believe me, go take a look at Bank of New York Mellon's statements. I wish you luck. Its writedowns and charge-offs are mystifying.
Much of the support for FAS 157 comes from academics and accountants, while opposition stems largely from practitioners -- people actually trying to manage or oversee the banks. Timothy Geithner, recently confirmed as Treasury Secretary, said in his confirmation hearings that his team would come on board with a bold new plan. I believe that getting rid of mark-to-market accounting would be a great place to start.
For related Foolishness:
- Understand the basics: "Mark-to-Market Accounting: What You Should Know"
- An opposing view: "How Not to Solve the Credit Crisis"
- More accounting fun: "These Losses Could Mean Gains"
