Bank Loans Marked to Fantasy – The Next Bubble to Burst

I came across this interesting Bloomberg article in Mish’s blog, Next Bubble to Burst Is Banks’ Big Loan Values: Jonathan Weil:

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

While disclosures of this sort aren’t new, their frequency is. This summer’s round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Board’s rules.

The timing of the revelations is uncanny. Last month, in a move that has the banking lobby fuming, the FASB said it would proceed with a plan to expand the use of fair-value accounting for financial instruments. In short, all financial assets and most financial liabilities would have to be recorded at market values on the balance sheet each quarter, although not all fluctuations in their values would count in net income. A formal proposal could be released by year’s end.

Recognizing Loan Losses

[smartads]The biggest change would be to the treatment of loans. The FASB’s current rules let lenders carry most of the loans on their books at historical cost, by labeling them as held-to- maturity or held-for-investment. Generally, this means loan losses get recognized only when management deems them probable, which may be long after they are foreseeable. Using fair-value accounting would speed up the recognition of loan losses, resulting in lower earnings and reduced book values.

While Regions may be an extreme example of inflated loan values, it’s not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the company’s Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies.

Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

Please also consider what I posted in April regarding GE & Mark to Market:

The world’s biggest maker of jet engines and power turbines told shareholders last week that 2 percent of GE Capital Corp.’s assets are being valued based on market prices. The remaining $624 billion is being carried at levels that GE, the last original member of the Dow Jones Industrial Average, established in many cases years ago, according to CreditSights Inc.

“The notion of having 98 percent opaque and 2 percent valued with clarity is something that by its very nature would make investors nervous,” said Robert Arnott, founder of Research Affiliates LLC, which oversees $30 billion in Newport Beach, California and owned 481,201 GE shares as of Dec. 31. “Having some clarity on what the other 98 percent is worth is valuable.”

98% valued at fantasy prices, 2% at real world prices means that there is nothing but trouble down the road for GE.

I noted recently in Total US Credit and Loans – How Much Contraction Since Peak?:

Since the peak in October 2008, total credit and loans/leases outstanding have fallen by $725 billion, a 4.3% drop. And this doesn’t even take into account the decline in outstanding bond prices and unfunded liabilities. It is, indeed, tough to ascertain whether there is a decline in the net present value of unfunded liabilities. Thus we shall ignore them for now. However, bond prices have definitely declined across the board.

On top of that, I don’t think that people are oblivious to the fact that there is absolutely no way that all social security and medicare benefits will ever be paid. Thus it would only be reasonable to conservatively assume that the present value of those liabilities has dropped by the same amount. This would almost double the total contraction to around $4 trillion.

It is rather questionable whether all this credit is marked to market. I would say that all this number gives us at the moment is at the low end of the range.

The real contraction is obviously much more than stated in official reports. This may change in case the FASB follows through on its planned changes to accounting rules. It is rather remarkable that in spite of false over reporting of loan values, credit is contracting at this pace. I ask: How much will it be once they have to report real losses?

Whether they change the rules of this delusion game sooner or later or not at all. Bank loans are reported at ridiculous values and there is no chance of a substantial recovery until and unless the bad apples are sorted out.

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GE – What Are People Expecting?

GE’s dismal results seemed to take people by surprise last week, as Reuters writes GE results slam market:

NEW YORK (Reuters) – Wall Street stocks skidded on Friday after disappointing earnings at General Electric Co jolted investors who had hoped a U.S. slowdown would be mild and sent them scurrying to the safety of government debt.

The slide pulled European shares down as well, though Asian markets closed higher before the U.S. news hit.

The dollar fell broadly as GE’s results and lowered outlook for 2008 — along with a worse-than-expected slide in consumer confidence — undermined a view that the worst of a credit crisis that has battered markets for months might be over.

Oil steadied after an earlier decline as supply concerns and the weak dollar countered expectations that slowing economic growth will reduce global demand this year.

GE shares slumped more than 13 percent, their worst decline since the stock market crash of October 1987. The conglomerate, viewed as an economic bellwether because of the range of its businesses, reported an unexpected 6 percent decline in first-quarter earnings and lowered its forecast for 2008.

…let’s remind everyone about GE’s predicament, in March I referenced:

For more than a decade General Electric Co. could easily avoid disclosing the value of its real estate and business loans. Not any more.

Since Jan. 2, GE has lost 45 percent on the New York Stock Exchange, mostly because shareholders are no longer willing to accept whatever the Fairfield, Connecticut-based company tells them about its finance subsidiary unless it’s based on so-called mark-to-market accounting rules.

The world’s biggest maker of jet engines and power turbines told shareholders last week that 2 percent of GE Capital Corp.’s assets are being valued based on market prices. The remaining $624 billion is being carried at levels that GE, the last original member of the Dow Jones Industrial Average, established in many cases years ago, according to CreditSights Inc.

“The notion of having 98 percent opaque and 2 percent valued with clarity is something that by its very nature would make investors nervous,” said Robert Arnott, founder of Research Affiliates LLC, which oversees $30 billion in Newport Beach, California and owned 481,201 GE shares as of Dec. 31. “Having some clarity on what the other 98 percent is worth is valuable.”

The simple conclusion that one has to draw when applying simple math is precisely what I wrote back then:

98% valued at fantasy prices, 2% at real world prices means that there is nothing but trouble down the road for GE.

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GE & Mark to Market

Bloomberg writes Nobody Says Mark to Market Doesn’t Matter as GE Falls:

For more than a decade General Electric Co. could easily avoid disclosing the value of its real estate and business loans. Not any more.

Since Jan. 2, GE has lost 45 percent on the New York Stock Exchange, mostly because shareholders are no longer willing to accept whatever the Fairfield, Connecticut-based company tells them about its finance subsidiary unless it’s based on so-called mark-to-market accounting rules.

The world’s biggest maker of jet engines and power turbines told shareholders last week that 2 percent of GE Capital Corp.’s assets are being valued based on market prices. The remaining $624 billion is being carried at levels that GE, the last original member of the Dow Jones Industrial Average, established in many cases years ago, according to CreditSights Inc.

“The notion of having 98 percent opaque and 2 percent valued with clarity is something that by its very nature would make investors nervous,” said Robert Arnott, founder of Research Affiliates LLC, which oversees $30 billion in Newport Beach, California and owned 481,201 GE shares as of Dec. 31. “Having some clarity on what the other 98 percent is worth is valuable.”

98% valued at fantasy prices, 2% at real world prices means that there is nothing but trouble down the road for GE.

Federal Reserve Chairman Ben S. Bernanke said today that he wouldn’t support any suspension of mark-to-market accounting.

Once the world’s largest company, with a market value of almost $600 billion, GE has plummeted to $93.7 billion in New York Stock Exchange trading. The shares posted two of the three worst weekly declines since 1980 during the past month as investors speculate the deepest financial crisis since the Great Depression will cause more writedowns and losses at its finance division than the $10 billion the company anticipates.

GAAP Accounting

Last week, the stock fell below $6, the price of some GE light bulbs, for the first time since 1991. Today, GE jumped 20 percent to $8.87 after its finance unit sold $8 billion of government-backed debt.

“We have significantly increased transparency and disclosure,” GE spokesman Russell Wilkerson said in an e-mailed response to questions, pointing to a two-hour meeting the company had with analysts and investors in December to review GE Capital’s business. Still, “we recognize there is a need and an opportunity to do more.”

GE, which will hold a five-hour meeting with investors and analysts on March 19 to discuss the finance unit’s business, follows generally accepted accounting principles, which don’t require it to mark all assets to market, according to Wilkerson. In fact, the rules in many cases forbid it, he said.

GE Capital Forecast

GE predicts the finance unit will earn $5 billion this year, more than forecasts by analysts surveyed by Bloomberg. Goldman Sachs Group Inc. analyst Terry Darling in New York expects the finance unit to break even this year as losses from loan losses swell in commercial real estate and in Eastern Europe.

GE’s forecast reserves relative to loans of 2.5 percent this year are still “thin” relative to banks, which means raising more capital is “inevitable,” according to Darling.

The gap between GE and the analysts reflects differing valuations for assets in the finance division.

The unit is similar in size to the sixth-biggest U.S. bank, according to an estimate by CreditSights, an independent bond research firm based in New York. Most of its loans are senior secured debt tied to assets such as aircraft.

GE Capital generated 48 percent of the parent company’s $18.1 billion in profit last year. That compares with about 20 percent in the late 1980s, according to Nicholas P. Heymann, an analyst at Sterne Agee, a Birmingham, Alabama-based brokerage.

Differing Realities

He estimated in a note on March 3 that GE may need more money to cover losses of between $21 billion to $54 billion in the next several years. That would be almost as much as Merrill Lynch & Co. wrote down, according to data compiled by Bloomberg. New York-based Merrill was acquired by Bank of America Corp. of Charlotte, North Carolina.

Heymann’s “analysis is flawed and produces misleading estimates,” GE’s Wilkerson said. Heymann applies a historical loss rate of 2.5 percent for banks to GE’s real-estate equity holdings as well as its loans, leading to loss estimates that are twice as large as they should be, according to GE’s Wilkerson.

“The transparency is what you want,” said Barry James, chief executive officer of James Investment Research Inc. in Xenia, Ohio, which oversees $1.3 billion. “I don’t think anybody knows what they’re worth.”

‘Needlessly Destructive’

The debate over the fair-value rule, which requires companies to assess assets every quarter to reflect a market price, divides finance industry executives.

Banks say the rule, also known as mark to market, requires them to report losses from falling values even if they don’t expect to incur penalties because the assets aren’t for sale. The lower valuations can force companies to raise capital to comply with federal regulations.

Blackstone Group LP Chairman Stephen Schwarzman, the American Bankers Association and 65 lawmakers in the House of Representatives urged that fair-value accounting, mandated by the Financial Accounting Standards Board, be suspended last September. William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985, has called fair value “extremely and needlessly destructive” and “a major cause” of the credit crisis. Robert Rubin, the former Citigroup Inc. senior counselor and Treasury secretary, said Jan. 27 the rule has done “a great deal of damage.”

Blaming the Doctor

Goldman Sachs Chief Executive Officer Lloyd Blankfein, Lazard Ltd. Chairman Bruce Wasserstein and Treasury Secretary Timothy Geithner support fair-value accounting.

Fed Chairman Bernanke told Congress Feb. 25 that fair value is a “good principle in general” even if accounting rulemakers have to “figure out how to deal with some of these assets” that aren’t actively traded.

Today, the central bank chief in remarks prepared for an address to the Council on Foreign Relations in Washington added that he wouldn’t support suspending fair value accounting, saying “I strongly endorse the basic proposition of mark-to-market.”

Securities and Exchange Commission Chairman Mary Schapiro has said mark to market wasn’t a significant factor in the current crisis.

Blaming the rule “is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick,” Dane Mott, an analyst at JPMorgan Chase & Co., wrote in a September report.

This is 100% correct. Anyone who suggests that mark to market is a significant factor or cause of the crisis has no idea what he is talking about. William Isaacs statement is almost comical. Fair value is “extremely and unnecassarily destructive”? What is that supposed to mean? It is bad management and producing losses that is extremely and unnecessarily destructive, why would reporting the results of it be? If anything, getting the right reporting gives the managers in charge the ability to change course before it’s too late. Mark to market is in fact the solution, not the cause of the credit crisis.

GE, which may lose its AAA ratings from Moody’s Investors Service and Standard & Poor’s, will meet with analysts this month to make good on Chief Financial Officer Keith Sherin’s promise of a “deep dive” explanation of the finance unit. The company cut its dividend for the first time since 1938 last month to preserve $9 billion in cash.

“Investors need the assets broken down so they can see what’s really there,” said Craig Hester, president of Hester Capital Management, which oversees about $1.1 billion in Austin, Texas. “The market cares about whether GE is being honest. In the case of GE, there is fear.”

To contact the reporters on this story: Michael Tsang in New York at [email protected]; Rachel Layne in Boston at [email protected]

A House Financial Services subcommittee has scheduled a March 12 hearing on mark-to-market accounting rules. The most laughable statement in the article linked above:

In theory, mark-to-market provides good information for potential investors and prevents businesses from assigning any value they choose — likely a higher one — to things they own.

But mark-to-market can cripple businesses when no market for an asset exists, like now.

Big banks are struggling to survive — shares of Citigroup, once the world’s largest bank, closed at $1.02 today — because their balance sheets are poisoned with assets for which no market exists. Chiefly, the mortgage-backed securities based on lousy mortgages. No one wants to buy them right now, so that means no market exists.

Some day, there will be a market for those securities. But until there is, banks have to account for them at fire-sale prices, and that’s what’s making the banks sick.

If no market exists for an asset, it means that nobody wants to buy it. If nobody wants to buy it its price needs to be lowered. If nobody wants to buy it at any price its price is $0.00. Whether or not a business holds assets that are worth $0.00 versus $1,000,000 is something that an investor might want to know about if he commits his own money. Who can possibly support the view that lying to investors is a good thing?

What it most concerning about this whole debate on mark to market is that its main premise seems to be that we currently have mark to market accounting in place. Then why does GE only have 2% of its assets marked to market? Why does Citigroup still have $800 billion in overvalued SIVs? The problem is precisely that accounting rules currently enable businesses to try and trick the public by not pricing their assets fairly. President Obama himself implicitly called for mark to market accounting. When will we see any of it materialize?

GE is the last business from a list I posted half a year ago that has not yet asked for a bailout:

More prestigious businesses will be in line for bailouts shortly, in particular Citigroup, General Motors, Ford Motors, and General Electric are likely candidates.

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Finally – Obama Calls for Mark to Market Accounting!

President Obama has spelled out what neither Bush nor Paulson nor Bernanke nor anyone from the executive branch dared to tell the American people during this financial crisis.

In an interview with MSNBC’s Matt Lauer he implicitly called for mark to market accounting:

In an interview airing Monday on NBC’s TODAY show, Obama said the nation’s banks were in “very vulnerable positions” because of the reckless risk-taking that led to the meltdown of the financial services sector late last year. The situation he inherited 13 days ago is so bad that “it is likely that the banks have not fully acknowledged all the losses that they’re going to experience,” Obama said in the interview, which was conducted Sunday at the White House.

Stressing that ordinary Americans’ deposits, which are insured by the federal government, would be safeguarded, the president said banks were “going to have to wring out some of these bad assets.”

Hello?? Did anyone hear this? This bit seems to have gone relatively unnoticed with most people. Among all the stimulus nonsense and bailout mania, President Obama, in a relaxed manner, spelled out precisely what is needed for the US economy to get back on its feet. This is exciting news for anyone who, like me, has been waiting to hear anything like it for the past year and was instead consistently disappointed by repetitive and never ending Bush/Bernanke/Paulson lies and nonsense.

Obama then went on to utter the following 5 words:

…some banks won’t make it.

If he is serious about this, it marks a substantial change in the administration’s banking policy. This is bad news for most of the US’ national banks whose shareholders are still under the illusion that their assets are worth something, it is good news for the economy and for the people. If followed through upon, it significantly improves the outlook for economic recovery over the next years, that is of course after the government lets the sharp recession and the bank failures run their course in an unhampered manner.

As explained in the business cycle, the malinvestments need to be liquidated as fast as possible in order for phase 9, the correction, to be able to run its course. Marking bad loans to market is exactly what this is.

Dollar bulls, who are looking for a reason as to why the current short term Dollar rally might turn into a rather substantiated mid-term rally: This is it.

It will be interesting to watch the development of the money supply over the next few months. It is conceivable that the recent reflation attempts will prove completely futile and that the money supply growth will once again drop back to deflationary levels. In fact, if this administration encourages the destruction and consolidation of bad debts, I don’t see any other possible development than that.

Watch the video here:

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