Eureka! The Banking Industry’s Problems Are Solved!

Who knew it would be so easy? Who knew we could solve the banking industry’s collapse by simply changing how we account for assets. Eureka! Problem solved!

That seems to be the conclusion Wall Street came to earlier this week, judging by the reaction to Fed Chairman Ben Bernanke’s comments at the Council on Foreign Relations on Tuesday. During that speech, Bernanke weighed in on “mark to market” accounting, saying the following:

“The ongoing move by those who set accounting standards toward requirements for improved disclosure and greater transparency is a positive development that deserves full support. However, determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle.

“As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is underway on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers.“

Fed Chairman Ben Bernanke’s recent comments suggest “modifying” accounting rules might help the banking system.

What Bernanke did is shift ever so slightly toward the position of the banking industry’s apologists. These lobbyists, assorted policymakers, and pundits (including folks like Steve Forbes, who wrote an Op-Ed in the Wall Street Journal the other day), are arguing — once you cut to the chase — the following …

The problem with the banks isn’t all the crappy securities and loans they’re loaded up with.

It’s not that they took on too much excessive risk, lending against assets whose value is plunging.

It’s not that they funded asinine private equity deals, stupid commercial construction deals, and dumb home purchases.

It’s that they have to mark their book of securities made up of these bundled loans to market. And they argue that the prices they could get for those securities in the markets are “artificially” low — or in some cases, that there is NO market for them.

If only they could avoid marking those assets to market, or use their super- duper net present value and cash flow MODELS — which, surprise, surprise, say the “real” value of those securities is higher — then the banking system would be fine. We could all go back to the wonderful world of yesteryear.

There’s just one problem …

Pretending Something’s Worth More Than It Is Doesn’t Change Reality!

Look, the problem isn’t that there’s NO market for these bad securities. The problem isn’t that the prices are “artificially” low. The problem isn’t how we account for these assets. The problem is that the industry doesn’t want to acknowledge that today’s prices are the REAL prices.

There are tons of bidders out there for this crappy paper … at the RIGHT price. Vulture funds, hedge funds, private equity investors: They’re all raising billions and billions of dollars to scoop up cheap real estate, inexpensive bundles of mortgage backed securities, and distressed buyout loans.

But sellers don’t want to admit reality. They’re not hitting the buyer’s bids. They’re hanging on to the garbage securities, hoping against hope that they won’t have to sell at the true market prices. And the government is busy trying to figure out ways to prop up the price of the garbage rather than forcing banks to take their medicine now, even if it means the result is that they have to temporarily be nationalized or put into receivership.

There are plenty of buyers for bad paper — but too few sellers willing to hit buyers’ bids.

I understand why this is occurring: Policymakers are afraid of mass insolvencies. So they’re trying to figure out how to do something akin to the early 1980s use of Regulatory Accounting Principles (RAP), which papered over insolvencies in the Savings & Loan industry.

Of course, papering over the problem didn’t mean it went away. No surprise, then, that the unofficial nickname for RAP used to be Creative Regulatory Accounting Principles; you can figure out the acronym yourself.

Worse, many of the S&Ls that were granted forbearance were also allowed to try to grow their way out of insolvency. They increasingly gambled on new ventures, especially commercial real estate, to do so. Result: They eventually blew up anyway — at a much LARGER cost to U.S. taxpayers.

This strategy of delay, stall, and hope has another more recent analog: It’s exactly what we saw in the early days of the housing market downturn. Sales VOLUME dried up, while the SUPPLY of homes for sale surged.

Yet reported median prices didn’t decline. I lost count of how many people asked me: If the market is so bad, why aren’t prices falling? I answered that fewer and fewer buyers were paying inflated prices, holding up the median.

But the huge build up in supply and dramatic fall off in the sales pace meant it was just a matter of time. The TRUE, underlying market value of U.S. homes was declining; it just wasn’t being acknowledged by most sellers yet. Sure enough, the numbers eventually took a dramatic turn for the worse. It’s kind of like those old Road Runner cartoons, where the coyote runs over the cliff but doesn’t start plunging until he looks down.

It was just a matter of time before the true, underlying market value of U.S. homes sharply declined.

My Prescription: Deal with the Problem Head On!

The longer the industry tries to push out the day of reckoning … and the longer Washington pretends the problem is accounting rules (or even worse, short sellers, who also were cast as the latest bogeyman for the banking sector) … the longer this recession is going to drag on. It also increases the chance we end up like Japan, with zombie institutions consuming more and more government dollars even as the economy stagnates.

Think I’m crazy? Then consider this: If institutions just bit the bullet a year or two ago, and unloaded all this crappy paper at the then-available prices, they would be in clover today. They would have gotten much higher prices for these assets.

But they followed the delay, stall, and hope doctrine — and instead of learning from that mistake and changing course, they’re STILL making the same mistake today. They’re still saying their modeled prices are the “real” prices and that anyone who suggests otherwise doesn’t know what he’s talking about. They say if the accounting procedures are modified, and the regulators forebear, everything will be fine down the road.

That strategy didn’t work for the S&Ls in the 1980s. It didn’t work in Japan in the 1990s. It hasn’t worked so far this time around. And I don’t think it will work in the future.

Until next time,

Mike

About Money and Markets

For more information and archived issues, visit http://www.moneyandmarkets.com

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates
but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

Attention editors and publishers! Money and Markets issues can be republished. Republished issues MUST include attribution of the author(s) and the following short paragraph:

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

From time to time, Money and Markets may have information from select third-party advertisers known as “external sponsorships.” We cannot guarantee the accuracy of these ads. In addition, these ads do not necessarily express the viewpoints of Money and Markets or its editors. For more information, see our terms and conditions.