Banks May Not Be in as Bad of Shape as the Market Thinks
March 10, 2009

The narrative is well known. A bunch of greedy Wall Street bankers made trillions of dollars of bad loans to borrowers who had no chance of paying them back so that the bankers could earn obscene bonuses. Later when the loans went bad, the banks were left with billons in losses. The storyline has been so often repeated that it has become an article of faith in our national consciousness. But how likely is it that this is really what happened?

Dow Jones Bank Index

To believe this scenario you must be willing to accept a number of doubtful assumptions. In every major bank there are underwriters or risk managers that are the watchdogs on the quality of the banks assets. For this narrative to be true thousands of such underwriters were either compromised or became completely incompetent at virtually the same moment in history. These individuals' compensation are not typically tied to loan production so they have no incentive to take unreasonable risks. In fact, quite to the contrary they get fired when things go wrong.

Further at the executive level, we must believe that the top managers of these institutions were willing to bankrupt their companies in exchange for short term bonuses or, that they too were completely incompetent. In many cases, much of these individual's net worth are tied up in the stock of these companies. Therefore, their long-term financial interests were not consistent with the behavior suggested. Added to that, these guys were not dummies. Most were graduates of the finest business schools in this country. I find it pretty hard to believe the thousands of bankers suddenly went crooked, nuts or stupid all at the same time.

Next we must believe that millions of people decided to borrow more money than they had any chance of repaying. Now I agree that most of us tend to the optimistic side of the amount of the debt that we can handle. Does it really seem likely that millions of people bought a home when they knew they would default soon after the purchase and ultimately be forced out through foreclosure. Were they really willing to ruin their credit and have their families uprooted by forcible eviction? I suppose there might be a few people that would undertake such a proposition, but it seems incredible to think that millions of Americans families would subject themselves to the embarrassment and stress of financial ruin or that alternatively millions of Americans were too dumb to know that they were borrowing more than they could pay back.

I am probably skeptical of this narrative because I saw a similar one in the savings and loan crisis. Even today the commonly accepted cause of the savings and loan crisis was that a bunch of crooks looted the industry. However, after three decades, it is widely accepted among academicians and economists that fraud and insider abuse accounted for only 10% of the losses and that the real causes were a series of policy missteps by the government. (see www.aboutsavingface.com)

So is there a similar alternative explanation to the current mythology? It is extremely difficult in the midst of a crisis to sort out the events swirling around us. It was not until years after the savings and loan crisis that we were able to take full measure of the causes and effects. However, I have a principal suspect for the culprit in the current crisis and you will probably not be surprised that it comes from the government, in this case, aided by the Financial Accounting Standard Board ("FASB").

A fundamental issue in determining the health of any financial institution is to appropriately value its assets. Of course, in most cases this involves valuing the loans owed to the financial institution. In a traditional bank which makes loans directly to its customers, loans are valued at the amount owed by the customer unless there is some reason to believe that the customer may not be able to pay back the loan. Reserves for uncollectible loans are set by the bank and reviewed periodically by the bank examiners. It is a system that has worked reasonably well for almost a century.

However, in the late 1990s a fundamental change took place in the way mortgages (and some other loans) were originated. Instead of the financial institution making the loans directly to its customer, intermediaries began originating and securitizing huge pools of loans. On its face, this seems like a great boon to the banks. It reduced their cost of origination and provided them with a security that could be readily sold if they needed to increase liquidity.

Unfortunately, it turned out that there were a number of structural problems in separating the ultimate lender from the borrower. These problems will be the subject of another discussion. But there was another effect which ultimately proved much more insidious. Because the securities were more readily tradable, they were subject to the "mark-to-market rules."

In its simplest form, the mark-to-market rules are pretty straightforward. If a financial institution holds a security for which there is a ready market, that security must be shown at its market value. So if a bank owned Exxon stock for example, it would show the value of that stock at its market value.

However, any share of Exxon stock has exactly the same value as any other share. Also, there are metrics that allow investors to make reasonable judgments about the value of Exxon shares to, say, Chevron shares. This is not the case with the mortgage back securities (MSB). The value of these pools is tied ultimately to collectability of the underlying loans, which turns on the value of the underlying collateral, local market conditions, borrow credit worthiness and many other intangible factors that go into underwriting an individual loan.

The complexity of analyzing this array of factors on thousands of loans (especially when they were divided in tranches) creates an impossible task. The organizers of these transactions attempted to wire around this problem by having the credit rating agencies assign ratings to the pools. In their glee at the prospect of a whole new universe of fee income, the credit rating agencies rushed into to the market. (The role of rating agencies in this whole debacle is a story that has yet to be told.)

Unfortunately, the rating agencies made a fundamentally flawed assumption. They believed that home prices could not go down. As the real estate market and the economy began to cool, defaults in the loans began to occur. Suddenly the banks, the market generally and most importantly the banks' auditors and examiners began to doubt the collectability of the pooled loans and, therefore, their value.

Since these instruments were designed to be readily tradable, the mark-to-market rules applied. Auditors and bank examiners, determined to cover their own behinds, began to insist on marking down the MSBs. But because of the doubt that had crept into the market for MSBs there was no ready market. Banks, with the prodding of their auditors and examiners basically began guessing at what the MSBs might be worth and recording losses. Mind you, not actual losses of the sale of securities, but a theoretical loss on a theoretical sale. But the reduction of the bank's capital was not theoretical. It had to be reported to the SEC and the bank regulators.

Ironically, if the same loans in the MSB had been held directly by the banks, mark-to-market would not apply. The loans would be reviewed on an individual basis and an appropriate reserve established for the non-performing loans. But a bank may be forced to mark down the value of an MSB even if every loan in the pool is paying on time.

Once a bank's capital is impaired by these reductions in value, it is forced to de-lever. That means the bank has to sell assets to reduce the size of its balance sheet and to maintain the require capital ratio. Of course, when a large number of financial institutions all need to sell these assets at the same, they further depress asset prices, closing a vicious circle. The banks also began reducing new loans as a means to reduce the size of their balance sheet, thereby causing the banking crisis to spill over into the Main Street economy. As Main Street began to cut back, it eliminates jobs which mean more bank defaults, thus reinforcing the downward spiral.

But what if the MSBs have been marked down more than is really justified? Is that a possibility? I think so. We know that it happened in the savings and loan crisis. It has been well documented that RTC and its predecessors marked the S&L's assets to absurdly low levels. The liquidation of the S&L industry has been described as one of the greatest transfers of wealth in history as buyers at RTC sales made hundreds of millions of dollars.

Given the complexity of the MSB structures, it may be too early to predict that they have written down below their inherent value. But it is probably not a bad bet. If so, we may wake up one day to find out that much of the current misery was visited on us by accounting and regulatory rules intended to protect us. It would hardly be the fist time that unintended consequences have bitten us on the behind.