Saturday, August 14, 2010

“Extend & Pretend”: Where Are We After One [and a half] Years of the Suspension of the FASB Rules?

Note: I originally posted this on Yves Smith’s blog naked capitalism, last April 4. The original post is here.

Recently, William Black has more or less pointed out the same thing, as reported by Mish Shedlock here: With the financial industry having pressured Congress, the accounting rules have been softened to the point where they cannot discern a healthy bank from an insolvent one. Hence, zombie banks, and a Japanese-style lost decade.

My April 4 post:

In 1982, many of the banks hit by the Latin American debt crisis were effectively insolvent. Paul Volcker, as the then-Chairman of the Federal Reserve—charged with overseeing the banking system—effectively cast a blind eye on this banking insolvency.

Volcker’s reasoning seems to have been that the US banks were not broke—they were just getting temporarily squeezed. Volcker seems to have concluded that time would heal the balance sheet wounds caused by the Latin American defaults. Therefore, to hold the banks to the letter of the accounting rules would likely drive one or more of them broke, to no useful purpose—and it could potentially cause a bank panic and general financial crisis. But to pretend (for a while) that all was right with the US banks would avoid a potential panic—so long as the crisis sorted itself out and the banks repaired themselves by writing off and renegotiating their toxic Latin American debt.



Volcker gambled, and won: The US banks indeed took the Latin American debt hit, but grew their way out of their hole. None of the large American banks were pushed to bankruptcy in 1982, and by 1983, the worst had passed. By 1984, the biggest chunks of Latin American debt had either been renegotiated or written off—so far as the American banking system was concerned, the crisis was over, with not a single name bank going broke. And most importantly, stability and calm reigning all the while.

Score for Volcker and what we could say was the Volcker Call.

In 2008, when Lehman went bankrupt because of all the “toxic assets” on its balance sheet, the severe credit crisis that happened as a result was because everyone realized that Lehman was the canary in the coal mine. All of the American banking system was insolvent, for more or less the same reason: Assets on their books simply were not worth anything close to their nominal value. These assets were clustered around CDO’s, mostly in the real estate and commercial real estate markets.

To relieve the credit crunch that peaked in September, 2008, the Federal Reserve Board opened the money spigots—all kinds of lending windows were opened, with a dizzying array of acronyms, all of them doing basically the same thing: Lending out wads of cash at zero interest to the American banking system, all in an effort to keep it from going broke.

Between September, 2008, and March 2009, the Fed backstopped the entire US banking system—but it still wasn’t enough. The losses were too great, the holes in the balance sheets too big.

So on April 2, 2009, a key FASB rule was suspended: Specifically, rule 157 was suspended, related to the marking of assets to market value—the so-called “mark to market” rule.

Essentially, the mark-to-market rule means marking an asset to the value it can fetch in the open market at the date of the accounting period. If I own a share of XYZ stock which I purchased at $100, but today it’s quoted at $60, I mark it on my books at today’s market price—$60—not at the purchase price—$100. The reason is obvious: By marking the asset to market value, I’m giving a realistic picture of the financial shape of my company or bank.

However, ever since April 2, 2009, when the FASB rules were suspended, the American banking system has been floating on nothing by air. By suspending rule 157, none of the banks have had to admit that they’re insolvent. With the suspension of mark-to-market, accounting rules are now basically mark-to-make-believe.

Why was FASB rule 157 suspended?

Geitner, Bernanke and Summers seem to have been trying to duplicate what Volcker did so successfully in 1982. This period since March 15, 2009, when the suspension of the rule went into effect, has been called “extend and pretend”.

Has it worked?

Prima facie, it would seem so. The banks seem to be stable, and have been raking in the big bucks ever since the rule was suspended. The markets—from their March ’09 lows—have rocketed onward and upward. In fact, Citigroup stock has quadrupled, Goldman Sachs has doubled—everything is wonderful! Nothing hurts!

However, the basic problems in the banking system remain: The banks are still broke, because of the same reason—the toxic assets on their books.

The banks have taken “extend and pretend” to heart—they have lobbied to extend the suspension of FASB, while they have pretended to repair their balance sheets, when in fact, they have not.

In fact, compared to the write-off mania of ’08, the banks have not written off any of these non-performing assets. They sit like dead weight on the balance sheets of the banks—we still do not have a clear grasp of even how much of this garbage is still lurking out there, like turds in the Venice canals, because of the obfuscation of the basic accounting rules—an obfuscation which the banks insist on perpetuating.

The banks still have the holes in their balance sheets which caused the crisis in 2008.

But then, how have the banks made such staggering profits during the last year?

By trading. Instead of being banks, since March of ’09, the Big Six US banks have effectively become hedge funds. They have been trading themselves into profitability. Worst of all, these banks qua hedge funds have been making money by trading with each other. Price-to-earnings ratios bear this out—their general upward trend, across sectors and industries, even as the economy has been severely weakened, is indicative of a speculative bubble. A massive bubble—the kind that makes the Hindenburg look puny.

All of the markets have risen from their March ’09 lows because of what I would term musical chair trading—everyone makes money so long as the music doesn’t stop. The “music” of this metaphor is a combination of Uncle Ben’s easy money, relative calm in the world, and good ol’ “extend and pretend”, courtesy of FASB.

But when the music does stop, the banks are going to realize that it’s not that there’s one less chair in the circle. There are no chairs left.

That when the next crisis will hit—when the music stops, and everyone rushes to get out of their musical chair trading positions.

To continue with the analogy, when will the music stop? When will everyone rush to find a seat—and find that there are none left? My guess is, it will be something from left field, something in-and-of itself not particularly earthshattering: A punitive Israeli airstrike against Iran, say, or Somali pirates sinking a big oil tanker. A lousy consumer sentiment number, or a surprise burst of unemployment.

Why hasn’t Team Obama’s version of the Volcker Call worked? Simple—because Paul Volcker made it clear to the banks in ’82 that he would declare them insolvent, if they didn’t repair their balance sheets. Volcker scared the bankers, scared them enough to make then do what was necessary—which was to clean up their balance sheets.

What did Team Obama do 27 years later? Did they twist bankers’ arms, and force them to write off the garbage on their balance sheets?

No they did not. Instead, they bowed and scraped at the banksters, as if they were truly Masters of the Universe, instead of what they really are—scum of the earth dressed up in really nice suits.

In 1982—unlike 2009—the banks had a reason to try to renegotiate and write off the bad Latin American loans: Volcker was breathing down their collective necks, and the banks were scared of him. Volcker had a credibility then that Team Obama today does not have now—Volcker showed himself willing to bring the entire US economy to a halt, in order to purge inflation. What was putting a few big banks out of business, compared to that? Nothing—catnip for Volcker.

But Geitner, Bernanke and Summers have shown themselves willing to do anything for the banks—they’ve become twisted around, and come to think of the banks as ends-in-themselves, rather than means-to-ends, within the economy.

What should have happened starting in March of ’09 was for the banks to take the suspension of mark-to-market and used it to purge their balance sheets of all the crap they are still carrying.

But they did not. Nor will they. Because no one is forcing them to. No one forced them in April of ’09, no one is forcing them now in April of ’10.

Therefore, once the era of Musical Chair Trading ends with some ridiculous non-event that will send everyone panicking, the banking sector will be right back where it was on Septmber 18, 2008—the only difference, of course, being that Bernanke has already shot his wad, and politically, it will be impossible to pass another TARP.

That’s when the world ends—the second crisis will be loads worse than the one in the fall of ’08. Loads worse, even, than ’29.

When will it happen? I don’t know. Then again, I don’t know when the Yankees will next win the Pennant—but I’m pretty sure it’ll happen.

“Extend and pretend” could have been used to do what Volcker did in ’82—the Volcker Call. But Geitner, Bernanke, Summers, and ultimately Obama himself lacked the will or the gumption to force the banks to do what needed to be done—clean up their balance sheets. Write off all that crap.

So get ready: The countdown to oblivion was paused by “extend and pretend”—but it wasn’t suspended, much less averted. I don’t know if the end will be hyper-inflationary or mega-deflationary—all I know is that it’s gonna really suck.

4 comments:

  1. I agree that banks should have been required to unload or write off toxic assets in an organized manner and they instead are still concealing their liabilities.

    But I disagree with the idea that mark to market should not have been suspended.

    I also disagree with your analogy of "stock XYZ" being held on the books for $100 when its shares are at $60.

    A more accurate analogy is thus: your house has dropped in value, but you are planning on staying in it and continue to make payments. But under mark-to-market accounting you are in 'technical' default because you are under water, and you are required to immediately pay the lender tens of thousands of dollars or else face foreclosure despite the fact that you're still making your payments on time.

    Mark-to-market caused sound, performing assets to be valued at market value when they were undervalued because the market was irrational. Examples would be performing loans in a class that investors currently find stinky, or bonds at little risk of default and a decent coupon due in the future, but that the market undervalues at the moment because of current sentiment.

    So, lets put the blame where it lies: at the banks refusing to liquidate dead, failed positions and the government declining to force their hands. The blunt bat of mark-to-market isn't what's required.

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  2. To Old Poor Richard—

    I don't usually answer individual comments, but yours is a true critique of my piece.

    Thank you.

    Do feel free to e-mail me at your convenience.

    GL

    ReplyDelete
  3. [...Mark-to-market caused sound, performing assets to be valued at market value when they were undervalued because the market was irrational...]
    Nice concept, but who are you to say categorically that they are undervalued rather than fairly valued, and that the market is irrational instead of rational? No offense intended.

    It's just that for every person that agrees with you, there is another that doesn't.

    My proof? For every seller there is a buyer, and all these assets are held by someone right now. So even if some owners might like to get rid of some of their "undervalued assets" today, they **were** the buyers last time around. So, is the market rational only when it's their turn to profit, but not when it's not?

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  4. Gonzalo, I've become a big fan. Your writings are exceptionally informative. I especially like the insights on Latin American/Chilean crises.

    Richard - I take your point and understand the real-estate analogy - but I'd propose a far more relevant analogy as we're dealing with liquid assets. The analogy is your Mutual Fund statements - were they to be delivered showing only book value every quarter, it would be unacceptable and a gross misrepresentation of your net worth. You wouldn't be capable of making sound financial decisions based on such (dis)information.

    Why should a bank's balance sheet, in reflecting highly liquid assets such as MBS, be any different?

    ReplyDelete

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If you have a question or a private comment, do feel free to e-mail me at my address expat229@gmail.com.

GL