Bloomberg:  Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail

The warning was ominous: “Massive global wealth destruction.”

That’s what Lehman Brothers Holdings Inc. executives predicted before they filed the biggest bankruptcy in U.S. history. “Impacts all financial institutions,” read one bullet point in a confidential memo prepared for government officials obtained by Bloomberg News. “Retail investors/retirees assets are devastated.”

The message didn’t get through. Two dozen of the world’s most powerful bankers, brought together by Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Bank of New York President Timothy F. Geithner the weekend of Sept. 13, 2008, to devise a rescue plan for Lehman, were too busy saving themselves to see the larger threat.

…

One year later, policymakers haven’t learned the lesson of the bankruptcy, said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch.

Rather than break up institutions such as Bank of America Corp. and Citigroup Inc., or limit their expansion, the U.S. has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger. To protect against a bank collapse touching off another freefall, President Barack Obama has proposed regulatory changes that rely on the wisdom of bankers and government overseers — the same people who created the conditions that led to Lehman’s bankruptcy and were unable to foresee its consequences.

“Designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe,” Bernstein said.

Bloomberg:  Barclays Said to Repackage Top-Rated Bonds From Downgraded CDO

Sept. 3 (Bloomberg) — Barclays Capital repackaged a portion of a $1 billion collateralized debt obligation managed by Highland Capital Management LP that was downgraded in July into new securities with the highest credit ratings.

Barclays Capital is selling $77.25 million of securities backed by leveraged loans with AAA rankings from Standard & Poor’s and Moody’s Investors Service, said a person familiar with the offering who declined to be identified because the deal is private. The bank also created an $18.8 million piece rated AAA by S&P and a $250,000 unrated slice, according to the bond agreement.

Banks are turning downgraded securities into new investments with top credit ratings, seeking to create more valuable debt to sell or to restructure investors’ holdings. New York-based Barclays Capital is modeling the financing structure after so-called re-REMICs, which bundle mortgage bonds into new securities that may offer investors an additional layer of protection, or collateral, from downgrades.

“Critics of this practice have argued that it appears to be the creation of something from nothing — in effect ‘alchemy,’” Moody’s analyst Leonid Mogunov wrote in an August report. “Such repackaging can in fact produce at least one class of notes more creditworthy than the underlying CLO tranche,” he wrote.

The new bonds, known as Blue Wing Asset Vehicle, were created from the safest portion of Westchester CLO Ltd., a $1 billion CDO arranged in May 2007 by Lehman Brothers Holdings Inc. and managed by Dallas-based Highland.

Brandon Ashcraft, a Barclays spokesman in New York, declined to comment. Kevin Latimer, a partner at Highland, didn’t return a telephone call for comment.

‘Arbitrage Opportunities’

Credit-rating cuts may sometimes force investors to sell the debt and cause financial institutions that own the bonds to increase capital. More than $27 billion of home-loan bond re- REMICs were issued this year, according to a June report by Bank of America Corp., compared with $17 billion in all of 2008.

CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk intended to provide higher returns than other investments of the same rating. Westchester is a type of CDO called a collateralized loan obligation, or CLO, which focuses on doing the same with company loans.

“Repackaging is typically a regulatory maneuver,” said Gene Phillips, a director at PF2 Securities Evaluations Inc., an advisory firm in New York. “Some investors are also unable to hold securities that are rated below AAA.”

Moody’s lowered the $570.5 million top-ranked piece of Westchester CLO by three levels in July, to Aa3 from Aaa, citing an increase in defaults and low-ranking company loans. The ratings company has cut 2,560 portions from more than 650 loan CDOs this year through July 31.

“We expect to see more repacks as AAA downgrades have increased,” Phillips said.

To contact the reporters on this story: Pierre Paulden in New York at ppaulden@bloomberg.net

CLO Interest_Aug 09

Bloomberg:  Pimco Says Avoid ‘Black Holes’ in the High-Yield Bond Markets

Sept. 1 (Bloomberg) — Pacific Investment Management Co., the world’s biggest manager of bond funds, said investors should avoid “black holes” of the junk bond market as recovery rates drop.

“We’re somewhat more cautious about high-yield bonds,” Curtis Mewbourne, a managing director at Pimco, wrote in an article on the firm’s Web site. “Careful attention to credit selection and avoidance of so-called ‘black holes of credit’ will likely be a critical component to a successful investment strategy.”

Default rates may rise, while recovery rates for defaulted debt have fallen below 20 percent from about 40 percent, Mewbourne said, citing Moody’s Investors Service data.

Corporate bonds have rallied this year as markets rebounded from the financial crisis sparked by the collapse of the U.S. housing market in 2007 and Lehman Brothers Holdings Inc. last year. Pimco judges business and economic conditions are worse than in the third quarter of 2008, while credit spreads have returned to pre-Lehman levels, Mewbourne said.

Bonds have returned investors 13 percent this year, according to Merrill Lynch & Co.’s Global Broad Market Corporate Index.

“We don’t think a large allocation to high yield makes sense right now given our expectations that default rates will continue to rise and recovery rates will remain lower for unsecured bondholders,” he said. “However, there are select opportunities.”

Mewbourne said Pimco is finding “compelling value” in some parts of the investment-grade corporate bond market.

The company likes high-grade bank and utilities bonds, and some energy bonds. It also favors some high-yield metal and mining companies that will benefit from emerging-market demand for commodities, he said.

High-yield, or junk, bonds are rated below BBB- at Standard & Poor’s and Baa3 at Moody’s.

Pimco, based in Newport Beach, California, is a unit of Munich-based insurer Allianz SE.

MarketWatch:  Yes, there’s even risk in Treasuries – Brett Arends

If you or a member of your family has a lot of money invested in bond funds, you should hear what Thomas Atteberry has to say.

He’s a partner at fund group First Pacific Advisors and co-manager of the successful New Income (FPNIX) bond fund.

His warning? Investors in long-term Treasury bonds and high-grade corporates run a serious risk of losing money in real, inflation-adjusted terms, over the next few years. They may lose money even before you count inflation.

Why?

The yields on these bonds are ominously low. If they reverted to long-term averages, the prices would tumble. You may end up losing more on the falling price than you could earn from the coupons.

This is a Main Street danger. Many ordinary Americans who have fled the stock market have moved their money into the supposed “safe haven” of bonds instead.

According to the Investment Company Institute, investors this year have so far poured a remarkable $142 billion net into taxable bond mutual funds. By contrast, the amount of new money invested in stock funds has barely matched the amount withdrawn.

Investors seem indifferent to the risks. Right now, 10-year Treasurys yield an anemic 3.47%. Their median over the past 50 years was far higher: 6.21%.

The yield on investment-grade corporate bonds is better. According to the Federal Reserve, the average yield across two benchmarks of these bonds is now about 6%. But even that’s well below the average since the late 1950s, which was about 7.75%.

Bonds are like a seesaw: If the yield rises, the price falls. Rising worries about inflation, rising interest rates, or both could cause that to happen.

Atteberry has run the numbers on a few scenarios, and they aren’t pretty. If the 10-year Treasury reverts to more typical levels over the next five years, investors will end up making just 1.1% a year over that time. That’s before inflation.

A faster move would be even worse. If the bonds reverted to average yields within a year, he says, investors will lose nearly 16%.

Ouch.

The story for investment-grade corporate bonds is only a bit better. If these reverted to their 50-year averages over five years, investors would still make about 3.3% a year. Over one year they’d lose 9%. Again, this is before inflation, and any taxes.

Among the added dangers for private investors is that bond coupons are taxable as ordinary income. Meanwhile, any capital losses have to be used first to offset the lighter taxes on capital gains.

No one knows what is going to happen next, of course. Bonds may not revert to historic averages. If we see persistent deflation, the yields may even fall further and the prices may rise. But it’s a question of odds. Those investing in bonds may think they are playing it safe. Instead, they may be taking a bit of a gamble on inflation.

Mr Atteberry’s advice right now seems sensible. If you want less volatility and less risk, stick to shorter-term bonds

Even though default rates continue to rise, Banks are putting leverage on top of leverage…

Bloomberg:  Leverage Rising on Wall Street at Fastest Pace Since ‘07 Freeze

Aug. 28 (Bloomberg) — Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

Before Bear

The increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. The world’s largest financial institutions have taken $1.6 trillion in writedowns and losses since the start of 2007, helping to trigger the worst financial calamity since the 1930s, according to data compiled by Bloomberg.

Lending to purchase loans rated below investment grade and mortgage bonds is part of this year’s recovery in credit markets. Companies sold $889 billion of corporate bonds in the U.S. this year, a record pace, Bloomberg data show. The Standard & Poor’s 500 Index rose 52 percent since March 9, the best rally since the Great Depression.

Some areas of the credit market haven’t returned to the levels from before the collapse in real estate. Lenders are also requiring more collateral for loans.

Drop in Loans

Banks arranged $61.8 billion of leveraged, or high-yield, loans this year, a 74 percent decline from the same period in 2008, and 91 percent lower than two years ago, Bloomberg data show. Leveraged loans are rated below Baa3 by Moody’s Investors Service and BBB- by S&P of New York. No bonds containing new mortgages have been sold this year, except those with government backing, according to industry newsletter Inside MBS & ABS of Bethesda, Maryland.

The Fed data on loans by primary dealers is down from $113.8 billion in 2007. The data reflects so-called reverse- repurchase financing, securities-lending agreements and other arrangements.

Financing purchases of assets is filling cracks left by the government, whose lending programs to end the recession didn’t address some of the riskiest parts of the consumer and corporate debt markets.

The Fed’s $1 trillion Term Asset-Backed-Securities Loan Facility can’t be used to buy residential mortgage bonds and leveraged loans. The Treasury Department’s $40 billion Public- Private Investment Program excludes the loans and mortgage bonds that are repackaged into new securities.

‘Political Pressure’

“There is a lot of political pressure on banks to lend and this is one form,” said Ratul Roy, head of structured credit strategy at Citigroup in New York.

The Fed and government programs prompted sales of securities backed by auto loans, credit cards, equipment leases and auto-dealership debt.

Yields on top-ranked debt backed by auto loans and credit cards have fallen by as much as 2 percentage points relative to benchmark rates. The yield premium has shrunk to less than 1 percentage point since TALF began in March, according to Charlotte, North Carolina-based Bank of America Corp. data. The average interest rate on loans for new cars declined to 3.88 percent in June, from 8.23 percent in January, Fed data show.

The Fed is also buying as much as $1.25 trillion of so- called agency mortgage bonds. Fixed-rate, 30-year mortgages to borrowers with good credit who put money down are 5.29 percent, according to North Palm Beach, Florida-based Bankrate.com, or 1.85 percentage points more than 10-year Treasuries. The gap was 3.05 percentage points at the end of 2008.

Leveraged-Loan Prices

The increase in bank financing tracks a rebound in demand for securities and assets.

Prices for leveraged loans tumbled to a record low 59.2 cents on the dollar on average Dec. 17, before rebounding to 83.5 cents on Aug. 27, according to the S&P/LSTA U.S. Leveraged Loan 100 Index.

As much as 5 cents of the gains are partly attributable to “leverage coming back into the system,” according to Franz at Zurich-based Credit Suisse.

The senior-most bonds backed by adjustable-rate Alt-A home loans, or those with little to no documentation of a borrower’s finances, have jumped to 52 cents, from a low of 35 cents in March, according to Barclays Plc in London. Top-rated commercial-mortgage securities soared to 90 cents on average, from 72 cents in February, Merrill Lynch & Co. index data show. Merrill is a unit of Bank of America.

Credit Losses

The risk now is that new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to new York-based Moody’s.

U.S. financial institutions probably will report more credit losses as commercial real estate falters through next year, James Wells III, the chief executive officer at SunTrust, Georgia’s biggest lender, said in an Aug. 24 speech to the Rotary Club of Atlanta.

“If you lever up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable,” said Julian Mann, who helps oversee $5 billion in bonds as a vice president at First Pacific Advisors LLC in Los Angeles.

No Thanks

Chimera Investment Corp., the New York-based mortgage-debt investor that raised $1.5 billion by selling stock last quarter to buy devalued assets, hasn’t taken banks up on their loan offers in part because the company isn’t sure it would be able to continue “rolling” the financing when it matures, said Matthew Lambiase, the company’s CEO.

The lack of a “robust” market means lenders may have too much power to change terms, Lambiase said on a July 30 earnings conference call with investors and analysts.

Investments held with borrowed money by funds including Santa Fe, New Mexico-based Thornburg Mortgage Inc. and Peloton Partners LLP of London slammed the markets as retreating prices made banks wary about getting repaid.

That triggered margin calls, collateral seizures and obligations to unwind, fueling the downward spiral in credit markets. Thornburg, a 16-year-old home lender, filed for Chapter 11 bankruptcy protection in May. Peloton, a hedge-fund firm run by former Goldman Sachs Group Inc. partners, shut its $18 billion ABS Fund.

Money Down

Financing terms are more stringent than before credit markets seized up.

Investors seeking loans to buy non-agency home-loan bonds typically must put down 35 percent to 50 percent, according to four investors and bankers whose firms are using or providing the leverage and didn’t want to be named because the negotiations are private.

That compares to as little as 3 percent for top-rated mortgage bonds before the markets collapsed, according to Laurie Goodman, an analyst at Amherst Securities Group LP in New York. She was among Institutional Investor’s top-rated fixed-income analysts while at Zurich-based UBS AG from 2000 to 2008.

Banks are typically offering as much as $3 in financing for every $1 of equity investors in leveraged loans contribute, down from $6 to $7 before mid-2007, Barry Delman, a New York-based managing director of structured credit products at Scotia Capital, said in reference to so-called total return swaps. Scotia Capital is a unit of Bank of Nova Scotia in Toronto.

The swaps are a type of derivative where a bank passes on returns or losses from a pool of loans to an investor.

Citigroup, JPMorgan

The interest rate that investors are now being charged is usually between 2 percentage points and 2.75 percentage points more than the London interbank offered rate, according to Delman. Three-month Libor, or what banks charge each other for loans in dollars, was set at 0.36 percent yesterday, according to the British Bankers’ Association.

Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

JPMorgan and Citigroup, the second- and third-largest U.S. banks by assets, are offering similar terms, according to investors. Tasha Pelio, a spokeswoman at JPMorgan, and Jeanette Volpi, a Citigroup spokeswoman, declined to comment. Both banks are based in New York.

“To the degree leverage coming back represents a normalization of the markets, it’s a good thing,” said Michael Youngblood, a former mortgage-bond analyst who last year co- founded hedge fund Five Bridges Advisors LLC in Bethesda, Maryland. “But the idea it should be part of any permanent residential-mortgage-securities portfolio strategy is unwise.”

To contact the reporters on this story: Kristen Haunss in New York at khaunss@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net

AP:  Remember me? Wall Street repackages toxic debt

Excerpt (click on the link above for the full version)

Wall Street may have discovered a way out from under the bad debt and risky mortgages that have clogged the financial markets. The would-be solution probably sounds familiar: It’s a lot like what got banks in trouble in the first place.

In recent months investment banks have been repackaging old mortgage securities and offering to sell them as new products, a plan that’s nearly identical to the complicated investment packages at the heart of the market’s collapse.

“There is a little bit of deja vu in this,” said Arizona State University economics professor Herbert Kaufman.

But Kaufman said the strategy could help solve one of the lingering problems of the financial meltdown: What to do about hundreds of billions of dollars in mortgages that are still choking the system and making bankers reluctant to make new loans.

These are holdovers from the housing bubble, when home prices soared, banks bought risky mortgages, bundled them with solid mortgages and sold them all as top-rated bonds. With investors eager to buy these bonds, lenders came up with increasingly risky mortgages, sometimes for people who could not afford them. It didn’t matter because, in the end, the bonds would all get AAA ratings.

When the housing market tanked, figuring out how much those bonds were worth became nearly impossible. The banks and insurance companies that owned them knew there were still some good mortgages, so they didn’t want to sell everything at fire-sale prices. But buyers knew there were many worthless loans, too, so they didn’t want to pay full price for the remnants of a real estate bubble.

In recent months, banks have tiptoed toward a possible solution, one in which the really good bonds get bundled with some not-quite-so-good bonds. Banks sweeten the deal for investors and, voila, the newly repackaged bonds receive AAA ratings, a stamp of approval that means they’re the safest investment you can buy.

“You’ve now taken what was an A-rated security and made it eligible for AAA treatment,” said Richard Reilly, a partner with White & Case in New York.

As for the bottom-of-the-barrel bonds that are left over, those are getting sold off for pennies on the dollar to investors and hedge funds willing to take big risk for the chance of a big reward.

Kaufman said he’s optimistic about the recent string of deals because, unlike during the real estate boom, investors in these new bonds know what they’re buying.

“We’re back to financial engineering, absolutely,” he said. “But I think it’s being done at least differently than it was before the meltdown.”

…

CDOs are already complicated. Repackaging them makes it harder to figure out what the investment is worth. The more obscure the concept, she said, the more likely the deal has gotten too creative.

Wall Street has a tendency to push the boundaries of good ideas, Bowes said. But he said banks are still smarting from the market implosion and are unlikely to rush into new, risky ventures.

“A lot of the market innovations, they all started out with this fundamentally good concept and they often tend to deteriorate over time, or just evolve into more and more risky versions of the same concept,” Bowes said. “This time around, the likelihood is, it will take a lot longer for that to happen.

From LCD:

The default rate by amount in the S&P/LSTA Leveraged Loan Index will rise to an all-time high of 9.68% with the imminent bankruptcy filing by Reader’s Digest Association, from 9.57% at the end of July.

The default rate by number of issuers will edge up to 6.89%, from 6.87% at the end of July. That reading is highest since July 2001, when it stood at 6.89%, but it remains well beneath the all-time high of 8.23%, from December 2000, according to LCD.

Reader’s Digest, a Ripplewood-controlled publisher, today skipped a $27 million interest payment owed to bondholders and announced plans to file a pre-arranged restructuring plan under Chapter 11. The company’s loans in the Index are sizeable, originally totaling $1.21 billion, according to LCD.

The loan default will be the third of the month and the twelfth in the third quarter. Including Reader’s Digest, the 12 defaults total $5.5 billion. Reader’s Digest would be the largest, surpassing Lear at $1 billion.

The 10 other loan defaults in the quarter to date were building-products companies Euramax and Panolam Industries, automotive-castings manufacturer J.L. French, television firm NV Broadcasting, cake-decorating products company Wilton Industries, E&P company Express Energy, Texas-teams owner Hicks Sports Group, television-and-newspaper firm CanWest Media, industrial-coatings firm Arclin and component maker Cooper-Standard Automotive, according to LCD.

The shadow default rate, meanwhile, contracted to 11.05%, from 11.08% at the end of July, with total volume of roughly $7.99 billion. This rate includes loans that are paying default interest but are still performing, loan issuers that have bonds in default, and issuers that have hired bankruptcy counsel or have secured a forbearance agreement.

Names included in the shadow default rate that have engaged bankruptcy counsel include Simmons and Evenflo. Those that are in forbearance or that have corporate credit ratings of D or SD include Regent Communications and Georgia Gulf. The names of those that are accruing interest at default rates are confidential and will not be released.

Elizabeth Warren, head of the Congressional Oversight Panel, explains what is really going on with the increasingly irrelevant balance sheets of the bailout banks…

Elizabeth Warren (Video):  Toxic Assets Still in America’s Banks

Bloomberg:  Next Bubble to Burst Is Banks’ Big Loan Values – Jonathan Weil

It’s amazing what a little sunshine can accomplish.

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

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.

Widening Gaps

The disparities in those banks’ loan values grew as the year progressed. Bank of America said the fair-value gap in its loans was $44.6 billion as of Dec. 31. Wells Fargo’s was just $14.2 billion at the end of 2008, less than half what it was six months later. At Regions, it had been $13.2 billion.

Other lenders with large divergences in their loan values included SunTrust Banks Inc. It showed a $13.6 billion gap as of June 30, which exceeded its $11.1 billion of Tier 1 common equity. KeyCorp said its loans were worth $8.6 billion less than their book value; its Tier 1 common was just $7.1 billion.

When a loan’s market value falls, it might be that the lender would charge higher borrowing costs for the same loan today. It also could be that outsiders perceive a greater chance of default than management is assuming. Perhaps the underlying collateral has collapsed in value, even if the borrower hasn’t missed a payment.

The trend in banks’ loan values is not uniform. Twelve of the 24 companies in the KBW Bank Index, including Citigroup Inc., said their loans’ fair values were within 1 percent of their carrying amounts, more or less. Citigroup said the fair value of its loans was $601.3 billion, just $1.3 billion less than their book value. The gap had been $18.2 billion at the end of 2008.

Covering Liabilities

History provides some lessons here. A common problem at savings-and-loans that failed during the 1980s was that they relied on short-term funding at market rates to finance their operations, which consisted mainly of issuing long-term, fixed- rate mortgages. When rates rose sharply, the thrifts fell in a trap where their assets weren’t generating sufficient returns to cover their liabilities.

The accounting rules also left open the opportunity for gains-trading, whereby companies post profits by selling their winners and keeping losers on the books at their old, inflated values. Had the thrifts been marking loans to market values on their balance sheets, their troubles would have been clearer to outsiders much sooner. (The FASB didn’t require annual fair- value footnote disclosures until 1993.)

Arbitrary Accounting

If nothing else, today’s fair-value gaps highlight the arbitrariness of book values and regulatory capital. Banks already have the option to carry loans at fair value under the accounting rules. For the vast majority of loans, most banks elect not to, on the grounds that they intend to keep them until maturity and hope the cash rolls in.

Consequently, the difference between being well capitalized and woefully undercapitalized may come down to nothing more than some highly paid chief executive’s state of mind.

Fair-value estimates in the short-term can be a poor indicator of an asset’s eventual worth, especially when markets aren’t functioning smoothly. The problem with relying on management’s intentions is that they may be even less reliable.

At least now we’re getting some real numbers, even if you have to dig through the footnotes to get them.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net