The following Bloomberg article points out why I have repeatedly argued that banks will be earning a lot of money, Meredith Whitney’s counter-arguments notwithstanding. It also points out why the likes of John Hempton believe that the FDIC ‘stole’ Washington Mutual from shareholders and awarded it to JPMorgan, a view I have not supported (hat tip Marshall Auerback). For those of you who don’t think accounting matters tremendously in why banks are going to fare much better than anticipated, you need to read this article. I have bolded the most significant parts
JPMorgan Chase & Co. stands to reap a $29 billion windfall thanks to an accounting rule that lets the second-biggest U.S. bank transform bad loans it purchased from Washington Mutual Inc. into income.
Wells Fargo & Co., Bank of America Corp. and PNC Financial Services Group Inc. are also poised to benefit from taking over home lenders Wachovia Corp., Countrywide Financial Corp. and National City Corp., regulatory filings show. The deals provide a combined $56 billion in so-called accretable yield, the difference between the value of the loans on the banks’ balance sheets and the cash flow they’re expected to produce.
Faced with the highest U.S. unemployment in 25 years and a surging foreclosure rate, the lenders are seizing on a four- year-old rule aimed at standardizing how they book acquired loans that have deteriorated in credit quality. By applying the measure to mortgages and commercial loans that lost value during the worst financial crisis since the Great Depression, the banks will wring revenue from the wreckage, said Robert Willens, a former Lehman Brothers Holdings Inc. executive who runs a tax and accounting consulting firm in New York.
“It will benefit these guys dramatically,” Willens said. “There’s a great chance they’ll be able to record very substantial gains going forward.”
When JPMorgan bought WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent. Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.
Basically, all of these banks acquired loan books that were marked down tremendously before they went on the books. Now, they are going to use this to their advantage and run the ‘excess’ cash flow from these assets through the income statement. John Hempton has been particularly vociferous about the purchase accounting in the WaMu deal. Because I had puts on WaMu through August 2007, I tend to see Washington Mutual as a bankrupt organization that was destined to fail. If you read Hempton’s account, he makes an argument for the opposite. It all boils down to purchase accounting.
The purchase-accounting rule, known as Statement of Position 03-3, provides banks with an incentive to mark down loans they acquire as aggressively as possible, said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine.
“One of the beauties of purchase accounting is after you mark down your assets, you accrete them back in,” Cassidy said. “Those transactions should be favorable over the long run.”
JPMorgan bought WaMu’s deposits and loans after regulators seized the Seattle-based thrift in the biggest bank failure in U.S. history. JPMorgan took a $29.4 billion writedown on WaMu’s holdings, mostly for option adjustable-rate mortgages and home- equity loans.
“We marked the portfolio based on a number of factors, including housing-price judgment at the time,” said JPMorgan spokesman Thomas Kelly. “The accretion is driven by prevailing interest rates.”
What about the other transactions: Wachovia, Lehman, Countrywide, Merrill? I am sure you will find the same dynamic at work. The article goes on to mention how many of these deals will also be favourable: at least over the short-term – and that is what matters. If the big banks can re-capitalize during this recession and we get a recovery, they are going to be able to take the eventual writedowns in stride as recovery will buoy their earnings potential.
Watch Q2 earnings at the banks, because Meredith Whitney and others are expecting a horrendous quarter. I am not. I think this accounting swag is going to be a positive for banks and may cause their shares, now under pressure to stabilize or rally. Key names to watch: BAC, JPM, PNC, WFC, and COF, all of whom have benefitted from purchase accounting. You should notice that Citigroup is not amongst these names.
The full story is linked below.
UPDATE 3:40PM: Calculated Risk has a story out (Revisiting the JPMorgan / WaMu Acquisition) which suggests that JPMorgan, if anything, under-provisioned for the eventual WaMu losses. That would suggest a lot of writedowns over the life of the WaMu loans. This is an account that I would tend to believe as the housing market is worse than the baseline case JPMorgan presented after the acquisition (see my post “JP Morgan Chase buys WaMu out“). Again, I see WaMu as a bankrupt organization that was destined to fail. Nevertheless, over the short-term, accounting from the transaction can be favourable to JPMorgan’s earnings – and I see that as a net positive for JPM.
Update 540PM: Here is the associated viedo clip.
JPMorgan $29 Billion WaMu Windfall Turned Bad Loans Into Income – Bloomberg.com