What Home-Loan Banks reveal about the effects of mark-to-market


Back on the 16th, I posted a link to a Wall Street Journal article by James Hagerty which detailed how the Federal Home Loan Banks were able to prevent asset writedowns because of guideline changes to mark-to-market accounting.  I think the implications will be significant.  Here is what the article said (emphasis added):

A change in accounting policies allowed some of the Federal Home Loan Banks to avoid taking big hits to earnings for the first quarter.

Several of the 12 regional home-loan banks recorded losses and eliminated dividends in recent quarters because of write-downs on their investments in private-label mortgage securities. Such securities, packaged by Wall Street firms, don’t carry a government guarantee.

Now, the home-loan banks are benefiting from new guidance from the Financial Accounting Standards Board, or FASB, on the treatment of securities that companies intend to hold until maturity. That guidance allows companies to make a distinction between the portion of any decline in the value of a security they attribute to deteriorated credit quality and the portion blamed on other factors, such as distressed conditions in the market.

Only the part blamed on credit quality needs to be reflected in the income statement; the rest can be put into an account known as "other comprehensive income," which doesn’t affect earnings or calculations of regulatory capital.

The home loan banks say the new guidance allows them to give a more accurate picture of the losses they expect.

The long and short of this rule change is that financial companies will have much greater discretion in how they account for writedowns in asset-backed securities of credit cards, auto loans and commercial real estate (for more on this, see my post “A few comments about mark-to-market”).  In the end, this will bring accounting of asset-backed securities more in line with the accounting for loans.   To the degree that banks believe market prices reflect temporary impairments of assets they intend to hold to maturity, they can decide not to write down these assets.  Moreover, even if those assets wind up permanently impaired and must eventually be marked down, the banks can benefit from earnings in the intervening period between the likely original markdown under previous guidelines and the eventual new markdown under new guidelines.

Therefore, it should now be clear that many writedowns which would have occurred in 2009 will be delayed indefinitely.  In my view, this is a large reason why the financials had rallied so much from the beginning of March.  Moreover, banks are getting new capital from private investors now.  In the Fall and Winter this was unheard of.  Only the best banks had access to equity capital markets.

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What this means is threefold:

  1. Writedowns will be fewer in 2009 and 2010 as a result of marking assets as held to maturity.
  2. With interest margins high, banks are likely to increase large amounts of capital from earned income.
  3. Banks also have access to private equity capital and are likely to raise large amounts of capital through those markets.

So, for any given firm with large commercial real estate, jumbo residential real estate or credit card asset-backed security exposure, the stress to raise capital has been greatly diminished.  Overall, this will be a net plus to credit availability.  To be sure, large writedowns are likely to continue.  However, for most banks these writedowns are not going to exceed the capital raised and earned.



Home-Loan Banks Avoid Some Hits – WSJ

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