Citizens, The government says I can lie to you. Sincerely, The Banks

In my last post, I illustrated that home prices are likely to continue falling and will lead to billions of dollars in mortgage defaults.  Regrettably, this problem does not exist in isolation and should be reflected in the balance sheets of our financial institutions.  Curiously, the big banks have reported massive profits for the past couple of quarters [1].  So the question that must be answered is: How are the banks turning a profit when they should be losing billions on loans?

Once again, they are obscuring the truth, and the government is complicit in the ruse!  Let me show you how.

From Reality to Fantasy
Last year, the Financial Accounting Standards Board (FASB) was pressured by several senators and congressmen to relax a rule related to marked-to-market accounting. Marked-to-market accounting forced banks to mark loans to the value at which they could sell them on the open market. However using this accounting method, many of the biggest banks in the country would have been insolvent and unable to pass the “stress tests” last spring. So FASB yielded to political pressure and relaxed the mark-to-market accounting the rules. The rule change allowed banks to price bad loans to whatever their computer model said it was worth.  Unsurprisingly, the banks said they believed they would recover 90% to 100% of a loan’s value.  This practice is what some folks now call “mark to fantasy” accounting because computer models can be made to say anything [2].

Well, do we have any evidence to that these loans are worth less (err...worthless)? Yes, we do. The FDIC has closed over a hundred banks over the last twelve months and has had to find someone to take over these businesses. FDIC has been taking losses equal to 25% or more of the bank’s on entire asset portfolio [3].  Furthermore, delinquency rates in excess of 35% are being reported for many residential mortgage backed securities (RMBS) [4]. These two pieces merely imply that something is amiss within the banks.  Let me be more specific. The biggest four banks have $448 billion dollars of second liens and/or home equity lines of credit (HELOC) on their books [5], [6].  Many of these loans are on homes which are underwater on their first mortgage.  If the first lien is worth less than 100% then many of these loans are worth exactly zero, yet they are being reported at 90+% of value on banks’ books. Still, many of the losses are still hidden in their financial statements. The Federal Home Loan Banks [7] and Wells Fargo [8] are a prime examples of this type of accounting.

Bottom Line: The valuation of these loans are a fantasy.


Setting Up Crisis 2.0
Recently, it has been reported what set off the failure of Lehman Brothers and the financial crisis of 2008. Lehman Brothers was manipulating their quarterly reports using complicated financial instruments to make it appear they had billions in cash when they actually owned billions in bad loans [9], [10]. In reality, Lehman Brothers had almost no cash, and many on Wall Street knew it for months in advance.  It is also clear this kind of financial instrument continues to be used to this day by the banks, and since FASB has effectively legalized accounting fraud, they don’t have to tell you they are losing money [11], [12]. The banks know they are insolvent, and for this reason many corporations have curtailed tax payments in order to hoard cash [13], [14].  The cash hoard now totals over $1.2 trillion [15], and the banks will need it for the coming flood of foreclosures.  The other companies will need it as loans become more difficult to obtain.

Conclusions
The U.S. federal government spent several trillion dollars to bail out the financial system and clear toxic assets.  By all accounts, very little of bad debt has been cleared, and what remains on banks’ balance sheets gets more toxic by the day.  Our government’s failure to take meaningful action has allowed our financial system to remain broken.  The banks are unable or unwilling to make new loans which will severely limit both small business growth and job prospects going forward.  Furthermore, another liquidity driven financial crisis is likely to occur in the future due to losses in residential and commercial real estate markets.  This crisis will put most major asset classes (e.g. stocks, bonds, etc.) under extreme pressure as banks are forced into further deleveraging.  Serious measures should be taken to guard against risks imposed by the banks' implicit insolvency.  I will attempt to address these measures in a future post.



Links:
Citi Profit More Than Doubles - Wall Street Journal [1]
Now FASB Wants To Do The Right Thing? - The Market Ticker [2]
As of Friday August 19, 2009, FDIC Is Bankrupt - Mish's Global Economic Trend Analysis [3]
A Random Look At RMBS And The Economy - The Market Ticker [4]
Dimon Fumbles For His Protective Plate - The Market Ticker [5]
IRA Does It Again - The Market Ticker [6]
How $1 Trillion Time Bomb Posts a Phony Profit - Bloomberg [7]
A Sober Warning To the GOP And The Democrats - The Market Ticker [8]
Bombshell: We Now Know What Set It Off - The Market Ticker [9]
Repo 105: Lehman's 'Accounting Gimmick' Explained - NPR [10]
What The Lehman Report Proves: Financial Insolvency - The Market Ticker [11]
Big Banks Mask Risk Levels - Wall Street Journal [12]
Here Is Why Companies Are Hoarding Cash And Why They Will Not Let It Go Any Time Soon - Zerohedge [13]
GE: 7,000 tax returns, $0 U.S. tax bill - CNN Money [14]
Companies Puzzle Over Record Cash Hoards - Business Week [15]