SOMEONE IS LISTENING

A rather important notice came out of Washington the other day which I missed entirely, a doubly "me bad" event because it affirmed a position of mine that I had argued on these pages two years ago.  The Financial Accounting Standards Board ("FASB") released what they call an "exposure draft"  which is essentially a trial balloon on new regs which, if adopted, would dramatically change the manner in which bank's balance sheets and income statement are evaluated.

Going back in time, I pointed out that banking was a wonderful business because of the subjectivity involved; a bank was worth what the bank said it was worth, which whilst having its apparent dangers also eliminated the wild mood swings concerning bank viability which attack the most important thing in the industry which is confidence.  In the good old days when I was employed, the assets of a bank generally consisted of two things:  loans and bonds.  Loans were fairly straightforward; money was lent and expected to be repaid at a certain date(s) whilst being "serviced" through the collection of interest.  Loans could be categorized as either performing  (interest being paid and all other conditions being satisfied) or non-performing resulting from some conditions being impaired.  Then came along the concept of syndication in which banks shared the risk by selling part of the loan to another institution and from that development came the natural movement of buying and selling loans in the open market.  Overnight, there was very little differentiation between loans and bonds and as the lending markets expanded to all sorts of "lenders" the remaining differences were mostly lost.

In the good old days banks, as part of their capital base invested in bonds, usually of very high quality and some of which there were, by law, required to hold.  These were usually notes and bonds of the nation in which the bank was incorporated.  A bank could if they so desired purchase bonds not for investment purposes but as part of a issuing syndicate or simply to trade.  In my shop, we had a very strict rule in our merchant bank subsidiary in London: if we purchased a bond as a trading instrument,it would be placed in a trading account and would have to be sold within 30 days or either

1. remain in the trading account and "Marked to market" daily at the market price or
2. transferred to the Investment account at the then market price

Both of these actions had an effect on the Balance Sheet BUT on the Profit and Loss account as well.
If the bond went into the investment account at, say, 90% of the price at which it had been acquired, a loss of 10% was reflected in the P & L but the bond would remain valued at the initial booking price until sold.  Not so with the trading account.  Every asset in the trading account would be revalued every day and that revaluation would be reflected in the P & L daily.

As loans became to look more and more like bonds, the "mark to market" practice began to be applied to the loan book as well.  Theoretically, and in calm markets this is not a particular problem except for the sheer effort of evaluating billions and billions of loans and therefore, it was not done every day.  But in a volatile market it's a nightmare; in a period such as 2008 when, effectively, there was no market, it is impossible.  What happens is that risk managers tend to look to the lowest common denominator which for whom is zero.  The collapse of 2008 is the result.

What FASB did on Wednesday is to announce that when agreed, we would return to the old concept of assuming that loans were to be held to maturity and need not be marked to market if this were the case.  Further, the valuation of a loan on a credit basis would be made by the bank and it would be on that basis that a reduction in value would occur.  In my time, loans were classified in four categories; performing, sub-standard, doubtful and loss.  If sub-standard no reserve needed to have been taken but generally the industry standard was that some would be.  Doubtful was a truly bad category and required a  50% reserve and loss---well--loss was loss.  Bonds are to be treated in the same manner.  I assume an investment account designation and a trading account designation will reappear.

Intelligently, The same treatment is to be given to the liability side of the balance sheet.  In times of crises, the value of everyone's liabilities declines, but if you think about it if your debt is subject to a rapid decline in market price, if you have the wherewithal, you can buy it back on the open market and book a profit by reducing your liabilities at less than par!  The opposite of course is true if the market value rises.  Under the present rule, each occurrence whether acted upon or not produces a P & L event as mark to market so demands.  One therefore, has the sublime result of the value of an institution rising in bad times and declining in good times.  Hopefully, this will occur no more.

It is interesting to note that in the 5 years since the crisis, many of the instruments whose value collapsed resulting in the failure of so many institutions are still around and many have regained a substantial amount of there original value in the marketplace.  Many were "performing" at the same time their value was crashing.  If the "mark to market" mania had not existed in 2008 would the crash have been less severe.  A most interesting question and one which involves the make-up of the industry.  I have to think about this a bit more.  Come back and see us on Monday.