Time for banks to face up to reality.
By Daniel at 21 August, 2009, 8:15 am
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Aug. 21 (Bloomberg) — There are plenty of lessons to be learned from the credit crunch. Too bad we didn’t learn them from past upheavals.
Back in the early 1990s, postmortems of the savings and loan crisis found banks had too much leeway in determining potential losses. This ended up leading to bigger losses and making it tougher for regulators to deal with weakened institutions.
Fast forward to today’s crisis and investors and regulators are seeing this same problem. Bankers apply a light touch to loan-loss reserves, allowing them to reap profits — and bonuses — even though a day of reckoning may result.
The failure last week of Colonial BancGroup Inc., the largest U.S. bank to collapse since Washington Mutual Inc. did last fall, is the most recent example. In acquiring most of Colonial’s assets and liabilities, BB&T Corp. marked down the value of Colonial’s loans by an average of 37 percent.
That exceeds the average markdown of 18 percent at recently failed banks, according to research from Goldman Sachs Group Inc. When it took over Washington Mutual, JPMorgan Chase & Co. wrote down that institution’s residential mortgages by about 16 percent and home-equity loans by about 20 percent.
This means that the collapsed banks hadn’t created adequate reserves for possible losses, leading their loans to be wildly overvalued. The Federal Deposit Insurance Corp. is left to clean up the mess.
Change Afoot
There is some hope, however slight, that change is coming. For starters, the Financial Accounting Standards Board is considering applying mark-to-market accounting to all financial instruments, including loans.
Currently, loans aren’t adjusted to account for market values; they are carried at historical cost and a bank creates a reserve for potential losses. That reserve is based largely on management estimates.
While far from perfect, using market values for loans would take much of the guesswork out of management’s hands, countering their usual glass-half-full approach.
Regulators may also be ready to back away from the policy known as forbearance, or looking the other way when it comes to banks that are light on loan-loss reserves, now that the financial system seems to be on sounder footing.
The Securities and Exchange Commission this month sent a letter to banks calling for beefed up disclosures on reserves. The “Dear CFO” letter urged banks to provide more information about high-risk loans, such as adjustable-rate mortgages that have payment options. It also asked them to provide specific details, including geographic breakdown, for various types of loans.
Harsh Realities
While welcome, additional disclosure won’t force banks to face up to the harsh realities of rising job losses, declining consumer spending and mounting mortgage delinquencies. In that vein, it was encouraging to see the SEC also tell banks that it would be inconsistent with accounting rules “if you were to delay recognizing credit losses that you can estimate based on current information and events.”
The FDIC stuck a similarly veiled warning into an early August notice to banks regarding the way they calculate loan- loss reserves for junior loans such as home-equity mortgages on single or multifamily properties. Like the SEC, the FDIC noted that calculating these reserves is “inevitably imprecise and requires a high degree of management judgment.”
http://www.bloomberg.com/apps/news?pid=20601039&sid=a4LNv_COFnzY
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