Thursday, August 20, 2009

Bank Asset Values are a Lingering Problem

Is the recession over? Has the economic recovery begun? Will there be a double-dip recession?
The picture is fuzzy and one reason the picture is fuzzy is because so many banks and other financial institutions, investors, and regulators either don’t seem to have a good grasp of the value of many of the assets on the balance sheets of these banks and other financial institutions or because they are unwilling to confess what the asset values are.

Look at some of the recent articles that have been in the news this week. “Insurers’ Biggest Writedowns May be yet to Come” by Jonathan Weil, “Disclose the Fair Value of Complex Securities” by Robert Kaplan, Robert Merton and Scott Richard, “Citigroup’s Asset Guarantees to be Audited by TARP” by Bradley Keoun and Mark Pittman, “We Need Daily Data to Get Credit Markets Working Again” by Richard Field,

All of these articles have to do with financial institutions knowing and reporting, as well as possible and as often as possible, the current value of their assets. The managements of financial institutions claim that this will inhibit their actions and force them into decisions that are not in the best interest of their institutions or the financial markets. These managements are wrong!

We are hung up right now because we don’t know the value of those assets either because the banks don’t know what the value of those assets are or the banks are not revealing what the value of those assets are.

I believe that we would face less uncertainty now and may have even avoided a good deal of the financial collapse of the last two years if these financial institutions would have been required to regularly report the fair value of their assets and responded more rapidly to changing market conditions.

Even better, it would have been a sign of outstanding management and real leadership if the banks themselves had been more open and transparent with the financial community, rather than require regulation to force them to release this information.

Alas, this didn’t happen.

This whole dilemma, to me, comes under the “No Free Lunch” argument.

Bankers mismatch the maturities of their assets and liabilities and take advantage of the positive slope to the yield curve. But, in doing so they take on more interest rate risk. Financial markets move against them and the price of the longer term assets decline. Whoops! The benefit the bank got by taking on the extra interest rate risk has backfired. Well, nothing comes for free!

Bankers add riskier loans to their loan portfolio or buy riskier securities to increase their yield. But, in so doing they take on more credit risk. The economy slows down and now these loans or securities face a larger default rate than the bankers had anticipated. Whoops! The benefit the bank got by taking on the extra credit risk has backfired. Well, nothing comes for free!

Financial institutions leverage up their balance sheets in order to squeeze out additional return on their equity position. But, in so doing they take on more financial risk. As assets prices go down the increased leverage backfires and their solvency comes into question. Whoops!

Bankers can’t get something for nothing. And, they can’t hide behind accounting rules in an effort to wait things out until times get better. As Kaplan, Merton, and Richard argue, banks typically fail to act when markets move against the risky positions they have taken and chalk the situation up to “unusual market conditions” or to “just a bump in the road”. And, if economic declines are relatively short and relatively shallow maybe they can get away with waiting the problem assets out. But, in deeper and longer periods of economic and financial dislocation they get trapped in their own failure to act. The asset values do not return to previous levels and the longer they wait to act on the existing problems the worse the situation on their balance sheet becomes.

Richard Field argues, in the article cited above, that banking and credit markets are having problems, not because the loans and securities on the books of the financial institutions are complex, but because they are opaque. This lack of clarity has helped to get us into the current crises and will continue to plague the recovery if it is not corrected. This lack of clarity allows bankers to continue to postpone action, it prevents investors from knowing the value of their investments, and it hinders regulators from in their efforts to understand the true condition of the financial institutions they are regulating.

As I have mentioned in previous posts, I have been involved in several successful bank turnarounds. One of the first things you have to do in turning around a bank is determine the value of your assets and you have to be brutally honest about what the values are. And, in going through this process, in every turnaround I was involved in, it becomes clear that the previous management failed to accept the fact that the value of their assets had declined, they continued to hope that the “unusual market conditions” would pass, and, consequently, by failing to act, the condition of the assets got worse and worse.

Good managements are not afraid of the truth and they are not afraid of releasing that information to the public!

Unfortunately, it is likely that the opaqueness with regard to the value of bank assets will continue.

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