Tuesday, April 19, 2011

Why Invest in Commercial Banks?

 Why should anyone invest in commercial banks these days?

My answer is that they should not.

My reason for this is that bank accounting is so screwed up that it is extremely difficult, if not impossible, to place a value on the assets of a bank. 

Now, this is a broad ranging generalization and I know that there are banks who are open and transparent about the value of their assets, but…

A case in point: yesterday, Citigroup released its earnings for the first quarter.  Let’s look at the analysis of these earnings by Francesco Guerrera and Patrick Jenkins for the Financial Times (http://www.ft.com/cms/s/0/8c5fb104-69e0-11e0-89db-00144feab49a.html#axzz1JsjXsOj5).

In order to reduce the impact of the new capital rules, Basel III, Citi has put “up for sale a $12.7 billion portfolio of bad assets that were responsible for some of its huge losses during the financial crisis.”

“Citi said the assets, which are believed to include subprime loans, mortgage-backed securities and corporate bonds, carried a ‘disproportionately high’ risk weighting under the new capital rules…”

Hence the desire to get rid of the assets.

“Citi’s decision resulted in a $709 million pre-tax charge in the first quarter but enables it to take advantage of a recovery in the market for distressed assets and boost capital buffers…”

“Citi said it had already sold about three-quarters of the assets at prices above the levels at which it valued them on its balance sheet…”

But, this background information follows.

“In order to put the assets up for sale, Citi had to reverse an accounting maneuver performed during the crisis, when it moved them from its ‘trading’ book to it ‘banking’ book.”

“Such a shift, which mirrored moves by other commercial banks, helped Citi to avoid suffering quarterly mark-to-market losses on those assets at the height of the turmoil.”

“However, accounting rules require financial groups seeking to move assets back to their ‘trading’ book to show that the facts around their initial decision had significantly changed.”

“John Gerspack, Citi’s chief financial officer, said the company argued that Basel’s higher risk weightings constituted such a change.  Citi’s argument was accepted by the US Securities and Exchange Commission, potentially paving the way for other banks to follow suit.” 

“Several banks have shrunk their balance sheets and shuffled assets in order to cope with the rise in capital requirements demanded in the Basel III regime.  However, their efforts have taken place largely behind closed doors, with very few providing details of their plans.” 

How is an investor really to know what assets will be treated in which way at what time?

And, the question can be raised concerning the treatment of Citigroup or other large banks relative to other, smaller financial institutions.  Smaller banks don’t have the expertise or can’t hire the expertise or don’t really have the ability to maneuver their portfolios in such a way.

However, in many cases in which assets cannot be “re-classified”, asset values have not been written down because “hope” was expressed that many of these assets would improve in value once the economy began growing again.

The ‘hope’ may be wearing a little thin as some borrowers may be running out of time.  See my post “Commercial Bank Closures,” http://seekingalpha.com/article/264104-commercial-bank-closures-2-3-banks-per-week-in-2011.

The situation may be changing in other areas as well.  In some cases, the change is coming from the regulatory side.  Take the case of the rating agencies and the municipal bond market.  In January 2011, Standard & Poor’s cut the rating of DeKalb County, Georgia from triple A to double A and then reduced it to triple B.  Now, S & P has withdrawn rating from it at all. (See http://www.ft.com/cms/s/0/106b35da-69e2-11e0-89db-00144feab49a.html#axzz1JsjXsOj5.)

“Matt Fabian, managing director at Municipal Market Advisors, says one reason why rating agencies may be acting more aggressively with patchy disclosure is regulation.  New rules, set out in the Dodd-Frank Act, have been introduced after rating agencies came under fire for miscalculating risk in mortgage debt before the financial crisis.”

The question now becomes: If Dekalb County was rated triple A in January and currently is not rated at all, what other triple A rated entities…or even A rated entities…might face lower ratings in the near future?

How should these assets be valued on bank balance sheets?

Over the past forty years, too many tricks have been played with bank accounting and bank accounting standards. 

As readers of my blog know, I am a strong advocate of “mark-to-market” accounting.  Bank executives make decisions and they need to be held accountable for them.  If they take risks then they need to own up to the risks that they have taken.  Bank accounting must become straight-forward enough and open enough for people that want to invest in them to have sufficient information to value their assets. 

I would think that the regulators would want this as well.

I am tired of hearing stories like the one on Citigroup reported in the Financial Times.  And, new stories pop up all the time.  In terms of accounting and openness related to the books of banks, there seems to be no difference between the regulators and the banks. 

If we are to have a safer banking system I believe that this situation must end!

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