Banks in the frying pan...

Discussion in 'Financial Cents' started by Jonas Parker, Nov 18, 2007.

  1. Jonas Parker

    Jonas Parker Hooligan

    From Financial Week:

    Banks in the frying pan
    How bad are the big banks' loan losses? Depends on how good their accounting models are. Auditors are about to weigh in. Will it be fair value at work or fear value at its worst?

    By Andrew Osterland
    November 12, 2007

    In the current Alice-in-Wonderland reporting environment in the financial sector, level three assets—those securities, derivatives and financial commitments that have no available market prices—mean a rabbit hole of trouble. And the banks with the greatest amounts of such assets on their balance sheets (not to mention exposure to them in off-balance-sheet entities) are expected to face further big write-downs at year-end.

    The third-quarter write-offs by the five biggest investment banks ranged from a low of $700 million at Bear Stearns and Lehman Brothers to a whopping $8.4 billion at Merrill Lynch. The huge hit that Merrill took in the third quarter, however, could be a harbinger of things to come at the other Wall Street banks, which are now carrying much greater amounts of level three assets on their balance sheets than Merrill.

    “There is a lot of uncertainty about level three assets,” said Gary Witt, a managing director of structured finance at Moody's Investors Service. “These are assets that have no good indications about their value.”

    Based on the latest financial reports of the five biggest Wall Street firms, the value of their level three asset holdings relative to firm equity is the following:

    -Morgan Stanley $88.2 billion, 250% of equity

    -Lehman Brothers $34.7 billion, 160% of equity

    -Bear Stearns $20.2 billion, 155% of equity

    -Goldman Sachs $51 billion, 130% of equity

    -Merrill Lynch $27.2 billion, 70% of equity.

    In the hierarchy of assets and liabilities defined by the Financial Accounting Standards Board in standard 157, level one assets are those whose price can be observed in an active trading market—IBM stock or U.S. Treasury bonds, for example. Level two assets don't have active trading markets, but they are similar to other assets that do have market prices—restricted shares of IBM, for example. Level three assets are those that don't trade in active markets and are sufficiently unique that their value can't adequately be determined based solely on the market prices of other things. Their value has to be estimated based on unobservable things like expected cash flows or anticipated default rates. In other words, they are guesstimates made from mathematical models.

    FAS 157, which goes into effect for all companies on Nov. 15, was adopted early by most of the investment banks as well as the larger commercial banks like Citigroup, J.P. Morgan and Bank of America.

    The large amounts of level three assets that the banks are carrying don't mean that they are headed for insolvency. But it does mean that the quality of their financial reporting is deteriorating along with the credit markets. The level three assets include tranches of CDOs, the leveraged loan commitments and the complicated derivatives that the market currently wants no part of. And as long as the uncertainty over those investments remains, the banks will suffer. “It's very much in the interest of the banks to disclose as much as possible and to write down their losses,” Fed chairman Ben Bernanke said at a hearing of the congressional Joint Economic Committee last Thursday.

    How big will the year-end losses be? Wall Street analyst Michael Mayo from Deutsche Bank has suggested they could be in the neighborhood of $50 billion. Citigroup analyst Matt King pegged it at $64 billion. And Bob Janjuah, a credit strategist with Royal Bank of Scotland Group, reportedly threw out the staggering figure of $100 billion in further write-downs for the banks. He expected losses for the entire market could be as much as $500 billion.

    The range of estimates suggests that the reported losses will be big, and also could be wildly inaccurate. “It's not that banks are trying to hoodwink people, but they don't have the ability to value these things,” said Dick Bove, an analyst with Punk Ziegel who has been cautious on the investment banks since the beginning of the year. On his blog, the Big Picture, analyst Barry Ritholtz estimated the total level two assets of the five largest banks and brokers to equal 10 times their shareholders equity.

    What these estimates mean to banks' reserves, however, remains a mystery. That's because of the trade-off involved in fair-value accounting. While the information it produces may be more relevant to investors than the historical costs of assets and liabilities, it is also less reliable. And in an environment where markets have virtually frozen for a wide array of financial instruments, the information is now a lot less reliable. “We may have reached the natural limits of what accounting can do as a model,” said Michael Kraten, a former auditor with Deloitte & Touche and now president of Enterprise Management Corp., a management consulting firm.

    In the absence of market prices, the banks rely on financial models and “unobservable inputs,” in the parlance of FAS 157, to determine the value of these instruments. With the recent, arguably late, downgrades of structured products by the rating agencies, those models will spit out much lower values for the securities in the fourth quarter. However, no two banks use the same models or make the same assumptions. “There's a lot of judgment involved in valuing level three assets, and there's a lot of variation in practice,” said Mr. Witt.

    The auditors will have their hands full with year-end audits. The American Institute of Certified Public Accountants issued guidance for auditors in dealing with valuation issues in June, though it won't become effective until next year. The industry's new trade group, the Center for Audit Quality, weighed in on the issue last month with a report on fair-value measurements in illiquid markets. (See “The Secret Behind Wall Street's Q3 Profits,” FW, Sept. 24.) It gave notice to corporate executives that prices in trading markets, regardless of how thin the markets may now be, can't be ignored. Nor can the discounts that the market is applying generally to financial obligations. “They were getting out in front of the issue and telling companies that they can't hide behind a valuation model and hope that liquidity returns to the markets,” said Kevin Mixon, an analyst with RiskMetrics Group.

    Whether they have the ability to assess the accuracy of the thousands of Ph.D.-engineered models that the investment banks typically use to value assets is an open question. “The auditors have some smart people,” Mr. Kraten said. “But they're outgunned in this.”

    So what will year-end financials reveal about the health of the investment banks? Go ask Alice. FW
survivalmonkey SSL seal warrant canary