Accounting is destiny

So, unusually, Felix Salmon is wrong:

In order for banks to offer principal reductions, two criteria need to have been met: (a) they came into the mortgages via acquisition, rather than writing them themselves; and (b) they bought the mortgages at a discount… Economically speaking…what the banks are doing here does not make sense. Either writing down option-ARM loans makes sense, from a P&L perspective, or it doesn’t. If it does, then the banks should do so on all their toxic loans, not just the ones they bought at a discount. And if it doesn’t, then they shouldn’t be doing so at all.

It makes perfect sense for banks to reduce principal on loans valued at less than par on their books, and to refuse to do so for other loans.

Let’s suppose we have a loan whose direct value will increase if we offer to reduce the principal owed. That’s not a rare situation. As Salmon writes, “a sensibly modified mortgage is likely to be much more profitable for a bank than forcing a homeowner into a short sale or foreclosure and trying to sell off the home in the current market.” Under these circumstances, one effect of a principal reduction is to increase the expected present value of the cash flows associated with the loan. Ka-ching!

However, there are two offsetting effects. The most widely discussed is moral hazard. Banks worry that borrowers for whom a principal reduction would impair rather than enhance the economic value of the loan will find ways of getting reductions too, by strategic mimicry or due to changing norms and public pressure. That helps to explain why (Salmon again), “principal reductions were being done on many mortgages which were actually current and in good standing, rather than on mortgages which were careening towards foreclosure.” Keeping principal modifications something that is offered only to “our best customers” keeps the practice voluntary. It preserves banks’ freedom to discriminate between profit-making and loss-making modifications.

The second offsetting effect of an otherwise desirable principal reduction is a matter of accounting. If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity.

Of course this is a matter of mere accounting. Whether or not a bank takes a capital hit has no bearing on whether a principal reduction will increase the realizable cash-flow value of the loan.

But accounting is destiny. The economic value of a bank franchise, both to shareholders and managers, is intimately wound up with its accounting position. A bank whose books are healthy may distribute cash to shareholders and managers, while a bank whose capital position has deteriorated will find itself constrained. A well-capitalized bank is free to take on lucrative, speculative new business, while a troubled bank must remain boringly and unprofitably vanilla. The option to distribute and the option to speculate have extraordinary economic value to bank shareholders and managers.

You cannot understand banking at all unless you understand that banks must be valued as portfolios of options. You can value some businesses by estimating the present value of cash flows from firm assets, and then subtracting liabilities. But banks are more complicated than that. The value of a bank is a function not only of expected cash flows, but of the shape of the probability distribution of those cash flows, and of the diverse arrangements that determine how different cash flow realizations will be split among a bank’s many stakeholders. A hit to a bank’s capital position narrows the distribution of future cash flows (by attracting regulatory scrutiny) and diminishes the degree to which cash flows can be appropriated by shareholders and managers rather than other parties. To say that a bank should only be concerned with maximizing the long-horizon value of its loan book is like arguing that the holder of a call option ought not object if her contract is rewritten at a higher strike price, because, after all, changing the strike price doesn’t reduce the economic value of the underlying. A bank’s accounting situation and regulatory environment define the terms of the options that are the main source of value for big-bank shareholders. Accounting changes imply real transfers of wealth.

Now the value of a bank to shareholders and managers is very different from the social value of a bank. If we aggregate the interests of all of a banks’ claimants — shareholders, managers, bondholders, depositors, counterparties, guarantors — there is far less optionality. From a “social perspective”, what we want banks to do is to lend into enterprises whose interest payments reflect real value generation and then maximize the expected value of those cash flows, irrespective of who gets what among bank claimants. If we were serious about that, we would force banks to write down their loan portfolios aggressively, so that going forward shareholders and managers have nothing to lose by offering principal modifications when doing so would maximize the cash flow value of their loans. But if we did force banks to write their loan portfolios down aggressively, the shareholders and managers with nothing to lose would be different people than the current shareholders and managers of large banks, via some resolution process or restructuring. Which is much of why we didn’t do that, when we had the chance, and why bank mismanagement of past loans continues to exert a drag on the real economy as we try and fail to go forward. This very minute, there are homeowners who are nervously hoarding cash, who are leaving factories idle and neighbors unemployed, in order to maximize the option value of the bank franchise to incumbent shareholders, managers, and uninsured creditors.

 
 

29 Responses to “Accounting is destiny”

  1. Ted K writes:

    The best post you’ve written in awhile. Great stuff. I kind of lost faith in Felix Salmon when he made one of his first video posts advising (talking down to) small individual investors that they couldn’t compete with hedge funds and the like, and basically, in not so many words, telling them to stay out of the market. This type of talking down to people is why people take default “choices” on their 401(k), have limited and crappy choices on the menu of 20 garbage funds offered by their employers plan provider. See here: http://online.wsj.com/article/SB10001424052702303365804576430153643522780.html?mod=googlenews_wsj#articleTabs%3Darticle

    and here: http://grahambrokethemold.blogspot.com/2010/02/is-401k-really-good-for-you-or-just.html

    I think Felix Salmon basically a good guy, and is very good at amalgamating huge amounts of internet info. He’s a good journalist generally. But I think when it comes to some financial issues sometimes Salmon has his head up his a.s.s. This is one of those times. And when he tells individual investors to be passive to the “big players” like some rape victim http://www.youtube.com/watch?v=tCMTeweaiCQ , is another time.

  2. walt writes:

    “If a bank has purchased a loan at a discount, however, the loan is on the books at [the bank's] historical cost.” Who sold those loans at discounts? We know taxpayer money was used to buy them: the banks were and are insolvent.

  3. Anonymous writes:

    [...] [...]

  4. vlade writes:

    Excuse the expression, but this is a cool way to look at it – not least, because it offes a new way to look at regulation, where the regulator can make choices that move the banks from forward-like companies (to extend the metaphor) to option like.

    My feel on that is that most of the current regulation confuses forwards with in-moneys.

  5. [...] about this subject, see Felix Salmon’s piece on it yesterday, and Steve Randy Waldman’s counter. (And yes, I believe that moral hazard is a very real problem when it comes to principal [...]

  6. SW:
    Until you’ve been a CPA and seen financial institution accounting up close, you can’t believe how bad it is. You can’t believe how little most bankers understand about the economic implications of accounting.
    Among other things, the SEC, Fed and Treasury encourage bad bank accounting to foster the illusion that banks are solvent when in many cases they are not.

  7. But this ignores the fact that accounting and bank accounting, is just a sort of bizarre fiction. When fractional reserve lenders like banks can lend amount at any given time that amounts to 24 or 25 times their “capital” it is obvious that they are not “intermediating” anything. Banks are making up the money they loan. A banking license is a slightly constrained exception to counterfeiting laws. The whole notion of bank capital under modern regulation comes from an analogy to the role of specie in 19th century banking, where government used the possibility of the public redeeming a bank’s notes for specie to keep the issuance of such notes moderate enough to avoid (hugely) devaluing the currency — in other words, to keep the illusion of a stable relationship between money and actual economic value. I emphasize the word illusion, because if there was a lockstep connection between money and value, banking wouldn’t work–no one would accept the “made up” money of loans as being able to command real value. Money is a signalling system for people making economic plans, and banking sends out false signals to fool people into making more expansive plans, thus triggering economic growth (which is sometimes sustainable, and sometimes not.)

    But arbitrary regulations aside, the truth is, a lender defaulting on made up money damages…no one. Nothing in the real world has happened. No ‘destruction’ of value occurs when the loan is defaulted upon. It was all fake to begin with. The bank could easily make up more money and stay in the game, if it was allowed to by ‘the authorities’.

    So all of this is a purely socially constructed game…just with serious consequences. But I find it astounding how invested people are in these widespread social fictions. We must have ‘solvent’ banks, even at the cost of 10% unemployment. We must finance most undertakings with this thing we call ‘debt’ even when it clearly magnifies risks to everyone when there is a widespread loss of economic confidence. No alternatives to any established practice will be tolerated, or even thought about, because apparently God came down from Sinai and established bank capital, debt and bankruptcy regimes by divine decree, so there is no possible point in considering alternatives!

  8. vlade writes:

    @FWB, your misunderstanding of how the banks work is a rather depresingly common one.
    The bank capital is, very emphaticaly, NOT what the banks lend. It’s there to cover the losses from intermediation.

    Banks (talking normal deposit taking & lending banks) don’t create new money any more than short-sellers create new stock (ignoring naked short-sellers).

    In effect, banks ARE short-sellers of money – and the regulation around that is a bit more stringent than for stocks – non-deliveries are equal to defaults. Of course, the trick is that the banks have a lender of a last resort – the CB, which is often more likely to lend cash against cr*p collateral than your stock broker (he could go out of business, CB can’t).
    Of course, the notion that banks have to have deposits before they can lend is as spurious as that you can only sell stock that you own or already borrowed. If there’s a lender in the market that can deliver you stock before you have to deliver, you can always sell stock, and if there’s someone to lend you money, you can always lend them on. And, as we’ve seen, CBs make sure that there’s a lender.

    Banking capital then serves to cover any losses from that short-selling, that’s all there is to it – it’s not to be lent. It has the same purpose as your margin with a stockbroker when you’re shorting something. It’s not even a liquidity cushion (because, for one, you can hold the capital in relatively illiquid stuff).

    Bank’s cash accounts must square at every end of the day – and they have to have a positive cash balance with the relevant central bank.
    Now, if you want to talk accounting profits and the like (such as pretending that MtM is real cash), we’re in an entirely different game.

    Oh, a last point – gold (or whatever), doesn’t solve the problem. Just look at real coverage (gold vs. M3 say) with just about any gold standard – it fluctuated between 10 and 50%, depending on the economic conditions. A truly 100% gold standard could work only if you eliminated any non-spot payments, which works in a small enough economy, but at certain size you just run of the time in the day to move all that physical money along the chain.

  9. Don Levit writes:

    I have researched quite a bit the accounting procedures of the federal government.
    I have a feeling they are much more lenient than the FASB for private businesses, or even the GASB for state governments.
    As some of you may know, the federal government is “regulated” by the FASAB.
    I find the accounting for the Social Security trust fund to be very interesting.
    When the Treasury borrows from the trust fund, it is a liability to the Treasury and an asset to the trust fund. So, for accounting purposes, it is a wash.
    The asset part is used immediately for other government expenses, yet the liability does not materialize until the trust fund outgo exceeds income (excluding interest), which happened in 2010.
    In addition, what the trust fund considers as $2.6 trillion of assets is merely the ability to tap the Treasury without an appropriation.
    In other words, the assets are not like assets that can be liquidated without raising new monies. The trust fund’s assets can only be tapped by raising general revenues, or raising the debt held by the public.
    In other words, the trust fund for Social Securuty is totally pay-as-you-go, even though it looks like it includes $2.6 trillion of gold ingots.
    Don Levit

  10. K. Williams writes:

    “This very minute, there are homeowners who are nervously hoarding cash, who are leaving factories idle and neighbors unemployed, in order to maximize the option value of the bank franchise to incumbent shareholders, managers, and uninsured creditors.”

    This sounds plausible, but there isn’t really any evidence of it in the data, is there? If homeowners are, in fact, hoarding cash en masse — that is, hoarding cash enough to leave “factories idle and neighbors unemployed” — then the savings rate should be notably, even unreasonably, high. But it isn’t. The US savings rate is 5%, which is well below the historical average in this country and obviously far below what it is in many other countries. Unless you want to argue that the savings rate should be much lower than it is now, I don’t see how you can make the case that cash hoarding as a result of too few mortgage writedowns is having a significant impact on the economy.

  11. [...] Steve Randy Waldman, “The economic value of a bank franchise, both to shareholders and managers, is intimately wound up with its accounting position.”  (Interfluidity) [...]

  12. Rob Parenteau writes:

    K. Williams – You have to look at household net saving, or the financial balance for the household sector, which is gross saving minus investment in tangible capital (homes, mostly). As a share of GDP, you have to go back to the early ’80s to find household net saving as high as it is now, which is quite a shift from the unprecedented stretch of household sector deficit spending from 1999-2007. As Richard Koo and others find, once a prolonged asset bubble bursts, the domestic private sector (households and firms) will tend to try to rebuild their net worth and pay down debt by achieving a net saving position. This slows or reverses the revenue and profit growth of firms, and can lead to subpar economic growth, stagnation, or even a debt deflation spiral unless there is a sufficient increase in the trade balance and/or decrease in the fiscal balance. The reason why this high a household net saving rate did not prevent a strong recovery in the early ’80s is because Reagan pursued a military Keynesian strategy along with accelerated depreciation and tax code changes that helped spur business investment (temporarily).

  13. [...] July 12, 2011 Cathy O'Neil, mathbabe Leave a comment Go to comments I wanted to share this link with you; it is both interesting and relevant to another post I’m working on (a follow up to [...]

  14. K. Williams writes:

    “K. Williams – You have to look at household net saving, or the financial balance for the household sector, which is gross saving minus investment in tangible capital (homes, mostly). As a share of GDP, you have to go back to the early ’80s to find household net saving as high as it is now, which is quite a shift from the unprecedented stretch of household sector deficit spending from 1999-2007. As Richard Koo and others find, once a prolonged asset bubble bursts, the domestic private sector (households and firms) will tend to try to rebuild their net worth and pay down debt by achieving a net saving position.”

    While what you’re saying is true, it doesn’t really have anything to do with either Steve’s argument or my rebuttal. I’m not disputing that people are saving more than they were between 1999 and 2007, the bubble years. I’m saying that the rise in the savings rate is the result of the negative wealth effect from the decline in both housing prices and stock prices over the last four years, and the mpact on disposable income of high unemployment and slow wage growth, and not at all the result of households hoarding cash in order to pay off their mortgages (as Steve suggests). Indeed, far from households saving more than the should be (as Steve’s argument suggests is the case), they’re arguably saving less than you’d expect, given the magnitude of the drop in housing prices and the still-sizeable decline in stock prices. The point is that the data don’t provide any support for the idea that the lack of mortgage modifications is the reason “factories are idle and neighbors are unemployed.”

  15. JKH writes:

    “If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity.”

    Hmm…

    I think that implies/assumes that the loss provision taken up front by the bank when the loan is booked is equal to the purchase discount, which won’t necessarily be the case.

  16. [...] //]]> banking | housing Steve Waldman has a fantastic reaction to my post about principal reductions, saying that “accounting is [...]

  17. [...] Steve Waldman has a fantastic reaction to my post about principal reductions, saying that “accounting is destiny”: If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity. [...]

  18. winterspeak writes:

    JKH: Yup.

    Felix missed the point quite badly on this one (and continues to do so).

    But, without your proviso, I’m not sure Steve is right either.

  19. vlade writes:

    JKH/WS:
    I don’t believe bank takes a provision if it buys a discounted loan (over and above the discounted value).
    Say the NPV of the full-amount loan is 1m (if it would be repaid). It gets impaired, and I buy it for 500k. I have to get enough capital to cover that 500k – but no other extra provision (yet).
    It also means, I can do a notional mod up to 50% of the original notional (which would drop the NPV from 1m to 500k I bought it for) w/o loosing any value.

  20. JKH writes:

    Example:

    The bank buys the loan from a distressed bank @ 50 cents on the dollar.

    It makes an assessment as to what cash flow it expects from the loan over its lifetime.

    E.g. the cash flow it expects may be equivalent to the contractual interest payments, plus repayment of principal @ 70 cents on the dollar.

    The point being that, particularly in a distress sale, there’s no reason why the bank’s expectation for principal repayment must be the same as the discounted price it paid for the loan.

    The example depicts a cash flow expectation that is equivalent to an original loan of 100, plus contractual interest payments, with provision for a loan loss of 30, with an additional discount of 20 attributable to distress sale pricing. This loan would be booked at a current value of 50. Subsequently, over the life of the loan, income would be booked according to the contractual interest payment, plus accretion of the distress sale discount component of 20. Income would be booked roughly like that of a bond under accrual accounting, with a principal repayment of 70, initially marked at 50.

    Anyway, the book value of the loan would start at 50 and rise to 70, assuming eventual cash flows matched expectations. The accretion of the 20 would be part of periodic income and corresponding equity accumulation.

    The loss provision I suggested might be more conceptual than formal financial accounting, but it falls out in accounting logic from a comparison of expected cash flow against loan book value first originated by the selling bank. It’s effectively an allowance for eventual expected losses from this original book value. The degree to which the purchasing bank would be “comfortable” with principal mod depends on expected cash flow, not on accounting. Expected cash flow, as in this case, may not correspond simply to the price discount.

    If, in the example, the bank accepted a principal mod of 50 (the new net book value of the loan), this would be inconsistent with its expectations for cash flow. It would be undoing that component of income and equity appreciation it expects due to the accretion of 20 of the discount into income over the remaining life of the loan. With such a mod, the bank would have to change its expectation to conform to the lower expected principal repayment (or total cash flow) inherent in the mod. So in that sense, it can’t afford to do such a mod, because it simply doesn’t make sense according to its actual cash flow expectation. The economics of cash flow expectation drive the mod decision; not the accounting.

  21. JKH writes:

    P.S.

    In the above example, it’s also possible that the recognition of the income corresponding to the 20 component may be deferred until the point where the cash is actually received, but that also doesn’t change the economic rationale for the mod decision.

  22. mbs writes:

    another consideration that FS alluded to (in perhaps overly derogatory terms) are the beliefs of the banks. he suggests that no bank wants to “admit” (to itself?) that /it/ made bad loans and as a consequence it fails to offer loan modifications on their loans. reality may be that banks think this because it is true. lot of the paper that banks are buying was originated by now-defunct outfits which presumably had very bad underwriting standards (the countrywides). the buyers (FS talks of JPMchase) are in a position to buy b/c (among other things) their underwriting wasn’t quite so god-awful. anecdotally, i was shopping for a mortgage in ’05 and found chase’s product line-up to be expensive and “unimaginative” (aka not completely imprudent). in this context, if you are looking at two identical mortgages (based on the hard information) one you originated, one you bought from countrywide then your probability of default on the countrywide paper may be considerably higher… but banks being banks, accounting gimmickry is sure to play a role.

  23. vlade writes:

    JKH:
    Disclaimer: I have very little knowledge how it works for individual loans, I know how it works for derivatives and suchlike.
    You say “original loan of 100, plus contractual interest payments, with provision for a loan loss of 30″.
    Why, when I bought the loan for 50 – which would go on the books as the original loan cost – would I take another impairment of 30? Wouldn’t that immediately create an accounting loss to me? If I bought the loan for 10, would it mean I’d have to take a provision of 90?

    I may believe that the loan’s value is 70, and I can then provision for the 20 difference, and say enter the loan in as cost 50, value 70, but take provision of 20 released as appropriate. But that still leaves me with space to do the mod so that the expected cashflows add up to the total value of 70 w/o taking any other provision. If I was the originating bank, I’d not do it w/o taking a loss straight away (I did anyway, as whoever sold it for 50 must’ve taken loss, but that’s immaterial to the seller).

    I don’t have to do the mod – it could well be that I’d be willing to take a punt on the real estate markets recovering or whatever.
    But my ability to do the mod is less constrained than the originator’s one, as I carry the asset at lower value (regardless of whether it’s 50 or 70). The economic loss on the loan was already realised by the seller.

  24. JKH writes:

    vlade,

    I said:

    “The example depicts a cash flow expectation that is equivalent to an original loan of 100, plus …”

    “Equivalent to” means it is as if the buyer takes over the loan as originally booked, with further book adjustments as indicated. The book value of the loan is 50, but the economic value may be higher (by 20). That’s why the buyer won’t do the mod down to the book value.

  25. vlade writes:

    JKH: Understood. But that means there’s already 30 write-off (very importantly by someone else – the orginator.

    If you say that econ value is interest on 100 + principal repayment of 70 – well, I get principal repayment of 70 only if the borrower defaulted somewhere down the road (otherwise I get 100).
    If that’s the case, I will be getting the interest for less than the life of the loan, until t_default, time of the default. I could get the same E[NPV] if I drop the notional – that should mean that new t_modified_default>t_default (ceteris paribus), so I get less interest, but for longer time. Depending on the initial values and the default probabilities, I may well be able to find a new notional that would E[NPV] the same (it may be higher than your estimated recovery, say 80). So, the value for me is the same – but it should be a bit more “certain” (as each repayment payment is a bit more certain, assuming finite budget of the borrower).

    The original owner of the loan has no such freedom to modify it w/o NPV impact – more parameters need to be moved for it to keep the same NPV (say extend maturity but increase rate, drop notional but decrease maturity and increase rate etc..) – and none of those are likely to be acceptable to the borrower.

    But maybe we’re talking cross purpose.

  26. [...] Accounting is destiny – via Interfluidity- It makes perfect sense for banks to reduce principal on loans valued at less than par on their books, and to refuse to do so for other loans. Let’s suppose we have a loan whose direct value will increase if we offer to reduce the principal owed. That’s not a rare situation. As Salmon writes, “a sensibly modified mortgage is likely to be much more profitable for a bank than forcing a homeowner into a short sale or foreclosure and trying to sell off the home in the current market.” Under these circumstances, one effect of a principal reduction is to increase the expected present value of the cash flows associated with the loan. Ka-ching! [...]

  27. [...] In fact, accounting rules make bank behavior “rational”: If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity. [...]

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  29. jim writes:

    There is one more factor that makes the banks’ decisions seem irrational: mortgage insurance. The bank who takes the charge for a write-down has different incentives than the insurer who takes the loss if the mortgage is in default.