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 |  Subject: Fiction in the world of banking  Sun Jan 06, 2008 7:19 pm | |
| Economic reality and fiction in the world of banking
NEW YORK: What better time of year is there than New Year's Eve to sneak in a little bad news?
On the other hand, what better time of year is there for a money manager to engage in a little window dressing to make a portfolio look better?
Either way, one end-of-year incident in 2007 illustrates two absurdities: the techniques that banks use to make themselves appear healthier than they really are, and the determination of some portfolio managers to get dubious-looking securities out of their portfolios by the end of the year.
Perhaps, just perhaps, it also shows that some investors have overreacted to the credit crunch of 2007, and that there really are buying opportunities around.
The bank in question is Zions Bancorporation, which operates in 10 Western states from a base in Utah. On the afternoon of Dec. 31, it notified the U.S. Securities and Exchange Commission that it had been forced to bail out an off-balance sheet affiliate by purchasing $840 million of securities from it.
That move produced an immediate loss of $33 million, since Zions paid more than the securities were worth.
Zions added that the affiliate, called Lockhart Funding, still owns $2.1 billion of securities, which it estimates are worth $22 million less than book value. Under the current accounting rules, it does not have to take that loss. At least not yet.
Let's first look at Lockhart and why it exists. In a world with sensible bank regulations, and accounting that reflected economic reality, it would never have been created.
Lockhart, which was set up by Zions in 2000, provides the cash for Zions to make small business loans. Zions turns those loans into securities, and sells the securities to Lockhart, which then borrows money in the commercial paper market. Lockhart also buys securities not put together by Zions.
Why bother? First, the loans disappear from Zions's books. Second, the bank regulators accept that fiction when they calculate how much capital Zions needs to have. As Clark Hinkley, a Zions senior vice president, told me, "It enabled us to essentially originate these loans and not have to keep tangible capital behind them."
The reason this is all fictional is that Zions has a "liquidity agreement" with Lockhart. If any of the securities go bad, Zions will buy them at book value. If Lockhart cannot raise money by selling commercial paper to investors, Zions will buy the paper or buy some of Lockhart's assets. For all practical purposes, Lockhart is part of Zions.
Zions has disclosed this arrangement over the years, so investors presumably understood it. But it made Zions appear to be better capitalized than it really was. The same is true of dozens of other banks.
The reason for the last-minute disclosure of the purchase of assets is that as 2007 ended, Lockhart found it impossible to sell enough asset-backed commercial paper, even though Zions itself has purchased $710 million of Lockhart paper. Since Lockhart could not sell the paper, Zions had to buy the assets.
And that brings us to the evidence of investor absurdity. An investor buying Lockhart's asset-backed commercial paper knew that Lockhart's assets backed the commercial paper. If that was not enough, the liquidity agreement means Zions effectively stands behind the paper.
Hinkley reports that these days Zions can, and does, borrow in the commercial paper market, and at lower rates than Lockhart was offering. That seems odd. Why would anyone prefer lower-yielding paper with less security? If I'm willing to lend you money without collateral, why would I refuse to lend if the loan was backed by both collateral and your promise to repay, and had a higher interest rate?
The answer is that asset-backed commercial paper has gotten a bad name, as unwary investors learned that the assets in question sometimes were funny securities backed by sub-prime mortgages. So money managers whose year-end portfolios will be subject to scrutiny by customers have fled from such paper, much of which must be rolled over every few days. The amount of outstanding asset-backed commercial paper is rapidly declining.
But no one is scared by commercial paper issued by banking companies and not backed by assets.
The Financial Accounting Standards Board and the bank regulators know all about this, and they have been talking about making changes for years.
But it is complicated, and nothing seems to happen.
We probably will get action if and when there is a good scandal. Perhaps some bank will fail even though it seemed to have plenty of capital. Then there will be expressions of shock, and calls for changing the rules to reflect economic reality. In the meantime, banks will be able to keep assets off their books - until they have to report the losses when the assets go bad.
http://www.iht.com/articles/2008/01/03/business/norris04.php |
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