Watchdog: Accounting Tied to Lack of Loan Modification

Posted by: Theo Francis on August 11

In the Gordian knot that is the financial crisis, there’s a surprising thread that connects many of the most intractable problems, including toxic assets, the small-business lending drought and the apparent reluctance of banks to modify mortgages for struggling homeowners: Last spring’s accounting rules.

At least, that’s the argument laid out today by Elizabeth Warren, chair of the Congressional Oversight Panel formed to scrutinize the government’s bailout efforts.

The thrust of her argument, as laid out in the committee’s latest report and a conference call with reporters this morning: A relatively simple change in how banks account for hard-to-value loans contributes to everything from small businesses having trouble getting loans to homeowners having trouble refinancing their mortgages to the federal government’s inability to get toxic assets off banks’ books. Altogether, she says, it threatens not just banks, but also the recovery as a whole.

“Who would have thought that boring old accounting rules have such powerful implications?” says Warren, a Harvard law professor who has devoted much of her research to consumer financial issues.

Unsurprisingly, the banking industry sees things differently. "We don't share a lot of views in common with Elizabeth Warren," Diane Casey-Landry, the group’s chief operating officer, told BusinessWeek. She describes the accounting-rule change as a fix for earlier rules that made banks look artificially worse off, and says the bigger obstacle to loan modification is the economy and unemployment. Lending, the banks argue, has slowed because the environment is riskier.

None of Warren's arguments is entirely new, nor do they necessarily exclude the arguments made by the banking industry. But Warren makes a cogent case. Here it is:

The accounting rule change effectively let banks value the whole loans they hold higher than where the market values them. As a result, the banks can get by with less capital than they otherwise would have to have. "That may make their paperwork look better, but it certainly doesn’t change their underlying reality," Warren says.

Still, given the chance to value the loans higher, banks won't want to sell their toxic assets. Doing so would mean recognizing potentially big losses. That, in turn, would mean having to raise new capital -- thus lowering the value of shares held by existing stockholders (including management, in all likelihood); some banks, unable to raise cash, would go under. Better, banks figure, to hold on to the loans and hope for the best, or earn their way out of the hole over time.

That helps explain the long delays in government efforts to resolve the mess, Warren argues.

But it also means banks may have still more incentives to avoid modifying mortgages for struggling homeowners. That's because modifying a loan changes its value -- lowering it, if the homeowner gets any substantial relief. Once again, banks may find it more appealing to sit on the unmodified mortgages and at least postpone the pain, if not avoid it altogether.

"So long as the banks can carry toxic mortgages on their books at a value that is higher than they can get either by selling those mortgages in the marketplace, or by modifying those mortgages when they get into trouble to keep the homeowner paying," Warren says, "then the banks … have no incentive to sell or to modify."

Meantime, the toxic loans also make banks less inclined to lend: Whatever the value on the financial statements, banks know they'll ultimately have to recognize deterioration in the loans value once loan payments fail to come in -- from unemployed homeowners, cash-strapped developers, struggling small businesses. So they have every incentive to hoard the capital they have instead of lending it.

"Regardless of how they carry the loans on their books, banks have some sense of whether they are facing a lot of losses next year or the year after," Warren says. "They try to hold on to [capital] against that day in the future when they're likely to take serious losses on those loans."

The problem is most acute among "smaller" banks -- meaning those banks smaller than the 19 behemoths that put themselves through government-supervised "stress tests." These banks do a lot of small-business lending, and are also more likely to hold whole loans than the securitized loans that the big banks liked.

As a result, Warren says, "if the smaller financial institutions remain at risk because of their toxic assets, it has implications not only for the stability of the financial system but also for the economy in restarting lending."

Warren stopped short of writing a prescription, calling it the COP's job to point out problems more than to craft solutions. But she urged greater transparency, giving investors better information about the loans that banks are holding, to let the market come up with their own valuations – and potentially clear the logjam. (Treasury spokesmen didn't return emails seeking comment.)

The ABA’s Casey-Landry didn’t actually dispute Warren's basic reasoning (though she and another ABA official questioned her use of the word "smaller" to describe institutions below the top tier of megabanks, given that some have tens of billions of dollars in assets). Instead, Casey-Landry offered alternative scenarios for slow modifications and the banks' reluctance to sell the loans the market won't touch.

First, though, she argues that the accounting-rule changes helped more banks stay solvent, by not forcing them to raise capital when capital was scarce. Casey-Landry says the ABA also has concerns about smaller banks, but that’s because the federal program to pump capital into financial institutions hasn't reached many of them. Out of more than 3,000 banks with $500 million in assets or less, just 234 have received federal funds, in part because the rules came out later and in part because the terms are less attractive for some closely held institutions. "We don’t believe the program has been user-friendly for community banks," Casey-Landry says.

She also argues that macroeconomic conditions and the design of the Administration’s loan-modification programs are bigger factors in banks' decisions not to adjust individual mortgages: If homeowners don’t have income, or have seen their wages fall because of a layoff, furlough or pay cut, no amount of modification will help them stay in their home -- and that’s increasingly what banks are seeing. "You can modify it, but it may not be successful," she says.

Of course, it remains to be seen whether waiting for the housing market to recover will prove more successful.

Update: A Treasury spokesman sidesteps the accounting question, chalking banks' ability to raise private capital up to improved market conditions. "While utilization of legacy asset programs will depend on how actual economic and financial market conditions evolve, the programs are capable of being quickly expanded if these conditions deteriorate," the spokesman says. "Thus, while the programs will initially be modest in size, we are prepared to expand the amount of resources committed to these programs."