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In a previous post, I featured this chart sourced from Bloomberg:


  It is quite telling, considering the state of affairs. Let us move on to this story from the WSJ:

U.S. banks have been dying at the fastest rate since 1992, mainly because of bad loans they made. Now the banking crisis is entering a new stage, as lenders succumb to large amounts of toxic loans and securities they bought from other banks.

Federal officials on Thursday were poised to seize Guaranty Financial Group Inc., in what would be the 10th-largest bank failure in U.S. history, and broker a sale of the Texas bank to Banco Bilbao Vizcaya Argentaria SA of Spain (See my proprietary research on this Spanish bank which suffers from the Spanish coastal real estate boom and bust - pdf  Banco Bilbao Vizcaya Argentaria SA (BBVA) Professional Forensic Analysis 2009-02-23 09:05:09 439.80 Kb ). Guaranty's woes were caused by its investment portfolio, stuffed with deteriorating securities created from pools of mortgages originated by some of the nation's worst lenders.

Texas-based Guaranty Financial Group was crippled by investing in securities issued by other lenders.

Guaranty owns roughly $3.5 billion of securities backed by adjustable-rate mortgages, with two-thirds of the loans in foreclosure-wracked California, Florida and Arizona, according to the company's latest report. Delinquency rates on the holdings have soared as high as 40%, forcing write-downs last month that consumed all of the bank's capital.

Guaranty is one of thousands of banks that invested in such securities, which were often highly rated but ultimately hinged on the health of the mortgage industry and financial institutions. "Under most scenarios, they were good and prudent investments -- as long as we didn't have a housing or banking crisis," says John Stein, president and chief operating officer at FSI Group LLC, a Cincinnati company that invests in financial institutions.

Thousands of banks and thrifts scooped up securities tied to the housing market or other financial institutions in the past decade. Such investments were alluring because they seemed certain to outperform Treasury bonds, municipal bonds and other humdrum holdings that dominated the securities portfolios at most banks for generations. As of March 31, the 8,246 financial institutions backed by the FDIC held $2.21 trillion in securities -- or 16% of their total assets of $13.54 trillion. The problems also underscore how the boom in securitization of loans instilled a belief that risks could be controlled, an idea embraced first by financial giants like Citigroup Inc. and Merrill Lynch & Co. and then smaller institutions reaching for higher profits. "We saw them as a safe investment, and now we wish we didn't have them," says Robert R. Hill Jr., chief executive of SCBT Financial Corp, a Columbia, S.C., bank with 49 branches. The bank has less exposure than some other small institutions, with the crippled securities representing about 10% of its investment portfolio. The overall impact on the U.S. banking industry's second-quarter results isn't clear, because disclosure of losses and even the types of securities owned vary widely from bank to bank. Some obscure their troubled holdings in a vague line item titled "other" in financial statements. "The very depth of the problem is very difficult for us to get our hands on," says Jim Reber, president of the ICBA Securities, the brokerage unit of the Independent Community Bankers of America, a trade group of 5,000 small banks and thrifts. "These securities have declined in value, and it is not clear when they are going to come back in value, if at all."Of course the securities will come back in value, once 110%LTV, no doc, interest only loans come back into favor to drive housing prices up 15% per year again!


Last month, dozens of small and regional banks said their financial results were bruised by a deterioration in their securities portfolios. Riverview Bancorp, of Vancouver, Wash., eked out a $343,000 profit, but the 18-branch bank took a $258,000 charge on a pool of securities it holds.

First Defiance Financial Corp. had a write-down of $874,000 on four investment pools valued at $2.3 million. Officials at the Defiance, Ohio, bank with 35 branches said it owns even more of those kinds of securities, but their performance is holding up so far.

The sickened securities fall into two categories. Guaranty is among nearly 1,400 banks that own mortgage-backed securities that aren't backed by government-related entities such as Fannie Mae and Freddie Mac. Such "private issuer" and "private label" securities are carved out of loans originated by mortgage companies, packaged by Wall Street firms and then sold to investors.

During the buoyant housing market, many of those securities earned top-notch grades from major rating agencies, giving bank CEOs, finance chiefs and treasurers comfort.


Small and regional financial institutions own about $37.2 billion of private-issuer and private-label securities, Red Pine estimates. But regulators are pressuring banks to write down the value of their mortgage-backed securities, now being downgraded as more borrowers fall behind on payments for the underlying loans.

Banks also are being battered by more than $50 billion of trust preferred securities, financial instruments that are a hybrid between debt and equity. From 2000 to 2008, more than 1,500 small and regional banks issued trust preferred securities, according to Red Pine data.

In a process similar to the securitization of subprime mortgages, Wall Street brokerage firms bought the securities from individual banks and packaged them into so-called collateralized-debt obligations. The firms then sold slices of the CDOs to investors, marketing them as lucrative but low-risk.

Many of the buyers were small and regional banks, which were confident they could evaluate other banks and attracted to the interest promised by the issuing financial institution.

But as banks struggle with rising loan losses, some issuers of trust-preferred securities no longer can afford their obligations. In the first half of 2009, 119 U.S. banks deferred dividend payments on their trust-preferred securities, while 26 defaulted on the securities.

The consequences are cascading down to banks that bought the securities. One banking lawyer who asked not to be identified describes the result as a "wonderful chain of stupidity."

Huge holdings of trust-preferred securities doomed six family-controlled Illinois banks that collapsed last month. Their capital ratios tumbled below minimum requirements when regulators forced the banks to write down the value of the securities, says Lyle Campbell, who ran the family's banking business.

The six failed banks, three of which opened in the Civil War era, had about $1.38 billion in combined assets. Their collapse is expected to cost the FDIC's strapped insurance fund $267 million.


Founded in 1938 as Guaranty Building & Loan in Galveston, near the Gulf of Mexico, the institution had swelled to $2 billion in assets and about 30 branches when the Texas real-estate bubble burst. In 1988, regulators declared Guaranty and more than 100 other savings and loans insolvent.

Guaranty was brought back from the dead by Temple-Inland Inc., a conglomerate that owned timberland, paper mills, a railroad and a small mortgage company. With government help, the Austin company combined the S&L and two other failed Texas thrifts into a new thrift that was twice as big.

By 2005, Guaranty had $18 billion in assets and 150 branches in Texas and California. That year, Guaranty bought nearly $3 billion of triple-A-rated mortgage-backed securities, according to company filings. Its holdings ballooned to $3.2 billion from $420 million a year earlier...

Under pressure from shareholders such as billionaire Carl Icahn, Temple-Inland spun off Guaranty in 2007. The housing market was sliding, but Guaranty didn't waver from its self-confidence.

"While the deterioration in the housing and credit markets is clearly significant, and could continue, it is important to note that we did not originate or purchase subprime loans, we have very few 2006 and 2007 vintage single-family mortgage loans, we buy straightforward structured mortgage-backed securities, and lending to home builders is a long-time core competency for us," Guaranty President and Chief Executive Kenneth R. Dubuque wrote in his first shareholder letter. Mr. Dubuque, who stepped down from Guaranty in November, couldn't be reached for comment.

All of the mortgage-backed securities Guaranty bought from 2005 to 2007 were created from option adjustable-rate mortgages, which let borrowers decide how much to pay each month.

And of the 45 private-label mortgage-backed securities in Guaranty's investment portfolio at the end of 2007, at least 26 were created from loans made by American Home Mortgage Corp., Countrywide Financial Corp., IndyMac Bancorp or Washington Mutual Inc. All of those lenders have since collapsed or been sold because of massive loan losses.

Delinquency rates on Guaranty's portfolio jumped to as much as 40% last fall from a range of 4% to 22% in 2007. Last month, banking regulators forced the company to write down the mortgage-backed securities by $1.45 billion, or more than a third of their value in November.

The write-downs plunged Guaranty's total risk-based capital ratio, a measurement of its ability to absorb future losses, to negative 5.5%, classifying the bank as "critically under-capitalized." The Office of Thrift Supervision took over Guaranty's board, and the FDIC rushed to find a buyer.

  Interesting stuff huh? You can't say I didn't tell you so. Remember this post from a year and a half ago: As I see it, 32 commercial banks and thrifts may see the feces hit the fan blades Friday, 23 May 2008? Look at the condition (or even teh existance) of those 32 banks now! Well, I am working on a new list to be out in a week or two. This ain't over ladies and gentlemen, despite the meteroic rise in stock prices over the spring and summer, not by a long shot.

Here is some additional excerpted research from IMF/CEPR guys:

  • The ongoing U.S. mortgage crisis has sharply eroded the market value of U.S.
    banks. By the end of 2008, more than 60 percent of U.S. bank holding companies had a
    market-to-book value of assets of less than one, while this was the case for only 8 percent
    of banks at the end of 2001. At the same time, the average ratio of Tier 1 capital to bank
    assets has stayed constant at about 11 percent throughout this period. The market value of
    bank equity thus has dropped precipitously against a backdrop of virtually constant book
    capital. This raises doubts about the accuracy of the accounting values of bank assets and
    liabilities reported on bank balance sheets. As for non-financial firms, accurate
    accounting information on banks is, of course, crucial, as bank customers, supervisors,
    and capital markets all need correct information in their dealings with banks (for an
    overview of the literature on the cost and benefits of enhanced corporate disclosure and
    accounting transparency, see Leuz and Wysocki, 2008).1  I've been warning my readers about this for 2 years now. I am taking a harder look at the market darling, JP Morgan, for I feel that everyone is ignoring both market values and counterparty risk concentration regarding this beloved behemoth!
  • This paper shows that banks systematically understate the impairment of their real
    estate related assets, especially following the onset of the U.S. mortgage crisis, in an
    effort to preserve book capital. Consistent with depressed bank share prices, we find that
    the stock market attaches significant discounts to banks’ real estate exposure, in the form
    of real estate loans and mortgage-backed securities (MBS), relative to these assets’ book
    values. Thus, the deterioration of these real estate assets implicit in bank stock prices is
    much larger than their impairment implicit in book values. Put differently, banks areshown to use the discretion offered by current accounting rules to value their real estate
    assets much more favorably than the market does as revealed by bank stock prices.
    Distressed banks in particular appear to use their accounting discretion so as to
    maintain a relatively inflated book valuation of assets and bank capital. We specifically
    document two methods by which distressed banks maintain relatively high asset
    valuations. First, banks with large exposures to MBS are shown to report relatively small
    loan impairments in the form of loan loss provisions and loan charge-offs. Second,
    distressed banks tend to classify a relatively large fraction of their MBS as held-tomaturity
    – to be carried at amortized cost – rather than as available-for-sale – to be
    carried at generally lower fair value. All this raises serious doubts about the information
    content of banks’ public accounts, especially during the current financial crisis.
  • To estimate implicit market discounts on key bank assets, we empirically relate
    Tobin’s q, computed as the market-to-book value of assets, to these asset exposures.
    Thus, we relate Tobin’s q to information on a bank’s exposure to real estate loans and
    MBS. Our primary focus is on real estate related assets, as these assets constitute a large
    fraction of the total assets of the average bank, and as declines in U.S. real estate prices
    have raised doubts about the underlying value of these assets. In 2008, real estate related
    assets amounted to about 63 percent of the assets of the average bank, of which 53.6
    percent were real estate loans and 9.6 percent were MBS. However, we also apply our
    methodology to other on- and off-balance sheet items, such as trading assets, deposits and
    other bank liabilities, the composition of bank capital, credit derivates in the form of
    credit protection bought and sold, and credit lines to securitization structures.
    For our study, we use quarterly data for U.S. bank holding companies from the
    Reports on condition and income (also known as Call reports) from the final quarter of
    2001 till the end of 2008, which completes a full business cycle as defined by the
    National Bureau of Economic Research (NBER). We find that the stock market started
    discounting banks’ real estate loans in 2005, and that the average implicit discount on
    these loans amounted to 10 percent by 2008. The discount on real estate loans for lowvaluation
    banks (with a value of q below the median) is estimated to be relatively small.
    This may reflect that low-valuation banks derive relatively large benefits from the
    financial safety net to offset loan impairment. As the average U.S. bank holding company
    in 2008 holds about 54 percent of its assets in the form of real estate loans, the implicit
    discount in loan values goes a long way toward explaining the current depressed state of
    bank share prices. We further find that investors first discounted banks’ holdings of MBS
    in 2008. For that year, we find an average discount on these assets of 24 percent (relative
    to other securities), while the average MBS exposure amounted to 10 percent of assets.
    The discount on MBS that are available-for-sale (and carried at fair value)
    implicit in share prices is estimated to be 23 percent, against a discount of 32 percent for
    MBS that are held-to-maturity (and carried at historical cost). Thus, even MBS that are
    carried at fair value appear to be overvalued on the books of the banks.
  • Pressures arose during the summer of 2008 to provide banks with more leniency
    to determine the fair value of illiquid assets such as thinly traded MBS to prevent these
    fair values from reflecting ‘fire-sale’ prices. Correspondingly, on October 10, 2008 the
    Financial Accounting Standards Board (FSAB) clarified the allowable use of non-market
    information for determining the fair value of a financial instrument when the market for
    that instrument is not active. Subsequently, on April 9, 2009, the FSAB announced a
    related decision to provide banks greater discretion in the use of non-market rather than
    market information in determining the fair-value of hard-to-value assets. As expected, the
    stock market on both occasions cheered the banks’ enhanced ability to maintain
    accounting solvency in an environment of low transaction prices for MBS. Using an
    event study methodology, we find that banks with large exposure to MBS experienced
    relatively large excess returns around both announcement dates, indicating that these
    banks in particular are expected to benefit from the expanded accounting discretion. First, let's bring back this chart...

 Then think of what happens to bank prices when 1) these rules are reversed and toughened relative to before and 2) the sh1t hits the fan as the deteriorating securities economic damage comes to the fore, despite any accounting games or shenanigans are played.

  • This paper provides two additional pieces of evidence that banks with large realestate
    related exposures use accounting discretion so as to maintain high book values and
    accounting solvency. First, banks have considerable discretion in the timing of their loan
    loss provisioning for bad loans and in the realization of loan losses in the form of chargeoffs.
    Thus, banks that are pressured by large exposures to MBS and related losses can
    attempt to compensate by reducing the provisioning for bad debt. Indeed, we find that
    banks with large portfolios of MBS report relatively low rates of loan loss provisioning
    and loan charge-offs.
    Second, we examine banks’ choices regarding the classification of MBS as either
    held-to-maturity or available-for-sale. We consider this categorization separately for
    MBS that are covered or issued by a government agency. In 2008, the fair value of
    especially non-guaranteed MBS tended to be less than their amortized cost. This implies
    that banks could augment the book value of assets by reclassifying MBS available-forsale
    as held-to-maturity. Indeed, we show that the share of non-guaranteed MBS that areheld-to-maturity increased substantially in 2008. Reclassification of this kind is also
    advantageous for banks whose share price is depressed on account of large real estate
    related exposures. Consistent with this, we find that the share of MBS kept as held-to maturitys significantly related to both real estate loan and MBS exposures. Moreover,
    these relationships are stronger for low-valuation banks.
    Taken together, our evidence on banks’ provisioning practices and MBS
    classification suggest that banks with large real-estate related exposures use the discretion ffered by accounting rules so as to inflate the book value of assets and of bank capital.
    Hey, I've caught a small bank red handed in doing this quarter after quarter as its share price has doubled. Where are the regulators when you need'em. Are they complicit. See pdf 1Q09 2009-05-07 06:34:52 460.74 Kb,

What's being done about this?

Well, I have been very critical of FASB in the past, for they have literally bent over (vaseline in hand) and allowed special interests to actually dictate the rules of proper accounting to accountants. Now, not only has this distorted the playing field of economic value (adn caused fundamental investors such as myself to disgorge some profits in the related bubble, see graph above), they have (again) put many a old ladies retirement fund at risk. Well, I will give credit where credit is due. They look as if they are trying to do the right thing. The following is sourced directly from the website...


FAS 157—improving disclosures about fair value measurements. After discussing the feedback received from field study participants on the proposed disclosure requirements, the Board directed the staff to draft a proposed Accounting Standards Update to improve disclosures about fair value measurements. The Exposure Draft would both clarify certain existing required disclosures about fair value measurements and propose several new disclosures, as described below.

  1. The Board will propose three new disclosure requirements:
    1. Information about the sensitivity of certain fair value measurements: If a change in one or more of the significant inputs to a Level 3 fair value measurement would significantly change the fair value, the reporting entity would state that fact and disclose the effect of those changes.

    2. Information about transfers in and/or out of Levels 1 and 2: A reporting entity would disclose information about significant transfers in and out of Levels 1 and 2 and the reasons for the transfers.

    3. Gross reporting of changes in Level 3 fair value measurements: Information about purchases, sales, issuances, and settlements, included in the reconciliation of Level 3 fair value measurements, would be presented on a gross basis rather than a net basis.

  2. The Board will propose two clarifications of existing disclosure requirements:
    1. Level of disaggregation: An entity is currently required to provide fair value measurement disclosures for each major category (class) of assets and liabilities, and the Board plans to provide guidance on the meaning of the term class. The Board believes a class is often a subset of assets or liabilities within a line item in the statement of financial position. An entity would apply judgment in determining the appropriate classes of assets and liabilities.

    2. Disclosures about inputs and valuation techniques: An entity is currently required to provide disclosures about the valuation techniques used to measure fair value. The Board will clarify that the disclosures about the inputs used are required for both recurring and nonrecurring fair value measurements. The Board also will clarify that those disclosures are required for fair value measurements that fall in both Level 2 and Level 3.

The Board decided that the proposal would be effective for reporting periods (annual or interim) ending after December 15, 2009, except for Level 3 sensitivity disclosures, which would be effective for reporting periods (annual or interim) ending after March 15, 2010.

The Board directed the staff to proceed to a draft of a proposed Accounting Standards Update for vote by written ballot, with a 45-day comment period.

FAS 157—applying fair value to interests in alternative investments. The Board deliberated issues raised by respondents to proposed FSP FAS 157-g, Estimating the Fair Value of Investments in Investment Companies That Have Calculated Net Asset Value per Share in Accordance with the AICPA Audit and Accounting Guide, Investment Companies. The following decisions were reached:

  1. The Board affirmed its earlier decision that an investment with a readily determinable fair value should be excluded from the scope of the final Accounting Standards Update. Additionally, the Board decided to clarify in the final Accounting Standards Update that the guidance would apply to investments in entities that (a) have the attributes specified in paragraph 946-10-15-2 of the FASB Accounting Standards Codification™, (b) report net asset value (or its equivalent, such as partner’s capital) to their investors, and (c) calculate net asset value (or its equivalent) consistent with the measurement principles of the Financial Services—Investment Companies Topic (Topic 946), that is, substantially all of the investment assets of the entity are reported at fair value.

  2. The Board affirmed its earlier decision that an entity would be permitted, rather than required, as a practical expedient, to estimate the fair value of an investment within the scope of the Accounting Standards Update using the net asset value of the investment (or its equivalent) if the net asset value is calculated consistent with the requirements of Topic 946 as of the measurement date. Additionally, the Board decided that an entity would be permitted to apply the practical expedient to investments acquired when there is a difference between the transaction price and the net asset value and recognize a gain or loss in earnings. An entity would not be required to disclose separately such gains or losses.

  3. The Board decided that an entity would be permitted to use net asset value as a practical expedient on an investment-by-investment basis. The entity would be required to apply the practical expedient consistently to its entire position in a particular investment.

  4. The Board decided that an entity would not be permitted to use net asset value, as a practical expedient, to estimate fair value of an investment in the scope of the Accounting Standards Update if certain criteria are met that indicate that it is probable that the entity will sell the investment in a secondary market. The criteria to determine whether the investment is likely to be sold in the secondary market would be similar to those in the Property, Plant, and Equipment Topic (Topic 360) for determining whether a long-lived asset to be sold should be classified as held for sale. The Board also decided that an entity would be required to provide additional disclosures about situations in which the entity determines that it is probable that it will sell an investment (or investments) in the secondary market.

  5. The Board decided to clarify that an entity may apply the practical expedient if the net asset value reported by the investee is not as of the reporting entity’s measurement date. However, the entity would be required to adjust the latest available net asset value for significant events that occurred since the date the net asset value was calculated by the investee so that the adjusted net asset value is effectively calculated consistent with the requirements of Topic 946 as of the measurement date.

  6. The Board decided to clarify that the disclosures are to be presented by major category, rather than by individual investment, and that those categories are intended to be consistent with existing guidance for major security types for debt and equity securities and major category of plan assets. The entity would be required to provide a general description of the terms and conditions for redemption of the investments in each major category. Additionally, for those otherwise redeemable investments that are restricted from redemption as of the reporting entity’s measurement date (for example, due to a lockup or the imposition of a gate), the entity would be required to disclose its best estimate of when the restriction against redemption might lapse. If that estimate cannot be made, the entity would disclose that fact as well as how long the restriction has been in place.

  7. The Board decided to clarify that classification within the fair value hierarchy of an investment within the scope of the guidance requires judgement based on the existing principles of the Fair Value Measurements and Disclosures Topic (Topic 820) and that all attributes of the investment should be considered.

  8. The Board decided that the disclosure provisions of the Accounting Standards Update would not be applicable to employers’ disclosures about postretirement benefit plan assets required by the Compensation—Retirement Benefits Topic (Topic 715).

  9. The final Accounting Standards Update will be effective for periods ending after December 15, 2009, with early adoption permitted. If an entity elects to early adopt the Accounting Standards Update, the entity would not be required to early adopt the disclosure provisions of the Accounting Standards Update.