Tuesday, 10 August 2010 19:46

Extend and Pretend: More Balance Sheet Fiction

by Manuel Rodriguez
Balance sheet fiction continues unabated, as evidence mounts that banks are creating bogus loan modifications to avoid having to write down loans and destroy capital.  

A recent article in the Wall Street Journal, here, highlights how accounting manipulation has increasingly become the tool of choice for dealing with a souring economy. Regulators, the Federal Reserve, the Treasury, and those with clearly vested interests have largely failed in their efforts to stimulate the broader economy. The one remaining tool in the toolbox, though, remains their most potent: create more fiction and re-write those facts which are inconvenient.

“Extend and pretend” has become de rigueur at banks and other financial institutions, financial sleight-of-hand which masks bad loans by purportedly modifying loan terms or providing repayment assistance. These modifications prevent the need to immediately write-down the loans or fully reserve for them. By forestalling these write-downs, banks avoid further destruction of their capital positions, which have been decimated by the economic firestorm.

Many of these loan modifications are shams, and are not designed to protect the commercial project’s viability. Instead, these bogus loan modifications ensure that banks maintain the loan as performing assets and prevent further weakening of their capital.

As the FDIC grapples with an uncertain economy, spurious loan modifications and the fictitious balance sheets they create may purposely delay efforts to close many of the 1000 or so troubled banks that are projected to be shuttered by the FDIC in the next few years. Efforts to delay these closings will, in turn, postpone the FDIC’s own financial Armageddon and taxpayer bailout. 

Evidence of Extend and Pretend is high:

1.      Restructurings of “nonresidential loans stood at $23.9 billion at the end of the first quarter, more than three times the level a year earlier and seven times the level two years earlier.”

2.      Regulators have developed new guidelines, which allow banks to record loans as   performing even if the value of the underlying property has fallen below the loan amount.

3.      About “two-thirds of bank commercial real-estate loans maturing between now and 2014 are underwater.”

4.      Banks currently hold some $176 billion in souring commercial real estate loans.

5.      At the end of the first quarter, “44.5% of debt restructurings were 30 days or more delinquent or weren’t accruing interest”, meaning that nearly half of the modifications were themselves failing, a figure likely to rise as the economy continues to worsen.

Restructuring a loan where the underlying value of the property is below the loan value is essentially a bet that the economy will improve and re-inflate the underlying asset value. A bet remains a bet, though, and judging by Wall Street’s recent performance in spotting the recent financial land mines, this too will end in another taxpayer bailout in the near future.

Fictitious balance sheets ultimately prevent banks from lending, as non-performing loans generate no cash flow and prevent banks from expanding their lending to other, more qualified borrowers. This, in turn, prevents small businesses and the overall economy from expanding. Ultimately, the banks will write-off the loans, necessitating capital enhancements or taxpayer assistance.

The only winners are the bank officers and employees, whose bonuses are tied to the “performance” metrics that are blatantly false. The banks’ shareholders lose once their true financial condition is revealed. In short, there are practically no winners in this process, which merely delays FDIC takeover of these failed banks.

Some analysts continue to insist that parallels with Japan’s “Lost Decade” are coincidental, and that the US economic crisis is distinguishable from Japan’s crisis. They note that structural differences exist between Japan and the United States.  The resulting crisis brought on by propping-up failed banks, though, remains the same: zombie banks unable to lend or properly conduct business, open for business in only a strict, technical interpretation.

The fiction being created also draws parallels to the exploding crisis at Fannie Mae and Freddie Mac. Before being placed into a federal conservatorship and effectively nationalized, these two mortgage behemoths continued to insist that their balance sheets and loans were properly valued and adequately reserved. We know how that turned out, unfortunately. Fannie and Freddie will ultimately become the costliest bailout in taxpayer history.

 The most amazing thing about the current crisis is our collective ability to suspend disbelief, or framed differently, our inability to be sufficiently skeptical when faced with historical antecedents. We have been lied to repeatedly, for many decades, regarding the true financial condition of our corporations and banks. The S&L crisis, Enron, Freddie Mac, Fannie Mae, Global Crossing, the current housing bubble, our pension liabilities, all are examples of our collective national hypnosis and delusion regarding the true condition of our financial system. Our national conceit blinds us to the fact that our system of financial reporting is fundamentally broken, and is no more accurate than a game of darts. We maintain trust in a broken system that has bankrupted our country and its pensions, and remain steadfast and loyal to the folks running this system. When will we learn?    



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