Thursday, May 27, 2010

Banks Get Murkier

Just as an incipient credit crunch lurks in Europe's weeds, the financial condition of major banks is getting murkier. Spain's credit crisis is mostly a matter of banks being overleveraged (its government isn't in bad fiscal shape, compared to many Western nations). Some Spanish banks may not be marking their real estate assets to market. Spain's government is merging banks rather than liquidating them, which might obscure rather than illuminate the financial weaknesses of the banking sector (kind of like the way grocery stores mix good string beans in with the crappy ones to make lazy shoppers buy some, well, crap).

In the U.S., Citigroup and Bank of America have admitted to misclassifying in financial reports repo transactions (which are loans) as asset sales. This echoes the infamous Repo 105 strategem used by Lehman Brothers to reduce reported leverage levels. Both Citi and B of A claim the amounts were immaterial and that the misclassifications were errors. Nevertheless, billions of dollars of transactions were involved, and a curious investor might wonder, in light of the magnitude involved, how sound the banks' internal controls were.

U.S. banks continue to benefit from accounting rule changes made by regulators last year under political pressure from Congress, which loosened requirements to mark assets to market. It's possible that the major U.S. banks hold hundreds of billions of dollars worth of hinky assets that are carried at valuations above market prices. With residential real estate wobbly and commercial real estate falling, the banks can't continue indefinitely to wear rose-tinted glasses when compiling their financial statements.

One reason why the stock market goes on volatility frenzies is that investors are ambushed by surprises. The sovereign debt crisis began with Greece 'fessing up last fall to having a lot more debt than it had previously acknowledged. Things went downhill from there as it became clearer that various EU members had debt problems. Spanish and other European banks are having trouble selling or rolling over commercial paper in the U.S. Credit default swaps protecting against defaults on bank debt have been rising in price. While many failures contributed to the current problems, a failure of proper accounting was among the most important.

"Garbage in, garbage out" is a time-honored axiom from computer science. It also applies to the financial markets. Bad or inadequate information results in poor pricing. When the truth comes out, abrupt shifts in valuation can be expected. When bank accounting goes hinky, the soundness of the financial system can be endangered. Taxpayers must then gird themselves for more bailouts. Bank regulators don't always encourage transparency, in the fear that the truth will spark runs on troubled institutions. But in today's computerized, Internet-connected world, there are no secrets. At least, not for long, and when the word belatedly gets out, the run is all the more panicked. Full, fair and timely accounting and disclosure by banks, nations and other debtors is essential to a healthy financial system. Such should be a primary goal of financial regulatory reform in the U.S., Europe and elsewhere. Expediency, however, militates in the other direction. Sunshine is the best disinfectant, but human frailty the greatest source of continued infection.

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