New Accounting Rules May Undermine Consumer Lending

Repeat after me: the credit crisis was the result of too much cheap and easy lending. Ergo, any return to healthier practices means more expensive and less readily available debt.

The problem is that the powers that be don’t quite grasp the implications, or to the extent they do, are still trying to have their cake and eat it too. They want a sounder banking system (or so they say, but with the banksters in charge, this is likely all talk). But heavens no, we cannot restrict credit, bad thing will happen, like a recession/depression, cheaper assets, and fewer campaign contributions.

The reality is that there is no nice, painless way out of the mess, as our high and rising unemployment rate attests. And how the new FASB rules 166 and 167, due to become effective next year, come into play, will tell alot about our tolerance for pain in the interest in getting the financial system on a more solid footing.

The reason I particularly cynical is what transpired with FAS 157. That rule went into effect at the end of 2007 (I believe November 2007 so that securities firms with November fiscal years would comply). It gave us Level 1, 2, and 3 assets, and required companies to disclose which fell in which valuation bucket. The higher the number, the fuzzier the basis for the price used. Level 1 assets were in actively traded markets where prices could be readily observed (think stocks and foreign exchange). Level 3, often described as “mark to make believe” was based on “unobservable inputs”. An accompanying rule required companies to put assets in the lowest numbered category, meaning most concrete valuation bucket, possible. In other words, no calling an asset Level 3 and valuing it as you damned well pleased when there was a more objective way of deriving a price.

So what happened? Bear Stearns crisis, FAS 157 is relaxed, banks can put assets in whatever category they choose. And what did we see? Huge increases in Level 3 assets, with banks contending markets had become illiquid and they therefore could not price a lot of stuff on their balance sheet.

If you believe all the increases in Level 3 assets were due to difficulty in getting prices or market inputs, I have a bridge I’d like to sell you.

These new FASB rules will require consolidation of QSPE, which is “qualified special purpose entities.” Off balance sheet entities were targeted to be killed as a result of Enron, but the financial services industry howled, since real estate securitizations and credit card conduits were off balance sheet vehicles. The compromise was QSPE, with the idea that a truly arm’s length entity like a real estate securitization, with no recourse to the parent if the vehicle go tin trouble, should be OK. Of course, that created a second set of messes, that assets, like subprime loans, which were not suitable for the “Q” treatment (accountants like to say “not Q-able”) were nevertheless put in these very sort of entities (this is one of the many reasons we are having difficulty with mortgage mods: these vehicles and the related arrangements were designed to be pretty passive once they were set up). But that is another topic.

The new FAS rules will eliminate the QSPE, which will have the effect of requiring banks to consolidate their off balance sheet vehicles. This makes perfect sense with credit cards, which are arguably not arm’s length (banks have in the past and are now intervening to rescue credit card trusts that have gotten in trouble. If they let one flounder, they would have a great deal of difficulty doing future deals). Consolidating these vehicles will reveal the banks to be even more thinly capitalized than they appear to be now. While investors in theory ought to understand the extent of bank off balance sheet exposures, in practice, few do. This change is likely to affect investor psychology and will probably lead lead banks to be far more stringent in extending credit. (An aside: I am surprised at mortgage securitizations being included. Banks have not acted to shore these up, and I can see a strong case for not consolidating them).

And that is why I expect this rule to be gutted shortly after launch, if it even gets that far. From Reuters:

The Federal Reserve’s program to revive the markets for U.S. securitized debt may be disrupted and credit to consumers choked off if planned accounting changes are implemented in 2010.

New rules by the Financial Accounting Standard Board, in the form of FAS 166 and 167, will force banks to put securitized debt back on balance sheets and retain continued exposure to the risks related to transferred financial assets, by eliminating the concept of a “qualifying special-purpose entity.”

The amount of capital available for making new loans to consumers for credit cards and mortgages may be restricted as a result.

“There are potentially huge consequences of the FASB changes. There are concerns over whether bank balance sheets will be stretched to the breaking point because of the amounts recorded on balance sheets,” said John Arnholz, partner at law firm Bingham McCutchen…..

“If you get off-balance sheet treatment, that provides a more efficient use of your balance sheet and has been the foundation of the structured finance market. Bringing it back on balance sheet would have an impact on all your various financial ratios,” said Mike Kagawa, portfolio manager at Payden & Rygel.

The American Securitization Forum recently asked U.S. bank regulatory agencies for a six-month moratorium relating to any changes in bank regulatory capital requirements resulting from the implementation of FASB’s 166 and 167…

The role that securitization has assumed in providing both consumers and businesses with credit is striking with currently over $12 trillion of outstanding securitized assets, including mortgage-backed securities, asset-backed securities and asset-backed commercial paper, the ASF said.

Industry experts said the accounting changes threaten to setback the huge strides made by the Fed’s emergency loan program, the Term Asset-Backed Securites Loan Facility, known as TALF, launched earlier this year.

Through the program, the Fed was able to bolster consumer lending and reopen the securitization market for consumer ABS, nearly shutdown by a deep credit crisis in 2008. The program also drove the high costs of funding dramatically lower.

However, issuance under the program may suffer a sharp setback if banks retrench from making new consumer loans amid capital constraints created by heavier debt loads and new accounting and administration costs. The increased costs to banks are likely to filter down to the consumer in the form of higher borrowing costs, as well….

William Bemis, portfolio manager at Aviva Investors said he expects asset back securities issuance to decline as a result of the new rules.

“Credit card issuance will decline going forward, primarily because the debt will be going on balance sheet now. The attractiveness of being able to get financing and remove assets off balance sheet will be less now,” said Bemis.

While banks may still opt to lend, some may not meet the ratings criteria under TALF, which requires top ratings from credit agencies, as they carry heftier debt loads.

“This could really stifle issuance under the program because you need two ‘AAA’ ratings to issue under TALF. The accounting rules have the potential to reduce lenders’ access to TALF, which the Fed has devoted $1 billion in funds to,” said another industry source.

Meanwhile, as the deadline looms closer, market participants are expecting the Federal Deposit Insurance Corp. to weigh in with further clarification on off-balance sheet rules for securitizations.

“People are getting discouraged because the clock is ticking and this is going to help dry up money that would be available for consumer lending. The Fed knows how important it is to keep credit flowing but it seem that’s not getting through to the FDIC.” said the industry source.

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  1. mannfm11

    I just read Andy Xie’s post on Caijing Why One Bubble Burst Deserves Another for the second or third time. In it, he mentions that Lehman died in vain, as they have done nothing to clean up this mess. He contends that Lehman could have been cleaned up for $50 billion instead of the trillions we have seen spent if the idea was to maintain the status quo. The lack of any intestinal fortitude on the part of the US and most likely other nations as well to rein in the freewheeling and unsecured lending of banks and Wall Street is going to doom the world to a long depression. The current news is there isn’t going to be any real derivative regulation because the prime players have set it up where they are going to be excluded. They took mark to market out, after the worm turned and it began to disfavor the players instead of favor them. I don’t know what they did with the lower of cost or market I was taught in school, but I do understand companies were marking up their assets and claiming they were income and they were marking down their IOU’s because their credit rating went to crap. Anything but recognize their assets have collapsed in value, which was the intent of the old accounting standards.

    The whole idea that the Enron technique would be allowed to cloud the issue going forward is quite absurd. This technique was taught Enron and installed by Wall Street and the big banks to start with and being it is their technique, there is no telling what other bombs are being hidden in this cellar. The entire system is as fraudulent as anything ever foisted on modern finance. Being banks create credit by acting as surety for their borrowers, the very idea that a bank may be creating more credit than it can pay off totally defeats this idea. I might as well, without a dime in my pocket, be able to lend someone $100 million as Citi. I could clearly invent a few assets to pose as $10 million or so and after collecting interest for a few years, I would have my net worth. But, I might also have to fold my tent.

    William Black of RTC fame and professor at UM Kansas City has come out and said the entire mess is criminal and the government is hiding the insolvency of the banks at all costs. It appears this cost includes potentially taking all the citizens of the US down the drain with them. If someone honest is allowed to write the history, this will go down as one of the great scandals of the ages. It is probably worldwide,to be honest.

  2. JLS

    Oh please. This could impact TALF or bank balance sheets? The willingness of the ratings agencies to issue ‘AAA’ ratings has not been a barrier for dodgey assets as yet, so TALF is unlikely to be affected. As for the balance sheets, the Fed has guaranteed the balance sheets of the largest banks and I’m sure that they can expand the definition of TBTF to ever smaller sized banks as needed.

    Nevertheless, these rules will never be implemented unless the political cost somehow becomes too large. Neither the Fed nor the banks want these rules. The banks will fight implementation because the rules will increase administrative costs. The Fed doesn’t want them because it doesn’t need the headache of backfilling balance sheets (again) and arm-twisting the ratings agencies. I would venture a guess that Bernanke and Geithner were primarily responsible for 157 lite and will likewise block implementation of 166 and 167 for the foreseeable future.

  3. Jo

    This is the problem with ponzi: it feeds on itself or it collapses.

    ps it was kind of ironic hearing from someone from Aviva on this (google deep enough and you’ll get it.)

  4. danm

    The reality is that there is no nice, painless way out of the mess, as our high and rising unemployment rate attests. And how the new FASB rules 166 and 167, due to become effective next year, come into play, will tell alot about our tolerance for pain in the interest in getting the financial system on a more solid footing.
    Agreed. But America will surely do whatever it can to make someone else pay for its excesses. If that means buying time, so be it.

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