Banks Start Volcker Rule Blame Game

Nothing like being able to use something in the headlines to hide your real behavior. And even better if you can get a banking stalwart columnist to run PR for you.

Readers may recognize this trick: executives using a big news story as an excuse for their behavior. For instance, as much as we are not fans of Obamacare, not everything bad in the health care arena can be attributed to it. Corporations and smaller businesses have been for some time shifting more of the burden of employer-provided health care benefits onto employees. This year, some of them are trying to blame increases on Obamacare, even though the ACA market is distinct from group plans.

We’re seeing a similar use of the Volcker rule as a scapegoat for other bank woes. A particularly amusing case comes this week when FT Alphaville and Bloomberg columnist Matt Levine have opposite readings on a not-all-that-consequential-except as bellwether case involving Zions Bank. Zions, a Salt Lake City institution.

Matt Levine, whose columns range wildly from amusing and informatively wonky to combining remarkable bank shilling combined with lack of awareness or concern about the limits of his knowledge, ran a column Tuesday, First Volcker Victim? Zions Dumping Its Hedge Funds. Tracey Alloway of FT Alphaville shellacked it while being nice about it (as in she demolished Zions’ remarkable claims, which Levine dutifully amplified, and sidestepped taking Levine to task).

Without unduly going into the weeks, Zions holds a lot of particularly bad CDOs called TruPS CDOs (for the purposes of this discussion, you don’t need to know their unsavory history, but if you are curious, FT Alphaville did good reporting back in the day when they were a hot topic, so I’d recommend searching their archives).

Zions is now claiming they will have to recognize nearly $400 million in losses on these TruPS CDOs due to the Volcker rule. From the Levine post; the indented quote comes from a Zions release; the paragraph is Levine’s take:

Zions anticipates that in the fourth quarter of 2013 it will reclassify all covered CDOs that currently are classified as “Held to Maturity” into “Available for Sale,” and that all covered CDOs, regardless of the accounting classification, will be adjusted to Fair Value through an Other Than Temporary Impairment non-cash charge to earnings.

Basically they had a bunch of collateralized debt obligations that they were planning to hold to maturity and so they were umm let’s say being a bit fuzzy about how much those CDOs were down on a mark-to-market basis. And then along came Volcker and, bang, they had to reclassify them as shorter-term holdings and mark them (down) to market.

But notice his “umm let’s say being a bit fuzzy about how much those CDOs were down on a mark-to-market basis.”

We need to discuss a bit how banks get to value assets (this is very simplified so I hope the accounting mavens don’t take offense). Remember, investment banks (when there were such beasts) were required to mark everything to market, but they had ways of fudging things (getting “marks” by trading small amounts at the price level you needed with cooperative buddies, or abusing models for those instruments that didn’t have a ready market price, and thus you had to mark it by model. We discussed the details of so-called Level 1, 2 and 3 assets back when this was a hot topic).

Banks are even more special than investment banks. They have two other valuation categories they can pick from. One is “hold to maturity.” Regulators really like to think that bank make loans. And if a bank made a loan and intends to keep it, it makes investors and the bank crazy if the loan is revalued at every twitch of the bond market. Hence the “held to maturity” category.

Banks also mark assets to market, just like the old investment banks did, in their trading books. But banks have another special category, available for sale. Banks have lots of money sloshing in and out, and unlike investment banks, it’s not just due to trading, but to all the payments banks handle, including foreign exchange. So banks are allowed to keep liquidity buffers in their Treasury departments. They get close to the best of all worlds: they don’t have to mark them to market on a daily basis, but they can trade in and out of them. This treatment is called “available for sale” and it’s that treatment that Jamie Dimon abused in using his Chief Investment Office as a proprietary trading unit. As we wrote during the London Whale scandal:

It’s likely that a significant portion of the CIO’s activities were an accounting gimmick. Let’s remember why it was located in Treasury: it is the chief “investment” office, because it is managing the “investment” portfolio. Banks hold liquidity buffers so that they can meet a bank run. They get special accounting treatment on these positions. While they can sell them at any time, like trading inventories, they are NOT marked to market. Instead, they are kept in an “available for sale” portfolio, which means they are effectively treated as on a hold to maturity basis. That, in really crude terms, means you don’t need to recognize losses until they look pretty certain (usually, credit related).

So what does that mean, in practical terms? It means the CIO is the perfect prop trading/income smoothing vehicle. You can realize gains whenever you want to, by selling (provided the position is in a reasonably liquid market) or possibly even moving it over into your trading portfolio and you can defer most losses. If it makes a turkey trade, it can bury it until the bank has other trading gains or income in other businesses to offset it. And it can keep profitable positions around and realize them as needed to smooth earnings (while the unrealized losses are reported in footnotes, most investors don’t seem to pay much attention to that item). Investors really like smooth earnings, they mistake them for stability and strength of the business, as opposed to adept profit management. No wonder the people in the CIO were so well paid. They’d have to be Dimon’s favorite people.

Now with mark to market positions, banks have to recognize losses immediately. But in “hold to maturity” and “available for sale” are required to report if they are “temporarily impaired” on financial statements (in Accumulated Other Comprehensive Income), but it does not affect income or regulatory capital. But if an “impairment” is “other than temporary,” then the instruments must be written down, and the hits to earnings and capital recorded.

The London Whale episode led regulators to become more bloody-minded about these issues (of course, that raises the question of where they were all these years…)

Now back to Zions. In a hold to maturity portfolio, banks are required to disclose its value in the financial statements. Thus these losses weren’t “created” by the Volcker rule. Zions was simply fudging its accounting in a big way and the Volcker rule flushed it out.

Alloway makes it clear where she comes out on this mess at the top of her post:

We haven’t forgotten who keeps us in business,” reads the slogan on the website of Zions Bancorp, Utah’s biggest bank.

We assume they’re talking about their accountants.

Jonathan Weil at Bloomberg is even more pointed in calling out the Zions misdirection:

It turns out that a good-sized chunk of Zions Bancorp’s earnings existed only in its executives’ minds. For this nugget of knowledge, we can thank the Volcker rule. Or at least that’s what the bank is blaming for its newfound losses…

The losses aren’t new. Zions just didn’t have to recognize them before because of the way the accounting rules let companies report their bond holdings. Zions had been classifying the CDOs as “held to maturity,” which let it avoid recognizing the decline in value as part of its earnings. Now that Zions no longer has the ability to hold them to maturity, the bank said it will relabel the CDOs as “available for sale” and write them down to their fair-market values, triggering the earnings hit.

In other words, the accounting rules had been letting Zions maintain a fiction.

And again, this number should not be a bomb from the blue; investors should have been able to determine the value in the footnotes to the financial statements. As George Bailey of Occupy the SEC told us by e-mail:

Zions reported losses appear to have been inevitable given their outsized position and concentration in the TruPS CDOs regardless of Volcker. No other bank came close.

To the extent that Volcker brought the day of reckoning forward for Zion, I think that was an intended consequence. It shouldn’t have been a great surprise that these structures were going to fall foul of the final Volcker rule. The regulators apparently showed some spine in this area.

Volcker aimed at reducing prop trading positions at the banks. The working assumption is that those trading assets are already reflected properly in financials so disposing of them should be a non-event accounting wise, absent a fire sale, or bogus valuations.

Given Zion’s concentration, they are going to have to close at firesale prices. That’s their poor judgement. It will have ripple effects for all the participants in that segment of the market, but its my understanding these particular CDOs make up a small piece of the overall market

I expect there are going to be more of these revelations as people get through the securitization restrictions. The final rule is stricter than the proposal, so there are going to be disruptions as banks evaluate how extensively they are going to have to restructure deals.

To the extent that previously undisclosed losses are sitting at the banks, I think that was an intended consequence, at least in principle. The Whale is the perfect example.

But Alloway also points out that all surprises will not be to the downside. Banks were using available for sale portfolios to hide profitable positions, which the bank could sell later in case they needed to shore up earnings. The Volcker rule is forcing them to rearrange their accounts to keep from recognizing these profits:

But Zions’ adventures in TruPS CDO accounting also highlights a wider trend in banking. While Zions is being forced to reclassify some of its assets from HTM to AFS, many of its banking brethren are heading the other way. That’s because many of them have spent the past few years building up massive AFS portfolios of higher-yielding assets to make up for a lack of profit margins on traditional lending, and those portfolios have been subject to some pretty big swings.

A recent analysis by SNL Financial estimated that the biggest US banks increased the size of their HTM portfolios by 26 per cent between the second and third quarter of this year – largely to avoid having to deal with the kind of mark to market volatility now descending on Zion’s portfolio of TruPS CDOs.

So while the Volcker rule fell short in many respects, we should take what solace we can in cases like Zions, where dubious practices that should have ended years ago are finally being halted. Sunshine is provide to be a good disinfectant.

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  1. Chauncey Gardiner

    Setting aside the issue of accounting valuation methods of bank assets for a moment, it seems self evident to me that the dominance of the financial sector in the economy and its over-saturation with money are key considerations.

    The public purpose of banking that was implicitly embedded in the Glass-Steagall Act evidently needs to again be explicitly force-fed.

    1. F. Beard

      Glass-Steagall did nothing to prevent redlining.

      Face it, government-backed credit creation is a centuries old racket that corrupts entire societies and cheats and oppresses the poor and other so-called non or less “creditworthies”.

      And is it even positive sum in the long run? That remains to be seen unless the value of (non-rich) human life is assumed to be near zero.

      And is it even necessary (TINA)? NO!

        1. F. Beard

          Yet Watts and other black communities burned in the 1960s, iirc. A people so desperate they’d burn down their own homes screams injustice.

  2. F. Beard

    Wow! I’m amazed (and appalled) at the complexity of accounting rules. As a former software simulation engineer who came* to appreciate honesty, elegance, simplicity, logic, AND HUMILITY, I can only think of our money system as a shoddy, unnecessarily complex, dishonest, arrogant kludge**. No, I don’t know our money system that well but why should I learn a system that is a proven failure and which should be scrapped anyway for ethical reasons alone not to mention philosophical consistency and a host of other reasons?

    *Unlike central bankers, I had the luxury of learning without, say, killing 50-65 million people in WWII as the Fed did.

    **And what, btw, does it say about people who think TINA?

  3. DolleyMadison

    Can anyone explain the difference between marking something OTTI (Other than temporarily impaired) and “writing off” or “writing down”? Thanks!

  4. Chauncey Gardiner

    Really good question, Dolley, particularly given the behavior of the financial markets since the Great Financial Collapse of 2007-09 and related causal factors.

    I googled this summary of the issue of temporary impairment (and coincidentally noted that the date of the article coincided with the amazingly sharp and protracted reversal in U.S. markets off their March 2009 lows):

  5. susan the other

    Also Zions Bank was formerly the flagship regional bank in Utah. Mormon roots and all that. And Utah has always been the BFF for banksters. I wonder if Zions never anticipated there would be such a serious federal regulation. I think it is sorta poetic justice.

  6. Peripheral Visionary

    Levine came from Dealbreaker, where he was basically a perfect fit (Bloomberg must have offered him a large salary and/or lighter schedule to induce him to switch). He is very bright and very experienced in the financial industry, and I would be reluctant to describe him as “unaware”. I suspect he knows perfectly well how his indifferent attitude toward the financial sector will be taken by many outsiders, as evidenced by the snarky comments he sneaks in that seem to be custom designed to draw a response from political activists in particular.

    With any Levine article there are usually valid and sometimes unexpected insights into the financial industry to be had; but never rule out the possibility that he is trolling.

    1. Yves Smith Post author

      No, he’s openly dialed in some columns. There was one where he said at the top that he hadn’t even bothered to look into a whistle blower allegation, but there was nothing to see here. I find his columns to be more inconsistent in quality than you suggest. He does many where he’s got the details despite his snarky writing style, but there are others where he really has not done the work. or he’s wandered into terrain outside his usual beat and blows off real issues (like anti-trust law!).

  7. Christer Kamb

    It was government that more or less forced(opinioned) the FASB to “change the rules” in the midst of the crises(-08). Investmentbanks where given this loophole of mark-to-fantasy models to avoid bankruptcy. It was about the interpretation of i.e the FASB 157-rule how to define (bend) what “a fair value” really represents. The 157-rule came 2006 but was first practiced 2007(november) which then directly affected the company-books in their fiscal year ending december 2007. Stories where told that people at the FASB where truly annoyed about how government officials suddenly tried to influence with different views. And this is really an accounting-scandal(or more like corruption of some kind) if you think about how the banking-industry have been figthing for mark-to market prices since the 80´s and finally won. But they are never satisfied, are they!

  8. PopeRatzo

    It’s possible that the only thing that can make things significantly better would be to put the entire financial sector into rocket ships and send them into space one-way.

    Tell them there’s free money and free labor on Mars or something.

  9. steelhead23

    I’m so ignorant here, I hesitate to comment, but doesn’t implementing this rule create risks for the banks and the FDIC. I assume that those securities being held to maturity would constitute a portion of a banks regulatory capital, that is, reserves. I know that these assets fall into various forms, or tiers of assets, and I suspect the banks have to demonstrate that it has sufficient assets to meet all its reserve requirements. So, if by moving a security from HTM to AFS and marking it to market (which itself is heavily manipulated), a bank could fall below its regulatory reserve requirement, suggesting the bank should be reconciled. Might I assume that prior to adopting these new regs some effort was made (based on those footnoted accounting confessions in quarterly reports) to ensure the FDIC wouldn’t go broke? Don’t misunderstand me. I agree that the situation was untenable, I simply wish to feel comfortable that such consequences were considered before applying the remedy.

    1. tiebie66

      I have a somewhat related concern in that I wonder what else may reasonably be expected to come out in the wash. More specifically, what SHOULD come out in the wash and should have an eye kept out for? If it doesn’t, then that would raise a red flag.
      How big is the potential impact of the rule and would all the surprises (downside and/or upside) be benign? Might it trigger serious disruptions?

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