Banks and securities firms, reeling from record losses resulting from the collapse of the mortgage securities market, are failing to acknowledge in their income statements at least US$35 billion in additional writedowns included in their balance sheets, regulatory filings show.
Citigroup Inc subtracted US$2 billion from equity for the declining value of home-loan bonds in its quarterly report to the Securities and Exchange Commission on May 2 without mentioning the deduction in the earnings statement or conference call with investors that followed.
ING Groep NV placed 3.6 billion euros (US$5.6 billion) in negative valuations in its capital account, while disclosing only an 80 million euro depletion to income.
The balance-sheet adjustments are in addition to US$344 billion in writedowns and credit losses already reported on the income statements of more than 100 banks. These companies have raised US$263 billion from sovereign wealth funds, their own governments and public investors to shore up capital.
The balance-sheet writedowns also reduce equity, which needs to be replenished. Adding the US$35 billion leaves the banks with a US$116 billion mountain of losses to climb.
“The smart people are the ones who’ve identified the problems, put them out there in full transparency, and addressed them by raising more capital,” said Michael Holland, who oversees more than US$4 billion as chairman of Holland & Co in New York. “There is still billions of dollars of crap out there that hasn’t worked itself through the system. Banks need more capital to work that all out.”
ACCOUNTING RULES
Taking losses on a balance sheet instead of an income statement is acceptable under accounting rules, which make a distinction between so-called trading books and long-term investments. Changes in value on the trading side go straight to revenue. Changes in the value of bonds held for the long haul can be marked down on the equity line of a balance sheet, as long as the declines aren’t considered permanent.
Banks that are more willing to acknowledge their balance-sheet writedowns, such as ING, say the valuations of assets will be reversed when markets recover.
ING, the biggest Dutch financial-services company, said in its first-quarter earnings report last week that the drop in the value of bonds tied to home loans that are held to maturity is irrelevant as long as the underlying mortgages don’t default.
VALUE LOSS
With that logic, most of the writedowns on the income statements could be reversed if asset prices recover. While some declines in valuations may reverse, most of the losses are permanent impairments caused by surging defaults on US mortgages, said Janet Tavakoli, author of Collateralized Debt Obligations & Structured Finance.
“Of course we can’t tell how much of a bank’s portfolio may actually be good stuff that will pay back at maturity,” she said. “But there’s tremendous value loss that’s fundamental, not just due to credit market gyrations.”
Keeping those markdowns off income statements just delays the realization of the losses, said Brad Hintz, a New York-based analyst at Sanford C. Bernstein & Co.
“The banks that have taken advantage of this accounting approach are going to have a price to pay later,” said Hintz, the third-highest ranked securities analyst in an Institutional Investor magazine survey. “You don’t avoid the price. Those that have taken it all in their income statements will come out with clean balance sheets and move on.”
Ignoring bad debt and postponing inevitable losses was one of the main reasons behind Japan’s decade-long economic slump that began in the 1990s, said Boston University law professor Charles Whitehead.
JAPANESE LESSON
Faced with new capital requirements and a weakened ability to meet them, Japanese banks deferred the recognition of their losses, aided by regulators who refrained from implementing the rules, Whitehead wrote in a 2006 paper published in the Michigan Journal of International Law.
“US regulators may be tempted to go soft on banks too,” said Whitehead in an interview. “The new capital rules already rely significantly on self-modeling by the banks. So if anything, the risks may be greater in the US today than they were in Japan in the 1990s.”
The new bank-capital regime, known as Basel II, has gone into effect in some European countries and is being implemented in the US and others starting this year. It allows financial institutions to use in-house risk models instead of just relying on external credit-worthiness ratings in calculating their risk- weighted capital requirements.
The largest US securities firms have been under capital requirements shaped by Basel II since 2004.
BALANCE SHEETS
A review of the balance sheets and regulatory filings of more than 50 banks showed that 20 of them chose to keep some subprime-related losses off their income statements. The marks were recorded instead on balance-sheet items labeled “other comprehensive income” or “revaluation reserves.”
Washington Mutual, which has taken US$217 million in subprime-related writedowns against profits, kept a bigger amount on the other-comprehensive-income line of its balance sheet, which swung to a US$782 million loss in the first quarter.
The Amsterdam and Brussels-based bank Fortis, put 990 million euros in losses in revaluation reserves, in addition to the 3.3 billion euros it reported on its income statement.
Merrill Lynch & Co, which has booked US$31.7 billion from market markdowns in its income statements, is keeping another US$5.3 billion in losses on its balance sheet as other comprehensive income.
The revaluation reserve reduction of £740 million (US$1.4 billion) at London’s Lloyds TSB Group Plc is bigger than the £667 million charged against profit.
Officials at Citigroup, Merrill Lynch, Washington Mutual and Fortis declined to comment, while a Lloyds TSB spokeswoman said none of athe assets included in the available-for-sale reserves are considered to be “permanently impaired.”
The writedowns aren’t finished yet. Fitch Ratings Ltd expects as much as US$110 billion in additional losses on subprime securities.
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