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Commentary
“Each thing is of like form from everlasting and comes round again in its cycle.”
—Marcus Aurelius
With the summer solstice upon us, June marks both the official start of summer and the unofficial first anniversary of the subprime market collapse. It also appears to be the month that has officially ushered-in a bear market for U.S. stocks, with the Dow off 20% from its high of 14,164 points last October. One painful lesson learned from the events of the past year is the way pro-cyclical trends can exacerbate a problem. Witness the collision of:
- The adoption of mark-to-market or “fair value” accounting
- The excessive use of leverage
Fair Value Accounting
“The use of fair value to measure assets and liabilities should provide users of financial statements (present and potential investors, creditors, and others) with information that is useful in making investment, credit, and similar decisions—the first objective of financial reporting.” —Excerpt from Summary of Statement No. 157, Financial Accounting Standards Board
Bankers used to be incented to buy low and sell high. But, the industry’s adoption of mark-to-market accounting practices has encouraged the opposite behavior: buying high and selling low. This is exactly what we saw earlier this year when declining asset prices sparked a massive wave of margin calls and balance sheet de-leveraging.
Here’s a synopsis of industry credit losses versus capital raised since 2007:
| Region |
Write-Downs |
New Capital |
| The Americas |
$175 |
$159 |
| Europe |
$203 |
$147 |
| Asia |
$21 |
$16 |
| Total |
$399 billion |
$322 billion |
Source: Bloomberg
The well-intentioned conversion from accounting for assets on an historical cost basis (the asset’s original cost) to fair value (the current market value) was a way to boost transparency for investors. Instead, the unintended consequences have yielded staggering losses for investors and significant erosion of equity value. Since the beginning of 2007, global banking losses tied to asset write-downs have amounted to nearly $400 billion. Fair value critics clamor that it is absurd to continue applying fair value accounting to assets that literally have no discernable fair value (in that there is no market for them), and that the continued use of the practice will create more unnecessary earnings volatility.
Investors kicked-in just over $300 billion in new capital to bolster bank balance sheets over the past year, and asset valuations appeared to have stabilized after the government-brokered bailout of Bear Stearns in mid-March. A few brave economic wise men and some large bank CEOs even suggested we were more than halfway through the crisis—closer to the end of credit crunch than to the beginning. But sentiment once again turned very negative in June, as banks telegraphed another wave of write-downs, dividend reductions or all-out suspensions, and the need for more capital. A wave of selling subsequently hit the sector, putting much of the new capital investment “under water.” In textbook pro-cyclical fashion, these developments discouraged more private investment and perpetuated the sector thrashing, vividly depicted by the 18% drop in KBW’s Bank Stock Index in June.
Source: Bloomberg, KBW
Even some high-profile regulators are expressing alarm that the pro-cyclical trends could be an accelerator for more losses if the nearly $300 billion in new capital has not been enough to cauterize the wounds—and investors smarting from fresh losses are reluctant to ante-up again. According to FDIC Chairwoman Sheila Bair:
“Frankly, things may get worse before they get better. As regulators, we continue to see a lot of distress out there. Too many unaffordable mortgages are causing a never-ending cycle—a whirlpool of falling house prices and limited refinancing options that contribute to more defaults, foreclosures and the ballooning of the housing stock.”
Leverage
“The use of credit or borrowed funds to improve one’s speculative capacity and increase the rate of return from an investment, as in buying securities on margin.”
—American Heritage Dictionary
At the same time the industry was adopting mark-to-market accounting to enhance investor transparency, financial institutions including banks and hedge funds became heavily reliant on leverage to amplify returns. Credit was free-flowing and readily available for a variety of reasons, but the global commodities boom and surging emerging market exports were key, as an overabundance of accumulated capital went in search of an investment home. Meanwhile, the market’s addiction to leverage was driven by the confluence of low borrowing costs, a flat yield curve, and hyper-competition among investment managers to generate profits. Investment banks and hedge funds typically operate at about 30 times leverage (assets over equity), which means that they borrow and invest $30 for every $1 in capital held on the balance sheet. More highly regulated commercial and savings banks typically operate under 10 times leverage and GSEs tend to run in the mid-20s.
As housing prices declined, subprime borrowers began to rapidly default, and banks were forced to devalue the asset-backed securities that were collateralizing the leverage used to invest in the securities in the first place. The devaluation forced the margin calls, and banks sold to meet the calls, which caused more mark-to-market losses as the two trends fed off each other like a tornado spawned from a hurricane.
Looking Back and Ahead
June 2008 was a painful month for bank stocks. The “but wait, there’s more” messaging from bank managements regarding their impending need for more capital and the specter of more asset write-downs was unfortunately delivered against an unsavory backdrop of rising inflation and unemployment with the so-called “Misery Index”—a combination of the unemployment rate and the headline consumer price index—approaching 10% for the first time 15 years.
Source: Bloomberg, Bureau of Labor Statistics
Banks, however, don’t have a monopoly on the pro-cyclical negativity; it is also happening at the “retail” level. The S&P/Case Shiller Composite-20 Housing Price Index continues to fall, plummeting about 15% nationally from a year ago.
Source: Bloomberg, Case-Shiller
This continued decline feeds the trend of rising residential mortgage delinquencies, as falling home prices make for an unattractive entry point into the housing market for potential buyers who are waiting for prices to plummet further. This behavior further depresses prices, while making it extremely difficult for existing homeowners with little or no (or even negative) equity in their homes to sell or refinance… which pushes delinquencies higher, which leads to more defaults, and declines in value. Seeing a pattern here?
Source: Bloomberg, Mortgage Bankers Association
Looking back over the first half of 2008, we saw fair value accounting and leverage— two otherwise investor-friendly trends—turn on investors as the pro-cyclical nature of the capital markets exacerbated the trends. At the June 25 FOMC meeting, Fed policymakers elevated the upside risk of inflation over the downside risk to growth and held rates steady for the first time since last September. The current futures markets imply that the Fed will hold again in August, but raise rates ¼ point in September. The feeling seems to be the Fed wants to raise rates now, but it is showing a more dovish face due to continued weakness in the financial sector. Let’s hope the optimistic bank CEOs are right, and we are closer to the end than we are from the beginning.
By Jonathan Hartley, Institutional Sales and Trading Manager at the Federal Home Loan Bank of Seattle.
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