Don Fishback’s Market Update

One of the key changes made last year to alleviate the financial crisis was the elimination of mark-to-market of illiquid securities that banks typically traded.  If you were a bank holding an illiquid security and it resembled something similar to what was being sold by a failing bank at an extremely low price in a panic situation, you had to mark your portfolio to that panic-driven low price.  The reason was that in most circumstances, the banks had no intention of holding those securities to maturity.  They wanted to unload them as soon as possible, sometimes to an SIV, other times to investors.

What happened, however, is that once the price reached a certain low level, many banks decided to hold these losers instead of selling them.  Regulators then changed the rule so that banks were allowed to use models to come up with valuations, instead of having to mark their price according to what was actually happening in the market.

The belief was that, if the banks didn’t have to write down these securities, they could then take the capital that was no longer tied to those paper losses, and instead apply it towards profit-making investments such as new loans.  Then, when it finally came time to realize the losses on the underwater securities, the profits from the new ventures would be sufficient to pay off the losses from all those bad old loans.

The change was a godsend to troubled financial institutions, because it delayed the day of reckoning till a time when they would … hopefully … be in a position to handle the losses.

Well, it looks like, at least in the commercial real estate market, some of delays are coming home to roost before the banks had expected, which is why this story is so relevant: ‘On the Edge’ Banks Facing Writedowns After FDIC Loan Auctions.  It’s a story about some loans the FDIC ended up with from a failed bank it took over.  Here are two key paragraphs:

If the loan is sold to a buyer who restructures it at less than book value or forecloses on the property, participating banks would have to write down their stakes, said Russell Mallett, a partner at PricewaterhouseCoopers LLP in New York who specializes in bank accounting. Absent a restructuring, banks have flexibility in how they value loans, he said.

…

“This is a situation the FDIC is going to face more, since the number of bank failures is going up,” said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine. “The FDIC is not in the business of managing loans, so they do have to sell them. But they also have to look at the bigger picture and take a global approach by liquidating those assets without hurting the banks that bought participations.”

It looks like mark-to-make-believe in the commercial real estate market is about to get a reality check sooner than people expected.

– Don