U.S. Financial Institutions are interconnected – as the fall of Lehman demonstrated, they are tied together and interwoven in a complex web of obligations which can rip, run or unravel with unexpected consequences. As such, they may be regarded, for analytical purposes, as having one balance sheet. Double entry bookkeeping, which underlies all GAAP accounting, suggests that assets should equal liabilities for this giant composite balance sheet. I doubt that it does. The purpose of the article is to raise questions on two areas that do not seem to add up, and suggest that exploring these relationships would be a good task for the systemic regulator.
Derivative Assets and Liabilities – Five large banks together constitute the bulk of the U.S. Derivative market. The nature of the derivative transaction is such that each position has two sides, an asset and a liability, which will be on the books of the counter-parties. While numerous hedge funds and other bit players add complexity to the picture, it is evident that collectively derivative assets should equal liabilities for the banks involved, since a majority of the trades eventually make their way back to the largest players.
Derivative Assets & Liabilities (in million $)
Of course, the argument could be raised, there are various hapless VIEs, QSPEs, mono-line insurers, unsophisticated investors, hedge funds or participants in the real economy on the other end of these trades, who collectively have made losing trades to the tune of $122 billion.
Trust but Verify – perhaps we would do better to trust the institutions involved: after all, they are the best and brightest, and at year end these figures will have to withstand the scrutiny of auditors. But somebody at Treasury or the Federal Reserve could do a verification exercise – tedious, but simple. Taking a random selection of 120 derivative assets from each bank, the auditor traces the chain of transactions until he finds the other side of the trade. Then the bank's valuation of the derivative asset is compared to the counter-party's valuation of the derivative liability.
Why 120 cases? Because we do not expect to find a variance in more than 2% of the cases, and if this exercise is completed and there are no more than 2 or 3 discrepancies, all is well. If, on the other hand, the two sides of the trade have different valuations on their reciprocal obligations, then the difference will need to be extrapolated across the 417 billion in assets and some adjustments booked.
Warranties and Representations – Huge amounts of residential mortgages of dubious quality were securitized in the course of the real estate bubble. In most cases, the originators, in order to sell the underlying collateral, made warranties and representations as to the quality of the mortgages, and undertook to buy back or replace any that were defective.
Now the OTS, not necessarily the most observant of regulators, has noted that many banks did not take the liability for potential mortgage putbacks seriously, and in point of fact felt that once the mortgage was sold, they were completely off the hook. But as early as 2003 the OTS noted that it did not work that way, and these warranties and representations could come back and cause serious trouble, creating stress or even insolvency. At the time the OTS felt the banks, beyond having a legal obligation, might even feel a moral obligation, in order to maintain their credibility and standing. How quaint.
MBIA (MBI), Ambac (ABK), Assured Guaranty (AGO) and their cousins the mortgage insurers have been booking and even collecting remediations in the form of put-backs relying on the warranties and representations made in the process of bundling, insuring and selling mortgages.
The issuers of the warranties and representations have been recalcitrant, attempting to stonewall these efforts. Dominic Frederico, CEO of AGO, gave a wonderful account of their process on their 4Q 08 conference call. Basically they continue to discuss, ad nauseum, cases that are black and white, open and shut. MBIA gave up in disgust and sued. Ambac is taking a middle route, suing some and relying on the process of discussions in other cases.
The accounting is debatable. MBIA has booked recoveries for identified cases, Ambac is now booking recoveries by extrapolating sample results across the transactions they have examined. The process is made more difficult by problems locating the files and records, the “dog ate my homework” defense. That defense will not hold water: if the originator can't produce the documentation then they did not deliver a mortgage and will have to make up the difference.
Mr. Market discounts the effect on the financial guarantors and mortgage insurers. They are going to go bankrupt before their claims can be brought to fruition. USG has a stake in the whole issue going away, because if it doesn't they will have to expend more billions propping up the banks.
The accounting on the bank side is marked by an extreme lack of clarity. They acknowledge the existence of warranties and representations liabilities, and will mention balances that they inherited from some of their acquisitions, but as a general rule do not see the need to take any reserves for losses from this source. The accepted technique is to state the gross amount of mortgages sold, add that reserves are booked based on experience, and then experience doesn't include any losses.
Bank examinations – the regulators have lengthy manuals for the use of examiners, providing explicit instruction on various topics, including warranties and representations liabilities. Again, the examiner could take about 120 cases from among a random selection of mortgages that were sold into securitizations, and test the quality. Based on what MBIA, Ambac, Assured Guaranty, Radian (RDN), MGIC (MTG) and PMI Group (PMI) have been finding, there is going to be about 20% bad. Whether this needs to be booked would require discriminating judgments on the efficacy of stonewalling and recalcitrance.
Investment implications – because any accounting adjustments that might be required would result in decreasing the net assets of banks, bank shareholders should price in the prospect of further dilution in order to bring capital back up to regulatory standards. Shareholders of insurance companies, GSEs or others who hold or insure RMBS which may have fraudulent collateral should inquire of management whether they intend to examine the quality of underlying collateral and assert their rights under warranties and representations.
Disclosure – net long MBI, no position in the other companies mentioned.