Reality Bites: Mark to Wishful Thinking Fails Again

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by: Kid Dynamite
Thanks to Karl Denninger for pointing readers toward this story from Bloomberg's Jonathan Weil:

Next time you see some company complain its “mark-to-market” losses aren’t real, remember this name: the Federal Home Loan Bank of Seattle. It used to claim that, too. And it couldn’t have been more wrong.

About a year ago, the government-chartered lender blamed accounting rules after it wrote down its portfolio of mortgage-backed securities by $304.2 million to reflect how much their fair-market values had fallen. While those declines counted against its earnings and regulatory capital, the bank said they were “well beyond any expected economic loss.”

The bank’s executives said they expected to lose a mere $12 million of principal over the life of the securities. That estimate proved far too hopeful, though.

The bank, one of 12 regional Federal Home Loan Banks that supply low-cost loans to about 8,000 member banks and finance companies, now says it expects about $311.2 million of credit losses on its portfolio.

As Homer Simpson would say... DOH! In case it wasn't clear: a year ago the market value of their portfolio fell by $304MM, but the bank claimed those were just temporary dislocations - panic in the market - and that actual losses would be $12MM. Now, reality has struck, and they have increased their loss estimates to $311MM. It seems that economists declaring the recession over and recovery imminent do not actually make recovery imminent.
But there's more:

The bank became a poster child for everything supposedly wrong with mark-to-market accounting. At a March 12, 2009, congressional hearing, U.S. Representative Ed Perlmutter of Colorado cited the disparity between the bank’s writedown and its much smaller anticipated loss as “an example that really was disturbing."

The congressman leading the hearing, Paul Kanjorski of Pennsylvania, pointed to a similar instance at the Federal Home Loan Bank of Atlanta. The bank reported an $87.3 million writedown on its mortgage-backed securities for the 2008 third quarter; however, it said it expected its actual losses would be only $44,000.

While that’s roughly equivalent to the losses from a modest studio condo foreclosure, Kanjorski didn’t question the tiny number, saying: “I find that accounting result to be absurd.”

“It fails to reflect the economic reality,” he said. “We must correct the rules to prevent such gross distortions.” Kanjorski, Perlmutter and other lawmakers told Bob Herz, the chairman of the FASB, that it needed to change its rules immediately so banks could show stronger earnings. The board, which fancies itself as an independent standard setter, complied a few weeks later.

The rest of the story: Last year when the Atlanta bank released its financial results for the third quarter, it said it had raised the credit-loss estimate to $263.1 million. (Here’s the math in case you missed it: $263.1 million > $44,000.)

Double DOH! In case that part wasn't clear - Congress was dismayed that banks were unjustly showing decreased earnings - after all, the banks clearly had very low estimates of losses compared to the panicking market which placed fire sale values on the portfolios. We needed to act to prevent such "gross distortions!!!" That crazy Mr. Market was harming the banks' earnings unnecessarily! Yet again, it seems that the banks were wrong: FHLB of Atlanta's $44,000 loss estimate was raised to $263,000,000. I mean - what can you even say about that? Insane.
In any case, Congress managed to push through a change in the rules:

The FASB rule change gave companies a new way to avoid counting paper losses from toxic debt securities in their earnings. Before 2009, whenever companies recorded writedowns on impaired securities that they labeled as held-to-maturity or available-for-sale, they had to run the full amounts through net income for any losses deemed to be “other than temporary."

Now they get to separate the impairments into two parts: estimated future credit losses and everything else. The first kind reduces earnings and regulatory capital. The other doesn’t.

Later, from Weil:

what happened here is that a few members of Congress bum-rushed the FASB into action based on a premise that was false, in a misguided effort to boost public confidence in the financial system through smoke and mirrors. It’s an open question if the board’s standard-setting process can regain its credibility someday. Undoing this disaster of a rule change would be a good start.

A peripheral lesson to be learned here is that rosy projections, hopes, and anticipations do not equate to a rosy reality.