Two Prominent Economists Admit Leverage Kills

Includes: BAC, BBT, C, WFC
by: Deep Value Guy

The people who brought you the Long-Term Capital Management debacle want banks to get serious about cutting their own leverage, applying fair value accounting to a wider range of assets.

Writing with two colleagues in the Financial Times on Tuesday, Nobel Laureate Robert Merton said banks, their regulators and legislators are conspiring to conceal depressed asset prices in order to avoid dealing with the consequences of insolvency. He wants wider adoption of fair value accounting to force banks to fess up to losses and raise more capital.

Speaking on Bloomberg radio, Merton’s long-time associate and fellow laureate, Myron Scholes, concurred.

This is very refreshing, an honest appraisal of the disease still infecting the financial system — leverage — from two prominent economists who learned the hard way that leverage kills.

These days it’s de rigueur to declare that the worst of the recession has passed, that we’re on our way to “recovery.” Never mind that big banks remain insolvent. Take away the government guarantees that provide them cheap financing and protect the value of their assets and many would be at risk of collapse.

As I argued earlier this week, the fall in real estate prices implies huge losses for bank loan portfolios, losses that could wipe out what’s left of their meager capital. We got another reminder on Monday of just how bad the losses might be. BB&T (NYSE:BBT) said it marked down loans acquired from failed Colonial Bank by 37 percent.

A loss rate half again as large, if applied to Citigroup (NYSE:C), Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC), would wash away what’s left of their equity capital. In other words, despite recent capital raises, their leverage remains way too high.

Merton and Scholes know about the risk of leverage. Their hedge fund, Long Term Capital Management, was levered 25 to 1 before losses wiped out capital, pushing leverage to 100 to 1. It took a bailout from Wall Street firms to make up LTCM’s capital deficit and prevent a systemic collapse.

Even after the stress test, big banks are still levered more than 20 to 1. Far higher when you consider losses they are hiding and off balance sheet assets they have not recognized. FASB has already instructed them to recognize off balance sheet assets beginning next year and their fair value proposals would, if adopted, kick in a year later.

True, it won’t be easy to put into effect. Banks’ existing fair value estimates are highly questionable. It’s not clear what assumptions they’re plugging into internal models in order to arrive at them. That’s why Merton argues estimates should be “independently validated by external auditors.” If that’s expensive or difficult – well, then that’s a price banks should bear for investing in hard-to-value assets.

One legitimate criticism with fair-value accounting is its procyclicality. Marking assets to market can inflate capital during bull markets and deflate it during bear markets, exacerbating market swings.

But not if regulators respond dynamically to market conditions. As bubbles inflate, regulators should increase capital requirements so that leverage doesn’t get out of hand. That way when markets turn south, banks will be well-capitalized to handle them.

Unfortunately, regulators don’t have the flexibility to be forgiving right now. Banks didn’t build up reserves during the fat years, so regulators must force them to do so during lean ones.

The first step in solving a problem is admitting you have one. Fair value accounting would force banks to admit they still have a leverage problem and, hopefully, inspire regulators to jack up their capital requirements.