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SEC to Fraudster Banks: We're Coming

After the stress test results came out a few months back, I did a piece  about how, while the government's scrubbing of bank balance sheets was certainly welcome, there were still a lot of things the banks weren't fessing up to. One of those things was loss reserves--that is, the amount of capital banks set aside to absorb losses on loans that turn bad. Here's a brief explanation:

The real problem is that the banks won't fully acknowledge their losses. One of the more elusive concepts in all of accounting is an exercise known as reserving. When a bank receives, say, interest payments on a loan, not all of that revenue is profit. Some of it must be set aside to cover the possibility that the loan could go bad--what's known as a loss reserve. The relevant accounting rule says banks must set aside reserves for any "probable" losses over the intermediate-term (usually a year). Though there is some debate among accountants over what probable means--some say a better-than-even-chance, others say 70 to 80 percent likely--it is hard to conclude that the banks are adequately reserved.

One way the Fed tracks this is by looking at the ratio of reserves to actual losses. Because reserves are forward-looking (losses you anticipate over the next year) and actual losses are backward-looking (losses you've already suffered), it's not hard to see why this ratio should have risen after last fall's financial crisis: The crisis meant there would be big future losses, as people increasingly defaulted on their loans (hence the need for heavy reserves), but not necessarily a lot of losses initially (since many of those defaults hadn't happened just yet). In fact, the ratio of reserves to losses has been basically flat or falling for the four biggest banks over the last several quarters. (The four banks declined to comment. Their public filings say they believe they're reserving adequately, while conceding that the exercise is subjective.)

A more direct way to see this is to inspect the losses the banks implicitly expect. In their annual filings, banks are required to attach a "fair value" to their loan portfolio (essentially a market price), which is different from the value the banks claim on their books. As Christian Leuz, an accounting professor at the University of Chicago, notes, subtracting this "fair value" from the "book value" gives a rough estimate for the losses a bank would suffer if it had to liquidate its portfolio immediately--which comes to about $196 billion for the country's four largest banks (assuming my math is right). This should be a very pessimistic number, since a bank can always make more money by hanging on to some of its loans, which banks often do. But, pessimistic as it is, it's far, far smaller than the government's estimate for these banks' loan losses under its stress-test scenario--about $345 billion.

Which is why this recent release from the SEC, brought to my attention by an observant source, is pretty encouraging. It's basically a sample of a letter the SEC says it sent out to "certain public companies" reminding them of their obligations to disclose how they set aside loss reserves, including all sorts of information that would give investors an idea of how large the losses are likely to be. (One example: "the approximate amount (or percentage) of residential mortgage loans as of the end of the reporting period with loan-to-value ratios above 100% [i.e., underwater].")

The SEC letter pointedly notes that, "the current economic environment may require you to reassess whether the information upon which you base your accounting decisions remains accurate, reconfirm or reevaluate your accounting for these items, and reevaluate your ... disclosure." (Translation: Now's the time to come clean.) Then it ends on this highly encouraging note: "[I]t would be inconsistent with generally accepted accounting principles if you were to delay recognizing credit losses that you can estimate based on current information and events. Where we believe a financial institution’s financial statements are inconsistent with GAAP, we will take appropriate action."  (Translation: For real.)

Good for Mary Schapiro for breathing some life into what had become a pretty pathetic excuse for a regulator under George W. Bush. Now let's see if the SEC  follows through.