Mortgage Losses Stuck on Some Balance Sheets: Report

Some market participants are playing a high-stakes game of poker with their mortgage-related losses, choosing to keep losses on their balance sheet rather than recognizing losses on an income statement, a report at Bloomberg News claimed on Monday. The report alleges that banks and securities firms are “failing” to acknowledge at least $35 billion in losses on their balance sheets, an amount equal to 25.4 percent of the $139 billion in write-downs that have already hit earnings. The issue here is how to value losses in assets held for trading versus held for investment purposes — institutions can classify assets into either category, although the election to carry a security in one category versus the other has distinct implications for reported revenue. From the story:

Taking losses on a balance sheet instead of an income statement is acceptable under accounting rules, which make a distinction between so-called trading books and long-term investments. Changes in value on the trading side go straight to revenue. Changes in the value of bonds held for the long haul can be marked down on the equity line of a balance sheet, as long as the declines aren’t considered permanent.

In other words, more than a few market participants have taken more hidden hits to their balance sheet as the assets they hold have tanked in value — but those losses haven’t been reflected in reported income, because the bank allegedly expects the assets to rebound in value at some point. Will they? The answer to that question depends on the nature of the securities themselves. According to the report, Citigroup Inc. (C) took a very quiet $2 billion hit to equity on its balance sheet during its first quarter earnings, tied to mortgage-backed securities; the number, however, wasn’t mentioned in an earnings call with investors, since it didn’t impact earnings. ING Groep NV (ING) (known in the States as simply ING Direct) made similar elections, placing 3.6 billion euros — $5.6 billion — worth of lost value onto its balance sheet, while only reporting $80 million euros worth of a hit to income, Bloomberg reported. Washington Mutual Inc. (WM) and Merrill Lynch & Co. (MER) took much of the same approach in reporting their first quarter numbers as well, among numerous others. The question, of course, is exactly what sort of assets are remaining on the books in the belief that asset values will recover. Not all market participants have made it easy for investors to suss this out of the earnings reports, which HW’s sources suggest is driving much of the speculation; and it’s worth nothing that there is nothing inherently wrong with marking a class of securities down and expecting values to recover at some point in the future. “Without question, some of these securities have been battered in ways that have nothing to do with their fundamental value,” said one source, a certified financial analyst who asked not to be named. But some analysts remain unconvinced, and are suggesting that with more losses yet in the pipeline for many of the world’s largest financial institutions, the need for more capital is paramount:

Declines in asset prices have spread beyond subprime though, affecting other mortgage bonds, securitized car and student loans, leveraged lending that backs private equity buyouts and credit derivatives. When all that is included, the IMF estimates that total losses from the U.S. subprime debacle will reach $1 trillion, of which $510 billion will be born by banks. That means some $130 billion in losses remains to be taken. “The $100 billion hole between writedowns and capital raised so far needs to be filled,” said Michael Mayo, a New York-based analyst who tracks the financial-services industry at Deutsche Bank AG. “If you don’t fill that hole, with the 20-to-1 leverage existing on average out there, you need to de-lever $2 trillion of assets. You can do that or raise more capital.”

Despite the pretty big numbers being thrown around, most of the sources that HW spoke with about the story suggested that caution was needed. “We don’t know exactly which assets are marked where, and at which institution, so it’s probably shooting the moon to suggest that most are improperly categorized, but I can certainly understand the concern,” said one source, an executive at a bank who noted that sensitivity to the roots of the Japanese economic crisis was likely driving much of the speculation. In the Japanese decade-long downturn of the 1990s, many economists have pointed to delaying inevitable losses at key financial institutions as one of the drivers that lengthened the crisis. Disclosure: The author held no positions in any publicly-traded companies mentioned in this story when it was originally published. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.

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