Did it occur to you to wonder why the two leading European nations, France and Germany, are so firm in calling for better oversight of ratings and for more regulation in general even while the banks in Europe exceeded those in the U.S. in terms of general leverage ratios? Why are the Europeans still speaking as if the U.S. caused the problems if the Europeans were so reckless themselves having ratios of 50:1? Well, we wondered. As it turns out, the Europeans were more cautious, or so they thought, than were the American banks. The Europeans required leverage ratios to be tied to ratings. The higher the rating of the asset, the higher the leverage allowed. What the regulators in Europe didn't know apparently is that the ratings companies in the U.S. were bought off by Wall Street and were not acting as true analysts. They were rating junk as AAA. This is why the Europeans want strong rating-agency oversight.
[The] investment banks asked the agencies to rate a large group of home mortgages in a pool known as a Residential Mortgage Backed Security (RMBS). The investment bank would divide the pool (the RMBS) into various tranches. The highest-rated tranche would be given a rating of AAA. Let's say that the AAA tranche was 92% of the loan pool. The AAA tranche would get the first 92% of all monies coming into the pool before the other investors were paid (again, really oversimplified, but that is the net effect). That would mean that the pool could have 16% of the home loans default and lose 50% of their value before the AAA tranche would lose even one dollar.
We all know now, though, that some of those AAA-rated tranches are in fact going to lose money. And the rating agencies are now writing down the ratings on the former AAA tranches.
I am not talking about the exotic CDOs and CDO squareds, or some of the truly toxic securitized assets which are going to zero. What I am writing about today are plain vanilla mortgages grouped together in securitized pools.
Marking assets to market when there are no markets is illogical. I have spent some time looking at these securities. Like kids, they are all different. And some are really different. Yet we make a bank mark an asset down because one that is in the same broad class is impaired. Like giving every 13-year-old in school an "F" in math because one kid failed.
There's the problem we've been writing about for months. They aren't bothering to sort out the strong mortgages from the weak. The longer they wait, the more the whole economy is damaged. The banks don't want to touch this stuff because the lower, illogical ratings dramatically harm the look of their balance sheets. They may be carrying perfectly good loans, but they are rated CCC across-the-board. Surely if we can see this, the Fed and Treasury can see it. John Mauldin obviously sees it.
[John Mauldin continues:] Further, we don't make a bank mark down the value of a loan on its books if interest rates increase. The loan, if sold into a market, would indeed not be sold for book value. But the bank keeps it at book value on its books, and simply realizes less interest. If we made banks mark down their assets because of interest-rate increases, we would lurch from one bank crisis to another with every interest-rate cycle.
But as a start, change the accounting rules so that we stop shoveling taxpayer money in the front door to banks and out the back door to hedge funds. That can be done quickly if the administration simply says "do it."
"The Financial Accounting Standards Board has said that it will issue new guidance on the application of FAS 157. That's encouraging, but can anyone recall when the FASB has been timely? The damage from this misguided rule is already huge, widespread, and growing daily. Mark-to-market accounting creates a powerful negative feedback loop. Actual or imputed FAS 157-related losses weaken capital ratios and undermine confidence in the financial system generally, which weakens the economy and adds pressure on loan pricing, causing more FAS 157 losses, and around we go. - John Mauldin
(John Mauldin, best-selling author and recognized financial expert, is also editor of the free "Thoughts From the Frontline" that goes to over 1 million readers each week. For more information on John or his free weekly economic letter go to: )