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Wednesday, March 04, 2009

The Paradox of Today's Financial Regulation

The FDIC has been monitoring the capital ratios of banks for decades to make sure they are appropriately capitalized. If they are "well-capitalized," then banks should feel good about themselves, right? Unfortunately, the mark-to-market rules have rendered the long-used FDIC capital ratios completely useless. As banking analyst Gary Townsend points out, depending upon whether a security is classified as a "loan" or an "investment" makes a significant difference for accounting purposes.

Look again at the example of The Bank of New York Mellon, which in the fourth quarter wrote down the value of its $5 billion Alt-A MBS portfolio by $1.24 billion, roughly a 25% mark to market. In its disclosures, the company noted that if that same asset were given loan accounting treatment (and what is a MBS but a collection of mortgage loans, after all?), its expected loss, based on estimated cash flows, would have been only $208 million, a mark of just 4.1%. The difference between the two accounting results: more than $1 billion.

Further, Townsend notes that mark-to-market is creating a ton of confusion out there and uses Capital One as an example:

Consistent with GAAP, Capital One reported a year-end tangible book value per share of $28.24, a substantial tangible common equity to tangible assets ratio of 5.57%, and a Tier 1 risk-based capital ratio of 13.6%, much more than well-capitalized for regulatory purposes. But subtract intangibles and the $12 billion in mark-to-market adjustments to assets and liabilities, and the company is insolvent. Obviously, no company can be well-capitalized and insolvent simultaneously, but is it any wonder that the market is so confused, that regulatory capital ratios are no longer credible, and that Capital One’s stock trades at $12.05, 43% of reported tangible book?

There are several things the government could do to help ease the financial crisis and mark-to-market changes wouldn't cost a dime. The existing rules just add too much uncertainty.