We must stop pretending and face reality

The game-keepers have turned poachers. The regulators are no longer regulating the banks and protecting us; they’re protecting the banks and regulating the flow of information to us. Aeschylus said that in war, truth is the first casualty; it seems truth doesn’t fare much better after a banking crisis either.

The Wall Street Journal reports: “About $770bn of the $1.4trn commercial mortgages that will mature in the next five years are currently underwater.” Billionaire investor Wilbur Ross said last week that the US is facing a “huge crash in commercial real estate”, with office vacancies at 17% and shopping centre vacancies at their highest in 17 years.

So you’d think the US authorities would be all over the banks to make sure that we, the public, get a fair and honest view of their murky balance sheets. Not a bit of it. Instead, the US authorities are allowing banks to classify loans as ‘performing’, even if the value of the underlying property has fallen below the loan amount (ie, it’s in negative equity).

The key difference so far between our banking crisis and the one that faced Japan from about 1997 is that the authorities acted more decisively to stop the dynamics of debt deflation setting in. The fiscal and monetary response has been so large that some now hope the usual drawn-out post-crisis resolution phase (where banks shrink credit and the economy teeters on the edge of recession for several years) may have been avoided. Banks are now profitable and the credit cycle ready to begin, they argue.

The trouble is, there has been some back-sliding since the big initiatives were announced. Now the US is taking an approach that looks dangerously like Japan’s. Research from the IMF and the Bank of England suggests a banking crisis can’t be resolved until the banks have fixed their balance sheets. To do that, they must identify and deal with non-performing assets. But if they don’t have enough capital, they can’t afford to realise all their losses from non-performing assets. So they tuck some under the mattress to be dealt with once retained profits have been built up.

The Japanese used book-cost accounting, so all loans stayed on the balance sheet at par value, no matter how badly they had deteriorated, until the loan defaulted and the bank had to make a provision against the likely loss. Our system is much better (at least, it was). But where once we had mark-to-market rules, whereby banks had to write down the values of securities to reflect lower market prices, the rules have changed. Since 2 April, securities have stayed in the accounts at much nearer to book cost than market value. Although this change only applies to securities, it’s contributed in a huge (though unquantifiable) way to the profits the world’s banks have been reporting since the start of the year (the rule change was retrospective). It’s no coincidence that markets have rallied since then. Everything looks OK again.

But securities aren’t the only potentially non-performing assets banks hold. Far bigger are their bank loan assets. So far, non-performing loans haven’t really featured in this crisis. But in the past, the worst losses have come from unsecured consumer loans and from commercial mortgages. US banks have been hiding potential losses on commercial mortgages by a policy of ‘pretend and extend’. This is where they roll over the maturity of a loan if its collateral has fallen in value, aiming to wait until the market recovers. But because all banks are in the same boat, none are likely to grow lending soon (US bank lending in the last quarter fell at an unprecedented annualised rate of 16%), so the market can’t realistically be expected to recover.

Rather than force banks to face up to these losses and deal with them (advice heaped on Japan by the US ten years earlier), the US authorities are helping the banks to hide the true state of affairs. Loans that are well under water but just making interest payments still qualify as acceptable loans. Next, banks will start letting the worst offenders off with lower interest bills too if Japan is anything to go by. At least the Japanese have the excuse that they started out with a book-cost accounting system, even if they then refused to change it. The US has now virtually completed the move to book-cost (ie, loss hiding) accounting right under our noses. The accounting bodies should be ashamed.

But does it matter? If we all pretend the banks aren’t in trouble and just wait, surely their retained profits will provide enough new capital to let them realise hidden losses? This sort of lazy thinking is seductive because it allows us to get out of a mess without too much pain. We can pretend the banks aren’t up the creek, but they know they are. Banks with too little capital and too many risk assets don’t want to add any more. Bank lending after the average bank crisis stays negative for 4.3 years. In Japan it was eight. So even if we pretend those bad loans aren’t there, it doesn’t mean banks can return to normal. All that’s happened is the US authorities have stopped pushing for a swift resolution and instead voted for a long, drawn-out one.

• James Ferguson is chief strategist at Pali International and writes the Model Investor newsletter.