Accounting at B of A and Fannie

Via Yves Smith, John Hempton analyzes the quarterly results of Bank of America (so-so) and Fannie Mae (terrible). The underlying issue is that bank quarter-to-quarter results are largely driven by the amount of provisions they take against future loan losses. You can think of this as a very rough approximation to marking-to-market — instead of waiting for the loans to default, you estimate how many loans will default in the future (that estimate should change as the economic situation changes) and put that amount of money into reserves. Then when the defaults actually happen, you take the money out of reserves.

Hempton argues that Bank of America and Fannie Mae are estimating extremely different future loan losses, and those differences cannot be attributed to differences in their current performance (the rate at which loans are defaulting now). If I wanted to be provocative I would only show you this quote:

If Bank of America were to provide at the same rate its quarterly losses would be 50-80 billion and it would be completely bereft of capital – it would be totally cactus. It would be – like Fannie Mae – a zombie government property.” [emphasis in original]

(“Totally cactus” — I like that.)

But to be fair, Hempton actually thinks that Bank of America is being only slightly optimistic and Fannie is being extremely pessimistic. Here’s his interpretation:

“[R]egulators are controlling Fannie in such a way that keeps it down. They are allowing Bank of America to act as if all is well whilst Fannie Mae appears to be a complete zombie. Which I think corresponds roughly to the new policymaker consensus that what is good for big banks is good for America.

“It is clear why BofA has chosen the 13 billion of provisions per quarter – which is that it roughly corresponds to their pre-tax pre-provision income. [Hempton is saying that if they took any more provisions they would be unprofitable.] Moreover – in my view the 13 billion per quarter is not far wrong so the decision is defensible. …

“[A]lmost however I cut it the situation is getting worse for BofA at roughly the same rate as it is for Fannie Mae.

“Except for one thing. The government wants BofA alive. Lots of people want Fannie Mae dead.”

By James Kwak

22 thoughts on “Accounting at B of A and Fannie

  1. Excellent post, but I doubt FM’s accountants are allowed by their bosses to be too overly pessimistic. Based on incentives, I would bet that FM’s accountants are much closer to being right than BofA’s.

  2. I wouldn’t trust Bank of America’s estimates on future loan losses anymore than I would trust Britney Spears to wear panties at a nightclub.

  3. I think the question is:

    Who wants BAC alive, and who wants FNM dead?

    And why?

    (This seems like a topic for Uncle Billy)

  4. If John Hempel’s analysis is correct then all BofA’s accounts mean right now is ‘if we were solvent then our accounts would have to look something like this’.

    As Hempel suggests, the only reason the regulators accept financial statements put together on this basis is that they want to keep BofA around. As a private sector entity it is for the moment a convenient fiction.

  5. Which I think corresponds roughly to the new policymaker consensus that what is good for big banks is good for America.

    Which is why they’re probably going to allow that Fannie-Goldman tax credit theft go through.

  6. why hasn’t there been more talk in the blogosphere contrasting the treasury’s treatment of the banks and Fannie/Freddie?

    james? simon?

  7. FYI, the “cactus” thing is a common Australianism. And sure enough, a look at his profile reveals he’s in Bronte, a (very nice) suburb of Sydney.

  8. While the gist of the article is probably correct, that B of A is overstating the value of its loan portfolio, the explanation of accounting is wrong.

    The loan loss provision is an expense and the “allowance for losses” account is referred to as a “contra” asset account (a negative asset – if you will). The idea is that the bank doesn’t know specifically which loans will be uncollectible, but under the matching principle of accrual accounting, it must recognize the losses currently, and not wait until actual default.

    In making this accounting entry, no cash is involved. No cash is in the “reserves” (allowance) account. The whole point of the allowance is to offset the loan account. When a specific loan defaults, the allowance account is “debited” and the loan account is “credited.” NO CASH IS INVOLVED. That’s the whole point of the loss…..the bank is not being repaid!

    Nonetheless, the article highlights the problem with many banks…their loan balances are not worth their book value, but the various regulatory agencies are allowing them to stay open in the hope that new, high-margin loans, will produce interest income that offsets the losses on the old loans.

    The unfortunate aspect of this policy is that no one can trust any bank’s financial statements and thus, non one will invest equity capital in banks….which means, the banks can’t create new loans….they simply extend and, in some cases, re-finance old loans. This is the Japanese lost-decade all over again.

  9. Question for all of us StatsGuy. If you take a look at the majority shareholders (“stakeholders”?) of BAC, you’ll probably glean some clues.

    Find out who really controls State Street (the folks who turned off the spigot for Lehman IIRC), Barclays, FMR, Vanguard, Growth Fund of America (The Capital Group), etc, and you’ll almost have the answers. Note the presence also of Paulson & Co in the group, poster child for “luck.” Remember also that Greenspan was hired by Paulson as a consultant after Paulson collected his $4B-$5B betting on the crash.

    As for FNMA? Lost touch with this after the takeover, but why is it mentioned without FHLMC (sorry, don’t like to use the warm and cosy cutesy names)? They were essentially identical. Did their assets end up looking much different? The easy guess is that some sharp outfit like “Pennymac” — who is reportedly not doing too well lately — will fall into some very nicely priced mortgages soon.

  10. Free markets are a myth. They don’t really exist. Modern day meritocracy, besides the most important success component luck, measures only individuals skills on tapping into the flow of information before others can.

  11. “In his investigation, Falcon concluded that the board of directors on which Emanuel sat was so pliant that Freddie Mac’s managers easily were able to massage company ledgers. They manipulated bookkeeping to smooth out volatility, perpetuating Freddie Mac’s industry reputation as ‘Steady Freddie,’ a reliable producer of earnings growth. Wall Street liked what it saw, Freddie Mac’s stock value soared and top executives collected their bonuses.”

    Life without book-keeping: A quote from the Chicago Tribune story.

  12. It seems that the different modes of valuation and accounting between the two is at issue. Standardized Accounting and valuation rules anyone?

  13. Actually, BOA is just as likely to lie about the quality of many of its (derivative) assets as are all of the TBTF’s. After all, why tell the truth and make those who are guaranteeing your survival look bad. Over the next couple of years, unless the real estate market improves, foreclosures stop and employment turns around, we are going to find out just how bad things are with the BIGS!!!

  14. A little quote from Tyler Durden at ZeroHedge:

    Yet where it gets moderately interesting is when analyzing Interest Rate derivatives (swaps, options and forwards), not only because the numbers suddenly really perk up, but because of the $420 trillion in notional OTC total, about $200 trillion is held by none other than the usual zombie stooges: Goldman, JPM, BofA, C and WFC. Do you see now why the Fed will kinda, sorta always and forever be forced to bail out this unholy pentagram? The shitstorm as a result of the collapse of one or more of the five major spokes of at least $420 trillion (and as much as $840 trillion) in IR derivs would basically wipe out anyone and everything in its path. No exceptions.

    Have a nice day on that happy thought.

  15. thanks uncle billy. but i once heard on 60 minutes that the saudis were like 60% shareholders of BAC. but this was like 5-6 years ago.

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