Read fine print to truly gauge your banker’s health

June 6th, 2009 at 04:26pm Annette LaCross

I suspect that we’ll start hearing some good news from banks in the second and third quarters.

After a year of staggering quarterly losses, mostly because of the suddenly ponderous weight of residential and commercial mortgages and mortgage-backed securities, we’ll start seeing gains.

At least I hope we do. If not, we’re in for a really bad year.

But my optimistic projection isn’t because I believe we’ve passed some kind of magic hour in the financial industry, after which earnings and profits mysteriously climb back into the black. Nor is it because banks have suddenly remembered how to, well, run a bank.

Rather, it’s because a change has been made to the rules of accounting, in this case a relatively obscure rule known less-than-affectionately as mark-to-market.

Mark-to-market accounting requires banks to price assets on their balance sheets according to what you can sell them for on the open market.

The banking industry pressured Capitol Hill relentlessly this year because mark-to-market forces it to lower the value of such assets as derivatives, even though many of the loans that back those bonds have yet to default and perhaps never will. But each quarter, those losses amplified the bottom-line losses at a number of the nation’s largest banks, wiping out their capital.

When the bottom fell out of the securities market last fall — and remember, the edges were beginning to fray more than a year before that — a mortgage-backed bond worth $10 million at the height of the bubble became worthless almost overnight, effectively wiping out the bank’s $10 million. The market had literally evaporated.

It required the bank to post the loss and scramble to raise more capital to cover it.

And this was a market worth trillions of dollars, with every bank, investment house and hedge fund in the world participating.

You can see why the banks were so bitterly opposed to the idea — the longer they had to post these assets as losses, the closer to collapse they came.

And you can see the reason for my rosy outlook.

Banks had the option of adjusting their first-quarter results to reflect the change to the mark-to-market rule. And if you’ll recall, the stock market reacted with wild abandon when so many of the nation’s big banks posted better-than-expected results.

But remember, the banks aren’t conducting business differently. They’re just changing the way they crunch their numbers.

So do the first-quarter numbers better reflect the state of the banking industry? Or should we trust the results of the past four or five quarters, before the rule was changed?

Contact Business Editor Annette LaCross at alacross@rrstar.com or 815-987-1295.

Entry Filed under: Banks, recession