MANAGING EARNINGS

It always amazes me that CEOs and CFOs get criticized for "managing earnings." Isn't that what CEOs and CFOs are hired to do?

CEOs lose their jobs when the businesses they run aren't profitable.

Critics respond, "That's not what we mean by 'managing earnings'. 'Managing earnings' involves actions like timing sales of securities to either increase or reduce reported net income or increasing loan loss allowances when everything seems to be going well."

Isn't that a wonderful concept!

Community bankers don't run securities trading accounts. They don't sell and repurchase their entire portfolio on a daily basis. In general, they realize gains and losses from securities much the same way individual investors do - and income taxes often play an important part in determining when it is advantageous to realize gains and losses.

Community bankers also know that good times don't last. Economic cycles have happened throughout the history and no amount of government planning and intervention has been able to put an end to them. Community bankers don't make loans when they know the borrower will not be able to repay them. However, they also know changes in economic conditions, incorrect assessment of borrowers, and other factors will result in loan losses.

Years ago, banks were required to maintain arbitrary loan loss allowances of 2.4% of total loans. Over time, the percentage was reduced and ultimately eliminated. Most recently, bank loan loss allowances were limited to amounts that were the equivalent of losses that had already been incurred - an interesting theoretical concept that essentially put loan losses on a cash basis.

Consider the following questions.

• How much different would the current "banking crisis" have been if banks had been allowed or even encouraged to build loan loss allowances in "good times"?

• Would investors have been in a better or worse position today if the accounting and practices of twenty years ago which resulted in "managing earnings" had continued?

I would like to have your perspectives. Post a comment - positive or negative.

Another Push for Mark-to-Market Accounting

The following excerpt from an August 19, 2009 story by By Jeff Kearns apparently written for Bloomberg reveals the thinking of award winning economists.

"Myron Scholes and Robert Merton shared the 1997 Nobel price for economics, and they are now united in calling for banks to give more accurate valuations on their illiquid assets.

Financial institutions should use mark-to-market accounting or list the hard-to-value securities on public exchanges whenever possible, Scholes said in a Bloomberg Radio interview yesterday. Scholes, winner of the Nobel with Merton for helping invent a model for pricing options, said investors need better data on prices to accurately value the debt and equity securities of banks.

“I’d like to see us encourage many more securities held on the books of the banks be migrated to exchanges if possible,” he said. Doing so would “allow for market discovery and market pricing as much as possible,” Scholes added.

Banks that oppose new accounting standards on asset values want to conceal depressed prices, Merton wrote in the Financial Times yesterday. He composed the column with Robert Kaplan, a professor at the Harvard Business School along with Merton, and Scott Richard, a professor at the University of Pennsylvania’s Wharton School.

“This is not the way forward,” they wrote. “While regulators and legislators are keen to find simple solutions to complex problems, allowing financial institutions to ignore market transactions is a bad idea.”"

The problem, of course, is they are only partially correct. Consider:

1. Using mark-to-market accounting sounds like a commercial for the use of a valuation model such as the Black-Scholes model co-developed by one of the economists. Could a valuation model be applied to a commercial loan? Of course! What is the probability the result would be correct, comparable or meaningful given the range of judgments that are required by any model? I suspect the answer is less than 50%. Do you suppose any of these economists have ever tried to value a community bank commercial loan portfolio?

2. The amount of documentation required to list any security on an exchange is staggering. How much documentation would be required to list a $1 million commercial loan to a privately held, non-rated corporate entity? Frankly, listing hard to value securities on public exchanges sounds like a fairy tale. (It also assumes those securities are for sale, which is usually not the case.)

3. Proponents of mark-to-market accounting apparently believe that every bank asset is being held for sale. In fact, most bank assets are not for sale. Their value arises from the payment of interest and principal over time. Mark-to-market accounting is liquidation value - not the value to a going concern.

4. If today's problem assets had been valued at "market" two years ago, most of them would have values at or near "par."

5. If you purchase a U.S. Treasury Note today and interest rates go up, the market value of the Note goes down. You would have suffered an economic loss because you would have earned a higher return if you had been able to buy that security today. However, we also know it is impossible to accurately time the market, so you would have suffered an economic loss if you had held cash instead of purchasing securities when you did. In addition, there is no assurance you would have purchased the securities at the optimum time. Fortunately, you don't need or want the cash represented by my investment in this Note so you wait another year and watch the value go back to par when it matures. Substitute "bank" for you and "commercial loan" for the U.S. Treasury Note and we have described the typical scenario for a community bank loan portfolio. Observations:

• A community bank loan portfolio is difficult, if not impossible, to accurately value because most privately owned commercial entities are not rated by credit agencies and industries, management, corporate culture and local economies vary widely.
• If a bank and its borrower can weather economic storms, the likelihood of repayment is usually very high.
• When a loan is deemed to be uncollectible in full or in part, current accounting and regulatory rules effectively require the loan to be valued at recovery value - cash that is likely to be received from payments and/or sale of the collateral. (This information is provided in the financial statements.)
  

Mark-to-market accounting works well for securities that are traded regularly on an active exchange.

Overdraft Fees

Some banks do have significant amounts of revenue from overdraft fees. They also generate revenue from interest on loans and investments, service charges, and other sources.

At one time overdrafts were an exception. Checks that would have resulted in an overdraft were returned and the customer was charged a fee generally the same amount as an overdraft fee. Someone didn't get paid because the check was returned. That person (or company) typically charged a fee to cover their collection costs and contacted the person who wrote the check and demanded cash or cash equivalent in payment. The result? The check writer was charged at least two service charges and had a black mark on his record. The person who received the bad check was inconvenienced, at best, and perhaps forced to borrow to make up for the lost funds.

If the bank paid the check and allowed an overdraft to be created, the customer is charged a fee and the person or company who received the funds is not affected.

Which choice is the best deal for the customer? Which choice is the best deal for the person who received the funds?

The High Cost of Government Intervention

Here's a link to an interesting article by Rajshree Agarwal, a business professor at the University of Illinois. According to Ms. Agarwal, "Massive bailouts and other moves by the U.S. government to stem a near-epic economic meltdown could set the U.S. economy back by more than a half-century..."

This story presents another aspect of the "too big to fail" argument that doesn't receive a lot of press.

Interested? Click here to access the article.

The High Cost of Solving "Crisis" Situations

It seems like we've gone from a crisis - we have to act immediately or everything will come crashing down around us - to a calmer perspective on the economy. As has happened in the past, we are adjusting to the current situation and are likely to do quite well over time.

Our government has moved on to solving another "crisis" - the high cost of health care.

We are just now beginning to read and hear concerns about the possibilities of high inflation and costs of financing a huge federal deficit. Strangely, these concerns were ignored when we were dealing with the last crisis. I'm certainly not an economist, but it seems odd that the solution for an economic downtown resulting at least in part from too much individual debt is for the government to take on huge amounts of debt.

Let's deal more deliberately and rationally with the next crisis. Health care for everyone is a wonderful idea. However, if we can't afford it, we shouldn't mortgage our futures to provide health care for everyone. Seems like it would make more sense to figure out what we could afford to pay and then see what we could buy with those dollars.

Leadership in Difficult Times

Uncertainty, fear and worry are usually associated with difficult economic times. These attributes are constantly reflected in media reports. One possible consequence is that affected individuals look for someone or something to place where they can place confidence and trust.

Consequently, individuals with a positive vision of the future who can inspire trust have a unique opportunity to provide leadership. A morally and ethically responsible leader of this caliber can have a positive effect on those around him or her.

According to research by Cass Bettinger, extraordinary leaders:

1. Know themselves; are emotionally intelligent, fully aware of their strengths and developmental opportunities, and are on a quest for continual self-improvement.
2. Foster adaptive, values-driven, high performance corporate cultures.
3. Build high-performance teams.
4. Are visionary; conceptualize, communicate, and reinforce a compelling vision of the organization's ideal future.
5. Are proactive agents of appropriate strategic change.
6. Master the financial and non-financial drivers of their businesses.
7. Focus, inspire, and build self-esteem.
8. Mentor, coach, and develop others.
9. Execute brilliantly.
10. Never stop learning.

Another essential quality of leaders is an ability to build effective teams. Leadership isn't about shouting orders so much as it is about building teams who understand the mission and are committed to working together to accomplish the stated goals and objectives.

Transparency

Although it sounds like a good idea to let the public know the condition of the large banks, I wonder about the potential negative short-term and long-term effects.

Does the U.S. government really know the parameters for a stress test? Are the parameters of the stress test "worse case," "expected" or something else? Shouldn't stress testing involve a number of scenarios? Will analysts and media experts believe the results? Will the results be reported fairly? Will there be a run on banks that fail the test? If so, how will the government handle the situation?

If our deposits are secure, why do we need to know the results of stress testing? When will the regulatory agencies start to release the CAMELS ratings? How will the public handle that disclosure? Will every bank need to be a "1"?

What do you think?