Bob Rubin Wants Your Kids to Pay for Banking Mess: David Reilly

Commentary by David Reilly

-- Here we go again. As proposals for a bad bank that would buy lousy assets from U.S. banks gather speed, an old stumbling block is re-emerging -- how to price the holdings the government would buy.

This is rekindling the debate over mark-to-market accounting and its role in the financial crisis, as banks try to find something to blame other than their own ineptitude while shifting losses onto taxpayers’ backs.

The talk about accounting also obscures a bigger issue: Who should shoulder losses from the housing and credit bubbles, us or our kids?

Using market prices makes it more likely that we, and the banks, will have to face immediate pain. Ignoring market prices means we pass the tab to future generations.

Not surprisingly, plenty of people -- now-retiring baby boomers, bank shareholders and executives -- prefer that someone else feels the pain.

For that to happen, these pay-later folks need to insist losses aren’t as big or as bad as mark-to-market makes them out to be. The problem is, markets disagree. So executives such as Robert Rubin attack the practice of using market prices.

Rubin, the former Treasury secretary and Citigroup Inc. director, laid blame for much of the crisis on mark-to-market accounting rules. During a talk at a public gathering in New York earlier this week, Rubin said such accounting did “a great deal of damage.”

Overlooking the Obvious

Never mind that he and fellow directors and executives at Citigroup misjudged the housing and credit markets. Never mind that they were unaware of a $25 billion risk the bank took on by way of collateralized debt obligations. Never mind that Rubin and his ilk didn’t complain back when such accounting led to big bonuses and huge profits in rising markets.

Wells Fargo & Co. Chief Financial Officer Howard Atkins, meanwhile, said Wednesday that any government-owned bad bank would need to buy toxic assets at prices that are based on estimates, or what he called “mark to model,” rather than the market. Never mind that estimates that ignore market values in the hope of capturing long-term, intrinsic value have repeatedly led banks and investors to miss the depth and severity of the crisis.

Thankfully, JPMorgan Chase & Co. chief Jamie Dimon, whose bank has weathered the meltdown better than most, struck a more realistic note during a conference last fall. Asked about market- value accounting, he said banks and investors had to realize that the losses are real.

Bankers’ own actions bear that out. While banks protest that market prices are too downbeat, each quarter they ratchet up loss expectations and chase markets down. And with each big bank acquisition -- Countrywide Financial Corp., Washington Mutual Inc., Wachovia Corp. -- the acquiring bank ends up recognizing huge losses on loans being bought.

Pricing Rotten Assets

If it creates a bad bank, the government will have to choose sides in this debate. Here are some possible outcomes.

Say a bank has a security it wants to sell to the bad bank. The face value is $100. The bank holds it at a value of $85. The market thinks it’s worth $65.

Banks will want the government to purchase assets for as high a price as possible, or at least to find some middle ground above depressed market values.

Buying the security at, or close to, $100 means the government would recapitalize the bank while transferring losses from shareholders to taxpayers.

Well, future taxpayers. They will be the ones who pay down the debt the government hopes to sell to fund this transfer, and make good on any losses. That debt, meanwhile, could prove stifling to the economy, and the losses pushed onto taxpayers could further undermine government finances.

‘Postpone the Pain’

“Creative pricing of toxic assets will only postpone the pain, extend the duration of the crisis, and present a bigger bill,” Northern Trust Securities Inc. economist Asha Bangalore said in a Jan. 23 research note.

If the government purchases the security at $85, the future losses and bill to the public purse would be less. The problem is, this price could cause banks to recognize as permanent their losses on other securities. Right now, they claim those losses are temporary.

Such a move would cripple banks’ regulatory capital ratios. Plenty of banks could still fail. In that case, banks and taxpayers both get hit.

Buying the security at the market price of $65 means banks and the financial system immediately face a day of reckoning. While bank balance sheets would get unclogged, many wouldn’t be able to, or willing to, face the losses.

Nationalizing Banks

“If the government elects to pay fair market value, the bank will likely not elect to participate as capital hits would be too dear,” Oppenheimer & Co. analyst Meredith Whitney wrote in a report yesterday.

That could force the government to nationalize banks or seize them as part of the process of buying up assets. Either way, shareholders would get wiped out.

The strain caused by owning up to losses today would be enormous. It would also make more sense if we want to move out of the crisis sooner rather than later.

And what if market prices indeed overestimate potential losses? We would pass a windfall to future generations, along with a stronger financial system. Nothing wrong with that.