by John Bougearel,
Author of Riding the Storm Out: What Do Investors Do Now?
Chris Whalen addresses evils of Mark-to-Market Accounting vs. the virtues of cash flow analysis in his March 8 weekly missive. (If you don’t already subscribe to his free weekly missive, please do). To read the full accounting of Whalen’s expose, go here http://us1.institutionalriskanalytics.com/pub/IRAMain.asp and scroll down two-thirds to the subtitle Bernanke Finally Fingers Mark-To-Market.
On Feb 24, 2010, Bernanke put his finger on a critical issue facing commercial real estate loans that will soon need to be restructured. The peak of that commercial real estate restructuring cycle is due in Q2 2012. And though Bernanke was not referencing other types of debt such as LBOs and M&As that also must be restructured in the next 1-4 years, the concept of using cash flow analysis is paramount towards mitigating the coming private sector debt restructuring cycle. From Bernanke: “commercial real estate loans should not be marked down because the collateral value has declined. It depends on the income from the property, not the collateral value.”
Whalen goes on to note that bank regulators have not yet picked up on the significance of using the cash flows and not the marked to market collateral values in determining the value of these existing loans that will need to be restructured. If and when bank regulators make this shift, and I think they will if the Chairman of the Fed is onto it now, this will certainly help mitigate the coming crisis. However, it won’t totally avoid the crisis because so many other overhanging issues.
First, the underwriting standards of all loans written in 2004-2007 were lax and “covenant-lite.” Without a doubt, many of these loans when they come up to be refinanced will not pass the smell test, and many loans will prove to be under or non-performing and likely fraudulently conveyed as well (though no fraud will be prosecuted because covenant-lite was all legal-beagles back then). The cash flows from many of these loans are apt to come up short, so, in these instances not even using cash flow analysis will help mitigate the losses in loan values. This will cause additional writedowns to be taken, defaults and bankruptcies in the private sector.
Secondly, as Rosner pointed out in “Securitization: Taming the Wild West” the credit mkts remain severely constrained and the securitization mkt largely remains frozen, as investors in these products have fled, due to the asymmetry of information, opaqueness and lack of standardization of contracts that still persist even three years after the credit crisis began. Without HUGE repairs to the flawed securitization mkts, access to credit for refinancing these loans will be practically non-existent. That in and of itself will be deflationary and create firesales, REGARDLESS of said cash flows from the existing loans. What I am saying is that using cash flows to determine loan values in 2011-2012 will still be insufficient conditions to gain access to much needed credit. As Rosner posited ”many of the problems in the real economy which stem from contraction in credit availability may be symptomatic of securitization market failures…To believe that real estate or the economy itself can find a self-sustaining recovery without first repairing this important tool of financial intermediation is unrealistic.”
Simply put, cash flow analysis is not a stand alone solution. Policymakers must also address and repair the flaws in the securitization model if they wish to see investors return to products in the credit mkts and ensure robust access to credit for borrowers that need to refinance their loans in 2012. The question is, can lawmakers make robust changes in the standardization of the securitization markets that are necessary to “support economic activity and productive growth” before the peak of the private debt restructuring cycle in mid 2012? Thus far, the weight of the evidence does not favor “prompt corrective action” being taken by lawmakers at all, let alone within a specified timetable, yet the need has been identified as urgent by Rosner: “There is an immediate need for regulators and policymakers to oversee the creation of a standardized market where assets can be securitized, priced, valued and consistently evaluated by investors. Short of prompt corrective action being undertaken to repair the securitization markets, the US economy will end up in yet another full blown credit crisis in 2012. And the problem of facing another credit crisis in 2012 is that the US economy is no longer firing on all cylinders as it was when the first full blown credit crunch arrived in August 20007. With the US economy is trying to limp its way out of the most severe recession since WWII, it can ill afford another credit crisis at this time. Much work needs to be done on the Hill, let’s hope they are shovel ready and not leaning on filibusters and hiding behind partisan politics as excuses for failing to act appropriately! Their failure to act appropriately thus far after the financial crisis has been stunning to say the least.
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