Plunge: How Banks Aim to Obscure Their Losses

An Interview with Lynn Turner

Lynn Turner served as chief accountant of the Securities and Exchange Commission from 1998 to 2001. In 2007, Treasury Secretary Henry Paulson appointed him to the Treasury Committee on the Auditing Profession.

Multinational Monitor: What is mark-to-market or fair value accounting?

Lynn Turner: Fair value or market value accounting is a requirement for a company to report their assets in their financial statements at what they are worth today - that is, what one could get for them if they were sold in an orderly market to another person. This compares to the other method of accounting - historical cost, which requires a company to report assets at the amount you paid for them, even if you bought them decades ago, such as with a manufacturing plant or a building.

MM: To what extent are companies required to use fair value accounting?

Turner: In the U.S. in general, companies are required to use it for stocks and bonds they hold, and for some, but not all derivatives, such as credit derivatives and futures contracts for commodities. Companies in the U.S. are given the option to use fair value accounting for all such investments and financial instruments, but not for assets such as real estate, manufacturing plants and equipment.

Internationally, companies are given the option of revaluing their property, plant and equipment periodically and reporting them at their fair or market values.

MM: How does this affect financial institutions and why is it such a controversial issue?

Turner: This affects financial institutions like banks or investment banks like Goldman Sachs and Morgan Stanley because most of their assets don't consist of property and equipment, it consists of investments or loans. For a bank, they don't have to report their loans at fair value, but they do have to report their investments at fair value. And since their investments are a much bigger percentage of their balance sheet than for other companies, it has a much bigger impact on them.

MM: The U.S. bailout legislation passed in September gives the Securities and Exchange Commission (SEC) discretion to eliminate mark-to-market rules. Who's behind that push?

Turner: The trade associations for the banks - the American Bankers Association and the Mortgage Bankers Association - are on one side of the fence. Those in opposition to the bankers are investors, consumers and the accounting firms.

MM: Is this a longstanding concern of the banks, or only one they adopted when their assets started to go bad?

Turner: This has been an issue for decades. This type of accounting has been debated going back to the 1920s, so it's not a new topic. Banks only raise a problem with it during down markets. You'll never hear a bank complain about it during up markets, when they want to take the gains as the stocks rise. But when they've made bad investments and they have to start reporting losses to the shareholders, to whom they are accountable, then they always seem to come out of the woodwork to complain and try to find a way to hide those losses.

They certainly exhibited the same type of behavior - fighting tooth and nail against fair value accounting - when the S&Ls [savings and loans] were failing in the latter half of the 1980s. They went in and lobbied the SEC a lot at that point in time. And they are back at it all over again today.

In addition, when you had the 1972-1973 bear market, insurance companies were found to have a lot of bad investments. We had the failure of the large Equity Funding insurance company at that point in time. The insurance companies fought tooth and nail against fair value accounting.

So it's nothing really new. It's just that we only seem to hear about it from the banks when they are having to book losses, not when they are having the chance to take gains.

I would also note that there is a rule that came out recently in the last few years, called Financial Accounting Standard Number 159, that allowed financial institutions the option to use fair value for particular investments. Dozens of banks exercised that option. But they typically only used it on assets or liabilities from which they had gains. They didn't use it as often for assets that had declined in value creating losses. It's also worth noting that the two most successful financial institutions in their respective industry segments, JPMorgan Chase and Goldman Sachs, are very strong supporters of fair value accounting.

MM: Do JPMorgan Chase and Goldman Sachs favor fair value because the rules work to their benefit? Or do you think it is because firms engaged in more honest accounting tend to do better?

Turner: Over the years I've sat down and visited with those two institutions and been inside of them. They have a fundamentally different philosophy than other banks. I think their management style is: you've got to stay engaged and on top of the assets that you're managing; you've got to know if those assets are changing in value and if so, what's causing it; and then you have to react appropriately with whatever your management strategy is.

I think that the reason those two support fair value is they believe that it's fundamentally sound business management in the industry. I would have to agree with them. I think those that are not as astute end up with greater losses because, quite frankly, they aren't as good at managing in such times. When that happens, they absolutely hate getting the report card with an "F" on it. Relatively speaking, JPMorgan and Goldman end up with a report card with a pretty good grade. The guys that are getting the failing grade are the guys that have proven to be not as good at managing and they don't like that report card. It's like a kid trying to find a way to hide the report card so mom doesn't see it.

MM: Critics of fair value say the markets are clogged up and not working properly. Banks and other institutions can't trade their paper at what the paper is actually worth, and if they have to mark down, they are going to show unreasonable losses. Whereas if they can just hold on a little while, wait until things get unclogged, they can get a more realistic assessment of what they hold. How would you respond to that overall argument?

Turner: I'd respond from a number of different perspectives. First of all, we're talking about subprime assets. There is a reason we call them subprime. They are not good assets. They are assets where people made loans without having any concept whatsoever of whether the other person could repay it - they didn't even know what the borrowers were earning. There are loans where they loaned out 100 percent of the value of a house and the values of those homes have declined 20, 30 percent. So of course those loans are under water, and of course there are great big losses that have to be taken. The International Monetary Fund and Bridgewater Associates have said that the losses will total somewhere between almost $1 trillion and $1.6 trillion. Yet through the end of September, the banks on a global basis have only reported about $500 to $600 billion in losses. So we know that there are hidden losses that haven't been incurred to date.

The other piece of evidence that we have is that ETrade sold these types of assets some time ago for 28 cents on the dollar. Merrill Lynch could only get someone to buy them for 22 cents on the dollar, and Merrill Lynch even put up 75 percent of the financing for that transaction, which means that the value is probably substantially less than 22 cents.

We just saw Wachovia, which is one of the biggest banks in the country, sell for $2 billion, when their inflated balance sheet said there was $75 billion in net asset values - clearly an inflated balance sheet. [Editor's note: Subsequent to this interview, Wells Fargo, benefiting from a major tax break, maneuvered to buy Wachovia for $14.4 billion.] The problem is that the banks have losses that they haven't reported. And they don't want to report them because of what it's going to say about their management style. They have their assets so overpriced that no one would buy them.

The only way you'll make the market liquid again and get those assets moving is if you bring those values down, just as ETrade and Merrill Lynch did, and ultimately Wachovia did with the whole bank, to a value where someone thinks they can buy it at that price and actually make a decent return on it. It's just like someone listing a house in the neighborhood at a price substantially above everyone else. You know you're not going to sell the house for a long, long time, if at all, until you bring the price down to where it's at a price people are willing to buy at.

The banks have to understand that they made really bad loans and really stupid management decisions. And now they have to face up to what they did, take their hits, and move on. And that means they're going to have to bring these asset prices down to where they can get buyers in the market. When they get the prices down low enough that someone can buy it for the price that it's being offered at, and get an acceptable return for the great amount of risk that is embedded in these assets, then they'll have buyers.

MM: What's at issue is not actual mortgages, but bundled, securitized instruments with pieces of a mortgage, right?

Turner: You've got different types of assets. You have investments from the security backed by an entire loan, to a security that's backed by another security, which only owns a portion of that loan. In the latter case, the risk becomes much greater because you only have a piece of a piece of something, and it's something that you really have no control over. It's those types of things that magnify the risk.

When you think about it, if mark to market was the problem, as many of the banks say, then we could just eliminate mark-to-market accounting and do away with the problem. We wouldn't need $700 billion in cash to fund these guys. But the reality is, it isn't mark to market that's the problem at all. It's that they made so many bad loans. They made so many of these loans, they've flat-out run out of cash, and that's why they need $700 billion. And by the way, the banks will admit that even if there was no mark-to-market accounting they would still want the $700 billion. That says a lot.

Whether you tell people the loan is worth $100 or it's worth $60, it doesn't change your cash balance one iota. It doesn't change the cash and it doesn't change the problem. That's why, at the end of the day, the only thing that solves this is to get cash and liquidity back into the banking system. These guys are just trying to avoid telling the rest of the world how stupid they really were.

MM: How important to the story is the ability of banks to do so much of their investing off the books? And why are they able to do that?

Turner: Banks have been taking packages of their loans, putting them together and securitizing them - that is, selling them as a package to investors - for decades. The first accounting rules were developed on that in 1974. They said if a bank securitized loans but didn't really sell them and just used the securitizations to raise additional financing to make more loans, the banks would have to keep those assets and loans on their balance sheets.

Unfortunately, in a critically flawed 1983 decision, the FASB [Financial Accounting Standards Board] reversed those rules and started to let the banks take the securitized loans and related debts off their balance sheets. As a result, the banks didn't have to show all that debt, all those liabilities they were incurring. It's now apparent that was a very fateful decision.

It's been clear that in the last two decades, the banks' ability to hide that financing - or even companies like Enron being able to hide that financing in "special purpose entities," or "special investment vehicles," which are nothing more than just a scam to keep things away from investors - has had a very devastating impact.

Both the Financial Accounting Standards Board here in the U.S. and the International Accounting Standards Board, are working to fix those standards and bring all those off-balance sheet things that have been hidden from view back into full view of investors and the capital markets.

Unfortunately, the FASB has done this about five or six times before. If they aren't successful this time, then, because of the devastation this has wrought on the markets and the economy, I think legislators would be well-served to step in and pass legislation that would require this to be on-balance sheet.

MM: Is there any legitimate argument for maintaining off-balance sheet operations?

Turner: For these transactions, which are most often nothing more than a financing of the assets, there is no rationale. It's only if you truly sold the asset, gave it up and no longer had any obligation or responsibility for it, that it would be appropriate for you to take it off your balance sheet. But the way the vast majority of these transactions are structured, that isn't what they're doing. They're truly just using this as another way to raise debt and increase leverage. And in that case there's no excuse for not having it on the balance sheet.

MM: What would be a handful of things that you would say ought to be part of a financial regulatory legislative package?

Turner: First of all, the markets have to become more transparent. Off-balance sheet accounting is one important item. That stuff - the assets and liabilities - needs to come onto the balance sheet. The lack of transparency surrounding credit derivatives must be fixed - one of our problems is that the regulators don't even know the magnitude of the market.

I think we also need to get much greater accountability and transparency regarding what our regulators are doing.

We've had no accountability in recent years. You had [former Chair of the Federal Reserve, Alan] Greenspan flood the markets with a tremendous amount of money, making debt the cheapest it's been in decades if not the last century, which facilitated these companies leveraging up their balance sheets. You've got to question whether or not that was the appropriate monetary policy or whether that was done for political reasons to cover up over shortcomings in the economy.

Federal Reserve Chair Ben Bernanke has already said the Fed needs to be much more transparent. I think that's absolutely true. And I think the same is true of the SEC and its enforcement actions.

With respect to the credit rating agencies, the SEC definitely needs more power over them. Under current legislation, if the SEC inspects a credit rating agency, and finds that the credit ratings are flawed, and done wrong, but still consistent with the policies and procedures established by that credit rating agency, the SEC is actually required to give them a passing grade. That is astounding. This is all documented in recent Senate hearings, where Chairman Cox said, yes, that's exactly what the situation is.

Certainly you've got to have something in the way of regulation over mortgage originators. This isn't the first time we've had this problem. We had the exact same problem back with the S&L debacle. Yet because of the strong banking lobby, we didn't put in the necessary safeguards to prevent these guys from making bad loans. The incentives in the system are now set up for the mortgage originators to make bad loans because they can now sell the loans off to other people. They make money on each sale, and don't care if the loan is good or bad. Those incentives have to change. Either the banks have to be required to keep the loans and not sell them off, or keep some interest in the loans themselves so they have some skin in the game.

I think we need to relook at the incentive system that we have here in the U.S. and try to find some market mechanisms to try and rein that in. I'm a big proponent of the "Say on Pay" [which would guarantee shareholders the right to a nonbinding vote on executive compensation], and until we get that there's no way we're going to rein in executive compensations.

We also need to go back and ask whether we should allow Wall Street to do all this financial engineering - a lot of which doesn't create value other than for those guys - and allow them to bring some of these toxic-waste type financial instruments into the marketplace. I would certainly be a proponent of setting up some mechanism to deal with that. I'm not a big fan of the government regulating the merit of some of these things - but they've done so much destruction to the system maybe I and others need to rethink that.

MM: What would be a sensible structure or set of principles to think about how you would deal with the next financial instrument that doesn't yet even exist?

Turner: I worked with groups of Wall Street firms that did this type of stuff. When I think back about that experience, Wall Street typically designs these things so that they hide something from the public or their investors. So when you have the CDOs [collateralized debt obligations] built on top of the other CDOs, they hide what the underlying assets are really like, or what the underlying mortgages are really like. In some of the off-balance sheet special purpose entities, like with Enron, it was to hide their financing.

If a new product comes to market, I think I would require that it be reviewed by the SEC. I would require the SEC to make a finding that all the economic factors that surround that particular type of financial instrument are all being clearly displayed to the public. So that if you're making a CDO on top of other CDOs, the public still gets to see those underlying mortgages and all the details about that. I think if you force that information out, these instruments will never get done.

When I say I don't want government intervention, that's not really true. I want the government to force them to tell the world about everything - and then they won't create these instruments. Forcing these transactions into the sunlight will eliminate the bad ones from being done. The government doesn't need to say, that's a good or bad deal, the banks just will never do them because they're bad deals. The reason they do them is to hide stuff.