Share |

Martin Schoeller: New financial crisis requires old thinking

Banks should urgently be relieved of the unnecessary duty to revalue their loan portfolios according to which price they could achieve if they sell the credit today. This method says something about offer and demand on the credit (commercial paper) trading market but it says little to nothing about the real value of the asset class "loans".

The world currently suffers from a chain reaction which was apparently triggered by the subprime crisis but also may be to a much greater extent by the fact that loan devaluation hits banks with a leverage of 1:12 (assuming 8% equity ratio in average) and might be often exaggerated. If a bank writes down 4% of its total assets, it theoretically has to get rid of 48% of its assets.

There are not enough buyers for such enormous amounts of loans that are being offered by the financial services sector simultaneously. The reason is the banks cannot suddenly be all duplicated or substituted by organisations that don't have the retail customer savings.

The consequence is a downward spiral without end because the oversupply of loans leads to more devaluation and more devaluation leads to more supply. The market cannot find a balance, because it is an artificial situation where enough demand cannot be created in the time needed, even not by organisations who do not suffer from the same strangulating regulations.

Loans are not assets like shares. Shares trade daily based on continuous public information from the companies and a part of world's savings is allocated to this trade. Taking away the banks, those who can take loans on their books (hedge funds hold only a small part of the savings) cannot substitute the banks' function.

So offer and demand cannot be balanced without wiping out a big part of the credit providers. A balance sheet should show the true and fair value of a company under the Going Concern assumption.

If you take away the going concern assumption from industry accounting principals and you would ask to value every pipe, hydraulic, cylinder or robot by its daily used machinery (or scrap) value, most of the industry would be bankrupt only to accounting standards. A loan gets paid on maturity, like a plant gets amortised after, for example, 10 years. The loan is worth the nominal value and not 87% as senior secured nor 69% as second lien loans are now being valued in London and New York.

The risk is taken care in the risk accruals over the years. This is the old European accounting method and we should very quickly return to this logic. This is especially to be considered by the EU regulating bodies. It will also reduce the inflationary habit of trading loans into multilevel constructions. As banks don't like and mostly cannot buy loans at the moment this is a good moment to restart the old bankers virtues.

As long as we force the banks to devaluate assets that are worth par at maturity, we will create opportunities for hedge funds benefiting from this market inefficiency derived from accounting rules that create a gap between book value and real value in the hundreds of billions of euros/dollars.

Not only rating has failed here, now an inadequate accounting rule risks to cripple the industry. Banks and insurers must be allowed to value loans in their balance sheets as long as they don't sell the loans at par.

Click here >>