One of the most flagrant forms of abuse of US accounting rules was the implementation of FAS 157 and 115 discussed over two years ago by Zero Hedge here. The rules, which were implemented in advance of the end of Mark To Market back in 2009 to prevent fair value from creeping into bank asset valuations, segregated bank assets into three categories: trading, available-for-sale and held-to-maturity (also known as banking). The chief distinction was that while "trading" assets could be, well, traded, on an ad hoc basis, they would also need to be marked-to-market, and as a result suffer valuation shortfalls which would possibly lead to bank undercapitalization when markets swooned. The held-to-maturity assets, on the other hand, were encased in a shell of impenetrable valuation, traditionally held on the bank books at par, as the assumption is that all would be money good at maturity. The one caveat is that banks could not trade out of these assets without a solid reason to justify shifting underlying assets from one class to another. Not surprisingly, in the volatile days of 2009 and 2010, most banks moved their asset holdings to the banking category leaving trading books empty. And while the FASB recently pushed to reinforce mark to market, that failed. Yet what seems to be happening is that banks are now voluntarily going back to Mark-to-Market in order to take advantage of what even they are obviously perceiving as ludicrous valuations for toxic assets. As the FT reports, Citi shifted $12.7 billion in bad assets from its banking book to its trading book, supposedly so it can be shielded from onerous Basel III capitalization requirements (minimum 7% equity buffer on banking book assets), but really so it can take advantage of an environment in which bidders for Maiden Lane II assets (primarily AIG itself indirectly through banks) are scrambling to bid on last pockets of remaining yield. What this means is that pretty soon all bank assets will be moved back to Mark To Market, leading in much more incremental volatility as these will be reflexive of market momentum and vol. But that is at least a few weeks away. And by then it will be some other CFO's problem.
FT explains further:
Citigroup has moved to cushion the impact of new global capital rules for banks, putting up for sale a $12.7bn (£7.8bn) portfolio of bad assets that were responsible for some of its huge losses during the financial crisis.
The US financial group revealed the move on Monday alongside first-quarter results that showed a 32 per cent drop in net income that was narrowly better than analysts’ expectations.
Citi said the assets, which are believed to include subprime loans, mortgage-backed securities and corporate bonds, carried a “disproportionately high” risk weighting under the new capital rules known as Basel III.
Courtesy of Citi's move, we now approximately how big of an asset markup the accounting valuation differential between either of two accounting treatments is:
Citi’s decision resulted in a $709m pre-tax charge in the first quarter, but enables it to take advantage of a recovery in the market for distressed assets and boost capital buffers as Basel III rules are phased in between 2013 and 2019.
In other words, based on a BOTE calculation, there is a $0.7 billion valuation impact on $12.7 billion in assets, or about 5.5% of value "pick up" from an asset's existence in non-MTM limbo. Incidentally, that is almost the entire equity Capitalization buffer banks currently have when all various gimmicks are eliminated. In other words, should every bank proceed to follow through in Citi's footsteps and prepare to offload toxic crap to funds suddenly overflowing with Other People's Yield Chasing Money ("OPYCM"), the US financial sector will end up having no equity buffer to soak up incremental losses. But once again, this is the problem of some other CFO down the line.
How and why was Citi allowed to proceed with this reversal of a process that banks fought and bribed so hard to be allowed in the first place?
In order to put the assets up for sale, Citi had to reverse an accounting manoeuvre performed during the crisis, when it moved them from its “trading” book to its “banking” book.
Such a shift, which mirrored moves by other commercial banks, helped Citi to avoid suffering quarterly mark-to-market losses on those assets at the height of the turmoil. Before that move, the bank had suffered billions of dollars in losses on such assets that eventually prompted the US government to spend $45bn to bail it out.
However, accounting rules require financial groups seeking to move assets back to their “trading” book to show that the facts around their initial decision had significantly changed.
One thing is certain: with the market now at the same level in terms of fixed income marks as the peak of the credit bubble (in the absence of CDO and generally synthetic assets, all cash products are trading at nosebleed levels), many more will follow in Citi's footsteps:
Several banks have shrunk their balance sheets and shuffled assets in order to cope with the rise in capital requirements demanded in the Basel III regime. However, their efforts have taken place largely behind closed doors, with very few providing details of their plans.
One exception is Barclays, which has signalled clearly that an entity it had created and spun off in the aftermath of the financial crisis will no longer be economic under Basel III.
Protium comprised a £7.5bn portfolio of largely toxic investments. The UK bank now plans to expedite the wind-down of the entity – which it funded with a loan to Protium management because the weightings applied to the loan are set to be as punitive as those on the underlying assets.
Bottom line: as the next Bernanke-blown credit bubble slowly hits the peak achieved back in 2008, banks will voluntarily undo all the processes established to protect banks not only from rational investors, but from themselves. Instead, with much more toxic assets available in the marketplace, the Sorosian reflexivity paradigm will gradually become more and more prevalent until once again the entire system is vibrating like a superstring on the whims of a irrational investing public, now comprising primarily of robots. And with QE2 about to go pulled, however briefly, leading to a risk asset plunge, there is absolutely nothing that could possibly go wrong with this arrangement pulled straight from the credit bubble playbook.