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Tip the balance sheet on mortgages

Accounting rules are worsening the liquidity crisis, says Home Funding chief executive Tony WardThe credit crunch has had everyone looking for a fall guy. In the UK, politicians and bankers have been particularly quick to point the finger abroad in an attempt to distance themselves from any imminent economic ill.

No one would dispute that events across the pond stimulated this crisis but the US sub-prime binge has been too con-veniently demonised as the source of all the malaise. This overlooks the complexity of the situation. I believe some of our current woes are exacerbated by accounting standards and a change in the rules could ease the pain.

When financial institutions, including banks, hedge funds and structured investment vehicles, invest in assets such as mortgage loans or mortgage-backed securities, they make a decision about how these assets will be treated. Their choice is based on their commercial intentions. The assets can be treated as tradable assets or long-term investments.

Many of the new investment bank-owned lenders hold their mortgage lending as tradable assets. The decision they take is crucial. If the institution decides that these are long-term investments, a provision for any non-performing portion of these assets can be made. So if some loans do not perform, this exercise allows a realistic provision to be made for them over a period of time. This, in essence, is how our major mortgage lenders operate.

However, if the assets are classed as tradable assets because the lender wrote the loans with the express intention of selling them through whole-loan sales or trading them through the eurobond market, their accounting treatment is far less forgiving in the current climate. Their value is derived by marking to market against existing secondary market values. Their value is what the market will pay for them at that point in time. What is more, this value is revisited every accounting period or whenever there is a very volatile shift in market pricing. The value is then reflected in the balance sheet and profit and loss account.

This is why so many banks are coming back with bigger writedowns. It is not because they suddenly find more bad business but because the accountancy rules demand that they reassess and reflect the market value of what they hold as tradable assets. As confidence diminishes in the secondary markets, so there will be fewer buyers and the rules of supply and demand will serve to further shift the value of those assets down.

But it is only a book exercise, I hear you say. Why does it matter? It matters because the writedown in value on the balance sheet of the bank results in a real impact on profit and loss, which is deducted from the capital, meaning higher posted losses and a reduction in capital for lending.

What is the answer? Move tradable assets into long-term investments and decide not to sell in this market but to hold them for the long term. The provision for bad debt then rep-resents the real underlying risk through borrower default and house price falls and not the change in price of a tradable security. This is likely to be significantly less. That way, some stability can be injected into the writedown cycle and confidence can begin to return.

This would need regulatory co-operation to allow a shift in accounting treatment, since accountants are not inclined to allow an arbitrary change in policy just because it makes the balance sheet and profit and loss of a bank look better.

The grim alternative is that the cyclical marking down of assets will mean that they will continue to force banks to write losses against capital that do not represent the real risks of those loans. This will continue to erode capital and shake confidence in the banking system. The true extent of the non-performing assets may be hugely overstated. Good news for the buyer, bad news for confidence in banks.

Accounting standards are brought in for good reasons but surely their application can reviewed in the reality of a market in turmoil? In this case, it is the law of unintended consequences that is in full effect.

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