Thursday, November 8, 2007

Creative Accounting

Countrywide, Washington Mutual Play Shell Games: Jonathan Weil

By Jonathan Weil

Nov. 8 (Bloomberg) -- Thanks to some snazzy accounting moves, this quarter's earnings at Countrywide Financial Corp. and Washington Mutual Inc. probably won't look as bad as they otherwise would. The flip side is that any resulting improvements will be purely cosmetic.

The balance-sheet maneuvers are a classic case of earnings management. Last quarter, both companies changed the asset- classifications for billions of dollars of mortgages to ``held for investment'' from ``held for sale.'' While the distinction may look arbitrary, the effect on short-term earnings under the accounting rules can be huge when loan values are falling, as they are now.

That's because mortgages classified as held for sale must be carried on the balance sheet at cost or market value, whichever is lower, with any declines hitting quarterly earnings. Mortgages held for investment, by contrast, need be written down only if they have suffered an ``impairment'' that is ``other than temporary,'' which can mean different things to different people.

A loan's real-life value, of course, won't stop falling just because the accounting treatment changes. Yet by reclassifying loans as investments, banks can postpone big losses, hoping the values rebound later. The problem is they might not, in which case investors could get blindsided.

Countrywide, which reported a $1.2 billion net loss for the third quarter, transferred $12.32 billion of prime mortgages to held-for-investment, after first marking them down by $418 million. The loans all were of the ``non-conforming'' variety that don't qualify for sale to Fannie Mae and Freddie Mac -- which in this market means there are few, if any, buyers. The biggest U.S. mortgage lender finished the quarter with $30.86 billion of loans held for sale and $83.56 billion in the investment category.

Under No. 3

Seattle-based Washington Mutual, where net income dropped 72 percent to $210 million last quarter, transferred $17 billion of loans to its investment portfolio, after first marking them down by $147 million. That left the nation's largest savings and loan with $7.59 billion in the held-for-sale category at Sept. 30 and $235.2 billion of loans classified as investments.

Banks can't avoid losses entirely just by reclassifying mortgages as investments. They still must set up valuation allowances and record charges to quarterly earnings for estimated credit losses, which hinge on the loans' collectability. But they don't have to record losses to reflect other variables that affect their loans' market values, such as quarterly interest-rate changes or a sudden lack of liquidity in the resale market.

Market Disrupted

Executives from Countrywide and Washington Mutual declined to be interviewed. In a statement, a Countrywide spokeswoman, Jumana Bauwens, said the Calabasas, California-based company made its reclassifications ``because the secondary market was disrupted in the third quarter, and the returns for holding the loans once marked down were attractive.''

When I asked if a desire to boost future earnings played a role in Countrywide's decision, she said the company had no comment.

A Washington Mutual spokeswoman, Libby Hutchinson, also declined to answer that question. In a statement, she said ``the transfer was the result of unprecedented disruption in the secondary mortgage market for nonconforming mortgage loans. As a result, today, nonconforming loans are primarily originated for our investment portfolio, and conforming loans are primarily originated for sale into the secondary market.''

Under the accounting rules, companies can label mortgages as investments only if they intend to hold them for the foreseeable future or to maturity. Countrywide and Washington Mutual no doubt would sell their reclassified loans today if they could. The accounting change tells you they can't and that they see no end in sight to the current market mess.

Good Cancels Bad

Other problems lurk. Because the transparency is so poor, investors can't see if the companies might have sold their best loans and stashed the bad ones in their investment portfolios. Such ``gains trading'' was a big problem during the 1980s savings-and-loan crisis, notes Donn Vickrey, editor in chief at Gradient Analytics Inc. an investment-research firm in Scottsdale, Arizona.

``From the disclosures they provide, you really can't tell the extent to which gains trading may have occurred,'' he says.

The markdowns the companies took before reclassifying their loans also are open to question. The rules known as Financial Accounting Standard No. 65 let lenders review their mortgages in pools, which are easy to gerrymander, rather than individually. They also can offset loans with embedded gains against those with embedded losses.

Intent's Value

The notion that a loan's value hinges on a holder's intent has some merit. Asset values are supposed to reflect the present value of future cash flows. If a lender plans to hold a loan to maturity, it might earn more money over the long term than if it sold the loan today.

For investors looking at a bank's current financial position, though, what matters is what the loan is worth now. That has nothing to do with the lender's stated intent.

It's become fashionable for corporate executives to complain that today's accounting rules are too complex. Yet when companies don't like the answers that simple rules provide, they often resort to complexity to get around them.

It would be much simpler if the rules said all loans must be carried at cost or market value, whichever is lower, even with all the subjectivity involved in estimating market values. Investors would be better informed, too.

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