Leveraged-loan rules give banks an edge over brokers

(AFP)   

When it comes to losses on leveraged loans – a big source of worry for investors in financial firms – banks may have an advantage over their brokerage-house rivals in weathering the storm.

Thanks to a quirk in accounting rules, banks such as JPMorgan Chase do not always have to book losses immediately on those loans, even as brokers such as Goldman Sachs Group are forced to take hits right away.

Leveraged loans – used by companies, usually with low credit ratings, and often to fund buyouts – were originally made with the idea that banks and brokers would quickly sell them to investors. When markets froze in August, institutions found themselves stuck with billions of these loans that they could not unload.

That led to losses last autumn as financial firms were forced in many cases to mark these loans down by about five per cent. The market for these loans is again struggling, and prices are falling further – in some cases to about, or even less than, 90 cents (Dh3.3) on the dollar – which will probably lead to another round of losses at financial firms.

This makes it more probable that some banks will look to shield at least part of their holdings from swings in market prices. By reclassifying some of the loans they hold, banks can avoid marking these loans to market, unlike brokerages, which have to price these at whatever investors say they are worth.

This is not to say that banks will be able to entirely sidestep losses stemming from leveraged loans issued to fund huge corporate buyouts. But any kind of shock absorber would be welcome, given the depressed market conditions now.

Still, while the accounting peculiarity may give banks an edge, it could also pose a danger to their investors, analysts warn. That is because investors could be lulled into complacency when it comes to the size and scope of the hits that the banks may face.

Banks and brokers have nearly $200 billion in leveraged-loan exposure. Given recent falls in market prices of these loans, that could lead to $10bn to $14bn in write-downs, Oppenheimer analyst Meredith Whitney estimated in a recent note.

Among banks, Citigroup and JPMorgan have the most at stake, with $43bn and $26.4bn in exposures, respectively, as of the end of last year. Among brokers, Goldman has the biggest leveraged-loan exposure, at $26bn, followed by Lehman Brothers Holdings with $23.8bn.

The fact that a bank and a broker holding the same kind of loan could see very different effects highlights what some analysts feel is a major flaw in the accounting for leveraged loans. Brokers for years have argued that banks should also be required to assess the values of all their financial assets using market prices.

The differing approaches also underscore that even as the use of so-called market values cause some firms to quickly recognise big losses – even if there are growing questions about the reliability of these values in frozen markets – not every financial player always has to measure up against this same yardstick.

Seem strange?
 
Even analysts think so.

“If you thought the accounting for investments in debt and equity securities was unnecessarily complex, the accounting for loans will make your head spin,” Credit Suisse accounting analyst David Zion wrote in a research note looking at issues surrounding loans.

JPMorgan said in January that it had reclassified about $5bn of $26bn in leveraged loans it holds. It declined to comment beyond what Chief Executive James Dimon said during a conference call.
 
He said the bank reclassified the loans this way because it believed that at current depressed prices, some of its leveraged loans “may be terrific long-term assets to hold”.

That said, the more favourable accounting treatment does not hurt, either. Here is how it works: Companies either classify loans as being “held for sale” or as investments, sometimes referred to as “holding to maturity”. Loans held for sale are carried at whichever is lower: the original cost or the current market value.

That is similar to “marking to market prices”. Any losses are taken in the current period.

But the value of loans held for investment does not change with every uptick or downtick in the market. Instead, such loans are said to be held at their cost, although they are initially marked to market prices if a firm is reclassifying them from held for sale.

The big benefit is that holding loans for investment reduces volatility. Brokers like Goldman, Lehman, Morgan Stanley or Merrill Lynch, on the other hand, have to mark just about everything they hold to market prices. So the firms – which together have about $91bn in leveraged-loan exposure – take losses right away.

This is not to say banks completely avoid losses on loans held for investment.

Dimon said in the bank’s conference call that while it would not mark the reclassified loans to market prices, it would “have to build up proper loan-loss reserves against those, and we would fully disclose that so there is no issue about what that did to the company”.

But in checking to see whether the value of a held-for-investment loan is impaired, a bank would look to see if there has been a change in the credit rating of an issuer, if the issuer has fallen behind in interest payments or if it looks like a delinquency could be looming.

A bank would not necessarily have to consider what the loan would fetch if sold in the market today.

That view, which reflects market perceptions, is what is causing big losses at many firms today. So looking only to credit quality could prove to be advantageous. (Dow Jones Newswires)

A Source Of Worry

$0.90: Or even less on the dollar is the price of leveraged loans as the market for these debts is again struggling while the prices are falling further

$200bn: Is the approximate amount of leveraged-loan exposure of banks and brokerage houses, which could lead to $10bn to $14bn in write-downs