Zombies Make Dangerous NeighborsDoug French Most people believe accounting is conservative, the rules cut and dried. Accountants make economists look frivolous. But accountants are people too, and FASB succumbed to pressure from Capitol Hill in the wake of the 2008 financial crash. How It All Started The SP 500 hit a devilish low of 666 on March 6, 2009. More major bank failures seemed a certainty. Somebody had to do somethingand in stepped the accounting board prodded by the House Committee on Financial Services. The board changed financial accounting standards 157, 124, and 115, allowing banks more discretion in reporting the value of mortgage-backed securities (MBS) held in their portfolios and losses on those securities. Floyd Norris reported at the time for the New York Times, The change seems likely to allow banks to report higher profits by assuming that the securities are worth more than anyone is now willing to pay for them. But critics objected that the change could further damage the credibility of financial institutions by enabling them to avoid recognizing losses from bad loans they have made. With that discretion, fund manager John Hussman writes, banks could use cash-flow models (mark-to-model) or other methods (mark-to-unicorn). And author James Kwak wrote on his blog The Baseline Scenario just after FASB amended their rules: The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets. Bad-Neighbor Banks Nobody has more friends on Capitol Hill than bankers, who are not wild about free-market capitalism when it works against them. Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market, Norris wrote for the New York Times on April 2, 2009. The change in the rules first of all allowed banks to remain in business. Second, with banks having wide discretion in valuing mortgage-backed securities, they had little incentive to care for the collateral of the loans contained in those MBSs. It may even be in a banks best interest to leave houses in what the Sun Sentinel newspaper called legal limbo. Last year the Florida paper devoted a three-part series to Bad-Neighbor Banks. When homeowners walk away, one would think it would be in the banks best interests to gain legal possession as soon as possible and either sell as is, or repair and sell quickly. Apparently thats not the case. All across Florida, banks have halted foreclosure proceedings because the remaining equity in the properties is deemed inadequate to cover the banks costs to reclaim title and maintain, refurbish and sell them, Megan OMatz and John Maines wrote for the Sun Sentinel. When pressed about weed- and rodent-infested abandoned properties, banks often pointed the finger at mortgage servicers. South Florida attorney Ben Solomon, who represents condos and community associations in foreclosure cases, stated, We see bank delays every day. They really continually have been getting worse. More and more time is going by. As banks sit on assets indefinitely without having to recognize a loss, homes get lost in vast bank bureaucracies. When the banks finally figure out what they have, lenders also have been walking away from foreclosure actions involving homes with low market values, after their cool-headed calculation that the homes cannot resell for enough to offset the costs of foreclosing, repairing, maintaining and marketing them, OMatz and Maines wrote. Now banks have rebuilt their balance sheets and are able to withstand losses from bad property loans. Enough banks are walking away from properties that the Treasury Department issued guidance in 2011, advising to do so cautiously. Banks that do foreclose with tenants living in a property are notorious for not maintaining their newly acquired properties. Some banks are failing to follow local and state housing codes, leaving tenants to live in squalorwithout even a number to call in the most dire situations, writes Aarti Shahani for NPR. Im not sure why anyone would expect banks to be good property managers. Banks dont want to take your home and own it, Paul Leonard, senior vice president of the Housing Policy Council, told NPR. Theyre stuck with plumbing and electrical maintenance that is well beyond their mission. They have to hire a property manager to take care of the property. Global banking behemoth Deutsche Bank foreclosed on 2,000 houses in the Los Angeles area between 2007 and 2011. The big bank was such a bad landlord, the city filed suit and the bank recently settled the case by paying $10 millionwhich the bank didnt even have to pay itself. According to Deutsche Bank officials, The settlement will be paid by the servicers responsible for the Los Angeles properties at issue and by the securitization trusts that hold the properties. If banks, not to mention Fannie Mae, Freddie Mac, and FHA, had been allowed to fail, the housing market would have cleared and stories like these would be a thing of the past. However, one intervention begets another, and the market is held stagnate. Auctions: Bids Coming Up Short While there are housing booms popping up in various cities, Bloomberg just reported a failed auction by the US Department of Housing and Urban Development (HUD). After successfully selling 50,000 non-performing, single-family FHA-insured loans since 2010, HUD deemed the bids for $450 million too low to accept at their October 30 sale. (As an interesting aside, the FHA was a product of Roosevelts administration during the Great Depression and hasnt required the help of taxpayers until this September when the agency asked for a $1.7 billion bailout to keep operating a piece of news that got drowned out by the looming government shutdown, the slowly developing Obamacare train wreck, and the Breaking Bad series finale.) HUD has another $5 billion auction scheduled and is currently qualifying bidders. The auctions run through the website DebtX, which has compiled a Bid-Ask Index to compare recent years buyers bid performance versus seller expectations. For the last three years, bids have come up short of sellers ask prices. The index prior to the failed auction was -5.7%. Meanwhile, the banking industry purrs right along earning a record $42.2 billion in the second quarter. For the banks, this was the 16th consecutive quarter of year-over-year increases. A primary driver of the record earnings is less money being socked away in loan-loss reserves. Banks put away the lowest loss provision since the third quarter of 2006. The banking industrys coverage ratio of reserves to noncurrent loans is still only 62.3%, far below what was once the standard of greater than 100%. Remember when President Obama and the Treasury Department claimed the bank bailouts were generating a profit? Special Inspector General Christy Romero overseeing TARP said, It is a widely held misconception that TARP will make a profit. The most recent cost estimate for TARP is a loss of $60 billion. Taxpayers are still owed $118.5 billion (including $14 billion written off or otherwise lost). Fannie Mae and Freddie Mac have turned things around and are generating huge profits, you say? Not so fast. According to bank analyst Chris Whalen, If we were to implement the guidance from FHFA today, it is pretty clear that the profits of the GSEs [government-sponsored enterprises] would have been largely offset by the allocations needed to replenish the reserves. GSE profits would disappear, and $10 to $20 billion would need to be added to reserves. Not only does FNM [Fannie Mae] seem to be unprofitable under the new FHFA guidance, but payments made to Treasury might need to be reversed, writes Whalen. A zombie government armed with accounting tricks has bailed out a zombie banking industry using even more financial phoniness. A few numbers pushed here and there, and the industry is earning record profits. But out in the real world where people live and work, things arent so rosy. Zombies make negligent landlords and dangerous neighbors. Read more from Doug French, former president of the Ludwig von Mises Institute, in the Casey Daily Dispatchdifferent writers, different topics, different investment sectors each day of the week. Get it free of charge in your inbox, Monday through Fridayclick here. 