We think Berkshire Hathaway (BRK) chairman Warren Buffett may have lit the match that set the market on fire during his CNBC interview this past Monday, March 9 when he called for a suspension of mark to market accounting at banks. He also said that regulators should not hurt bank shareholders by asking banks to raise capital at today’s (or Monday’s) low prices. He thereby gave cover to the idea that we should let banks “earn their way out” of trouble, presumably under the cover of government guarantees. In other words, we shouldn’t worry how much money taxpayers spend on bailing banks out, and taxpayers shouldn’t care about getting anything out of banks in exchange for TARP funds, Treasury guarantees, or extraordinary Fed loan programs. As long as the Fed can keep short term rates low the banks will have a low cost of funds (such as the 1.44% average cost of funds enjoyed by Wells Fargo in 4Q2008), earn big operating profits, and cover the cost of any writedowns, his argument goes.
Citigroup (C) head honcho Vikram Pandit understood Buffet’s meaning immediately. On Tuesday he issued a memo touting C’s quarter to date performance. Of course, C’s profit numbers for the first two months of a quarter conveniently omit any writedowns C may need to take at quarter end, but no matter. The memo leaked promptly, natch, provoking traders to buy the oversold conditions noted so clearly in this site’s Daily Commentary two weeks ago. Apparently, traders figured that if banks won’t have to tell the truth about their assets, the writedowns will stop, and they will report wonderful earnings. And on an accounting basis, they might well be right. Therefore, it was time to buy bank shares — and everything else.
The party continued on Thursday with hearings on accounting standards at a subcommittee of the House of Representatives (h/t, Naked Capitalism). Although SEC chair Mary Schapiro said she has “no plans” to suspend mark to market accounting, it would seem that Banking Committe chair Barney Frank and Rep. Paul Kanjorski (D-Pa.) will get the accounting standards loosened eventually.
We emphasize Buffett’s role because until last week he was a powerful advocate of realistic accounting standards. Indeed, in one of his annual letters to BRK shareholders some years ago Buffett went so far as to say that he reports his own mistakes scrupulously because “If you lie in public pretty soon you start lying to yourself,” or something close to that effect. Suspending mark to market — depending on what rule the Financial Accounting Standards Board eventually writes– could allow banks to lie to shareholders and everyone else about the value of the assets they own.
In earlier comments, neither Frank nor Kanjorski seemed to be advocating major changes in banks’ accounting standards. Did Buffett’s change of heart influence them? BUffet’s change certainly made it easier for Congress to cave in to the banking industry lobbyists who really want this one. Maybe one day the MSM will ask.
We don’t know why Buffett changed his opinion, but we can hazard a guess. Berkshire has large holdings in several banks, such as Wells Fargo(WFC), and recently bought preferred shares in Goldman Sachs (GS), and General Electric (GE), which has a large financial division. Before the open on March 9 when Buffett spoke to CNBC, the Dow stood at 6,627, there was plenty of fear in the market, and indignation was rising about how the AIG bailout was effectively funnneling government money to counter parties of AIG, including GS. Buffett must have been sorely tempted to do something to protect BRK’s financial shareholdings. Suspending mark to market would certainly give him some breathing room.
Much as we hate to disagree with Buffett, we fear that ending mark to market could hurt the United States badly over the long term. Certainly some banks will be able to earn their way out of their problems — we explained how in the bull case we gave for Bank of America (BAC) two weeks ago. On the other hand, we think that the weak banks will continue to bleed the Treasury and the Fed until they are shut down, and the longer we delay the worse it will get. We expect house prices will continue to fall and that will pressure the real values of banks’ housing related securities, no matter how they choose to account for them; we also expect banks to take additional losses in areas such as credit card portfolios and commercial real estate loans. Under these conditions reduced transparency will breed only more distrust, as lenders and counter parties begin to fear that the government will eventually run out of patience — or money — to keep propping up the sick banks. As far as we can see, Buffett’s plan works only if the economy turns around far more quickly than we expect.
Furthermore, by keeping weak banks open under existing management we are encouraging the very people who got us into this mess, to take more and more risks with public money in order to earn the profits they so desperately need. Heads they win, and they get to keep the profits. Tails the taxpayers lose. In additon, as long as the government props up weak banks, prudent banks will find it harder to compete. Japan propped up its “zombie” banks for years and that was a big reason for its “lost decade.” Better to decide all at once which banks are insolvent, have the FDIC close them down, and return them to private ownership as soon as possible after cleaning up the bad assets. Too bad it’s not going to happen that way.