A Midwestern Dairy Farmer Uses Common Sense to Explain Bank Balance Statements

This from ABC News on March 2, 2010 in an article titled, “Experts Warn Another Financial Crises on the Way” (emphasis mine):

Even as many Americans still struggle to recover from the country’s worst economic downturn since the Great Depression, another crisis – one that will be even worse than the current one – is looming, according to a new report from a group of leading economists, financiers, and former federal regulators.

……. The study says that “In 2008-09, we came remarkably close to another Great Depression. Next time we may not be so ‘lucky.’ The threat of the doomsday cycle remains strong and growing,” they say. “What will happen when the next shock hits? We may be nearing the stage where the answer will be – just as it was in the Great Depression – a calamitous global collapse.”

…… In the report, Elizabeth Warren, who was chair of the Congressional Oversight Panel, reiterates her calls for an independent agency to protect consumers from abusive Wall Street practices.

“While manufacturers have developed iPods and flat-screen televisions, the financial industry has perfected the art of offering mortgages, credit cards and check overdrafts laden with hidden terms that obscure price and risk,” Warren writes. “Good products are mixed with dangerous products, and consumers are left on their own to try to sort out which is which. The consequences can be disastrous.”

Frank Partnoy, a panelist from the University of San Diego, claims that “the balance sheets of most Wall Street banks are fiction.” Another panelist, Raj Date of the Cambridge Winter Center for Financial Institutions Policy, argues that government-backed mortgage giants Fannie Mae and Freddie Mac have become “needlessly complex and irretrievably flawed” and should be eliminated. The report also calls for greater competition among credit rating agencies and increased regulation of the derivatives market, including requiring that credit-default swaps be traded on regulated exchanges.

Why did Mr. Partnoy state that ‘the balance sheets of most Wall Street banks are fiction’?

It has to do with the suspension of the ‘mark-to-market’ accounting rules. Mark to market accounting rules were suspended last year to help banks ‘weather’ the financial crisis. What does the suspension of these rules mean? Let’s ask the Midwestern Dairy Farmer.

When the Midwestern dairy farmer values the cows in his herd, he knows that the higher producing milk cows are worth more than the cows that are not producing as much milk. Typically the younger cows produce more milk than the older cows. Younger cows not only produce more milk but will produce that milk for more years than older cows. That makes the younger cows worth more than older cows.

Mark to market rules applied to the dairy farmer’s herd would have the farmer value his herd at the real value of each cow with real value meaning what the farmer could get for each cow should he decide to sell them. Suspension of mark to market rules however, would have the farmer valuing each cow at ‘book value’ or the maximum value of each cow during each cow’s younger, maximum milk producing years. Suspension of mark to market rules in the case of the farmer would mean that even though the cow wasn’t worth what she used to be, the farmer was still carrying the value of the cow on his books at the cow’s value when it was a younger, higher producing cow.

Once these older cows started to die off, with mark to market accounting rules suspended, the farmer would continue to carry the value of these dead cows on his books as if the cows were still not only alive, but producing milk at the peak production levels of the cow’s younger years.

That method of accounting would certainly make the farmer’s balance sheet look good, but it would only be realistic if dead cows were worth the same amount as young, high producing cows.

As ridiculous as that analogy may sound, that, in essence is what’s happening on the balance sheet of many banks and what led the panelist in the story excerpt above to state that many bank balance sheets are fiction. Assets are being reported as being worth what they were at their peak, not their current, real, market value. The panelist quoted in the story excerpt above realizes this and understands that these assets aren’t worth what the bank is saying that they’re worth. The panelist knows that sooner or later this truth will become known.

He knows that dead cows aren’t worth what live cows are worth.

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