What's next for US banks
Two different kinds of accounting—fair value and hold to maturity—have
created two different kinds of crises. One is almost over. The other is only
Lowell Bryan and Toos Daruvala
With the completion of the US government’s banking “stress tests,” the rebound in firstquarter
2009 bank earnings, and the recent rise in the US stock market, it is fair to ask if we can
now see a clear path out of the credit crisis. How close we are to the restoration of a strong and
profitable banking and securities industry that is capable of providing the US economy with the
credit it needs to grow?
The good news is that we have probably turned a corner in the credit securities crisis that last
fall forced big financial institutions into collapse, nationalization, or extreme survival tactics.
But the contours of a broader resolution of the crisis will remain fuzzy for some time to come.
That’s because what many have been regarding as a single credit crisis is in reality the tale of two
closely related but different crises, each with its own pace, duration, and demands on banks to
rediscover operational discipline in a harsh economic and regulatory environment.
The first credit crisis was centered in the securities markets and initially manifested itself in the
subprime and mortgage-backed securities markets. Because of the fair-value accounting that
broker–dealers and investment companies use to mark assets to current market expectations,
these firms began to suffer deep losses on mortgage-backed securities long before large volumes
of loans started to default. This credit crisis started in mid-2007 and peaked in 2008, resulting
in the demise of Bear Stearns, Lehman Brothers, and Merrill Lynch, and forcing Morgan Stanley
and Goldman Sachs to become bank holding companies in order to survive. It also heaped huge
losses on the securities arms of major US banks and forced government takeovers or mergers on
AIG, Fannie Mae, Freddie Mac, National City, Wachovia, Washington Mutual, and others.
The good news is that we appear to be seeing the end of this credit securities crisis. That is
in part due to the clarity provided by the stress test exercise and the ongoing commitment
on the part of government not to allow a large-scale bank failure. The other credit crisis is a
commercial-bank lending crisis. While this crisis also stemmed from bad residential mortgages,
it involves a broader array of lending, including commercial real-estate loans, credit card
loans, auto loans, and leveraged/high-yield loans, all of which are now going bad because of the
economic downturn. The bulk of these loans are subject to hold-to-maturity accounting, which,
in contrast to fair-market accounting, typically does not recognize losses until the loans default.
The bad news is that this crisis is still in its early stages and may take two years or more to work
through the credit losses from these loans.
Of course, all large financial institutions hold both kinds of credit assets on their books. Some
of the largest broker–dealers hold 70 percent of their assets at fair value, while some regional
banks hold up to 90 percent of their assets in hold-to-maturity accounts. For the banking
and securities industry as a whole, about two-thirds of assets are subject to hold-to-maturity
It might seem odd that accounting methodologies can make such a big difference. At the end
of the day, what counts is the net present value of the cash flows from each asset, but those
are unknowable until after a debt is repaid. Fair-value accounting, based on mark-to-market
principles, immediately discounts assets when the expectation of a default arises and ability to
trade the assets declines. Fair-value therefore makes the holder of the assets look worse, sooner.
Hold-to-maturity accounting works in reverse and makes the holder look better for a longer time.
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© 2009 The McKinsey Quarterly