Citigroup Inc. subtracted $2 billion from equity for the declining value of home-loan bonds in its quarterly report to the Securities and Exchange Commission on May 2 without mentioning the deduction in the earnings statement or conference call with investors that followed. ING Groep NV placed 3.6 billion euros ($5.6 billion) of negative valuations in its capital account, while disclosing only an 80 million-euro depletion to income.
The balance-sheet adjustments are in addition to $344 billion of writedowns and credit losses already reported on the income statements of more than 100 banks. These companies have raised $263 billion from sovereign wealth funds, their own governments and public investors to shore up capital. The balance-sheet writedowns also reduce equity, which needs to be replenished. Adding the $35 billion leaves the banks with a $116 billion mountain of losses to climb.
``The smart people are the ones who've identified the problems, put them out there in full transparency, and addressed them by raising more capital,'' said Michael Holland, who oversees more than $4 billion as chairman of Holland & Co. in New York. ``There is still billions of dollars of crap out there that hasn't worked itself through the system. Banks need more capital to work that all out.''
Taking losses on a balance sheet instead of an income statement is acceptable under accounting rules, which make a distinction between so-called trading books and long-term investments. Changes in value on the trading side go straight to revenue. Changes in the value of bonds held for the long haul can be marked down on the equity line of a balance sheet, as long as the declines aren't considered permanent.
Banks that are more willing to acknowledge their balance- sheet writedowns, such as Amsterdam-based ING, say the valuations of assets will be reversed when markets recover. ING, the biggest Dutch financial-services company, said in its first-quarter earnings report last week that the drop in the value of bonds tied to home loans that are held to maturity is irrelevant as long as the underlying mortgages don't default.
Under international accounting standards, ING doesn't have a choice between including the negative valuations in its income statement and keeping them on the balance sheet, said spokeswoman Carolien van der Giessen.
``ING has carefully selected securities with high level of subordination which can absorb substantial further losses on the underlying portfolios before impairments would be triggered,'' Van der Giessen said in an e-mailed statement.
Under the same logic, most of the writedowns on the income statements could be reversed if asset prices recover. While some declines in valuations may reverse, most of the losses are permanent impairments caused by surging defaults on U.S. mortgages, said Janet Tavakoli, author of ``Collateralized Debt Obligations & Structured Finance,'' published in 2004 by John Wiley & Sons Inc.
``Of course we can't tell how much of a bank's portfolio may actually be good stuff that will pay back at maturity,'' Tavakoli said. ``But there's tremendous value loss that's fundamental, not just due to credit market gyrations.''
Keeping those markdowns off income statements just delays the realization of the losses, according to Brad Hintz, a New York- based analyst at Sanford C. Bernstein & Co.
``The banks that have taken advantage of this accounting approach are going to have a price to pay later,'' said Hintz, the third-highest ranked securities analyst in an Institutional Investor magazine survey. ``You don't avoid the price. Those that have taken it all in their income statements will come out with clean balance sheets and move on.''
Ignoring bad debt and postponing inevitable losses was one of the main reasons behind Japan's decade-long economic slump that began in the 1990s, said Boston University law professor Charles Whitehead.
Faced with new capital requirements and a weakened ability to meet them, Japanese banks deferred the recognition of their losses, aided by regulators who refrained from implementing the rules, Whitehead wrote in a 2006 paper published in the Michigan Journal of International Law.
``U.S. regulators may be tempted to go soft on banks too,'' said Whitehead, who teaches securities regulation, in an interview. ``The new capital rules already rely significantly on self-modeling by the banks. So if anything, the risks may be greater in the U.S. today than they were in Japan in the 1990s.''
The new bank-capital regime, known as Basel II, has gone into effect in some European countries and is being implemented in the U.S. and others starting this year. It allows financial institutions to use in-house risk models instead of just relying on external credit-worthiness ratings in calculating their risk- weighted capital requirements.
The largest U.S. securities firms have been under capital requirements shaped by Basel II since 2004.
Even if regulators are soft on banks and brokers when it comes to capital requirements, investors won't be, according to Samuel Hayes, professor emeritus at Harvard Business School in Boston.
The collapse in March of New York-based Bear Stearns Cos., once the fifth-largest U.S. securities firm, shows that fulfilling regulatory capital requirements isn't sufficient to survive, Hayes said. The SEC has said Bear Stearns was ``well-capitalized'' until the moment it faced bankruptcy as clients and creditors lost confidence and withdrew their money.
More Capital Needed
``They have to keep raising capital levels, there's no getting around that fact,'' Hayes said. ``Perception is so important here. If investors or creditors feel a bank doesn't have a strong capital cushion to face further writedowns, that could prove problematic.''
A review of the balance sheets and regulatory filings of more than 50 banks showed that 20 of them chose to keep some subprime- related losses off their income statements. The marks were recorded instead on balance-sheet items labeled ``other comprehensive income'' or ``revaluation reserves.''
Seattle-based Washington Mutual Inc., which has taken $217 million of subprime-related writedowns against profits, kept a bigger amount on the other-comprehensive-income line of its balance sheet, which swung to a $782 million loss in the first quarter. Fortis, the Amsterdam and Brussels-based bank, put 990 million euros of losses in revaluation reserves, in addition to the 3.3 billion euros it reported on its income statement.
Merrill Lynch & Co. in New York, which has booked $31.7 billion from market markdowns in its income statements, is keeping another $5.3 billion of losses on its balance sheet as other comprehensive income. The revaluation reserve reduction of 740 million pounds ($1.4 billion) at London-based Lloyds TSB Group Plc is bigger than the 667 million pounds charged against profit.
Officials at Citigroup, Merrill Lynch, Washington Mutual and Fortis declined to comment. Lloyds TSB spokeswoman Kirsty Clay said none of the assets included in the available-for-sale reserves are considered to be ``permanently impaired.''
The writedowns aren't finished yet. London-based Fitch Ratings Ltd. expects as much as $110 billion in additional losses on subprime securities.
Declines in asset prices have spread beyond subprime though, affecting other mortgage bonds, securitized car and student loans, leveraged lending that backs private equity buyouts and credit derivatives. When all that is included, the IMF estimates that total losses from the U.S. subprime debacle will reach $1 trillion, of which $510 billion will be borne by banks. That means some $130 billion in losses remains to be taken.
$100 Billion Gap
``The $100 billion hole between writedowns and capital raised so far needs to be filled,'' said Michael Mayo, a New York-based analyst who tracks the financial-services industry at Deutsche Bank AG. ``If you don't fill that hole, with the 20-to-1 leverage existing on average out there, you need to de-lever $2 trillion of assets. You can do that or raise more capital.''
One way to increase capital has been to halt or slow down the pace of share buybacks. Companies often repurchase stock to offset dilution that occurs when shares are distributed to employees as part of their compensation.
Citigroup, the biggest U.S. bank by assets, JPMorgan Chase & Co., the third-largest bank, and Morgan Stanley, the No. 2 U.S. securities firm by market value, have suspended stock-buyback programs. All the companies are based in New York.
Outstanding stock increased 7 percent at Citigroup, 4.3 percent at Morgan Stanley, and 2 percent at JPMorgan during the past two quarters, according to regulatory filings. New York-based Lehman Brothers Holdings Inc., the fourth-biggest securities firm, has done the same without announcing a suspension of its repurchase program. Lehman shares in circulation rose 4.3 percent.
The first place banks and brokers went looking for capital was in the deep pockets of the Asian and Middle Eastern sovereign wealth funds, flush with cash from rising commodity prices. Then they reached out to public investors, who were offered hybrid securities with characteristics of both equity and debt, limiting their dilutive impact on common shares.
The sovereign funds, which bought shares at 20 percent above today's market prices, are probably not coming back soon, said Jeffrey Rosenberg, a New York-based managing director at Bank of America Corp., who was among the first analysts to warn clients about the mortgage crisis.
`It's Like Shampooing'
Banks can't keep selling hybrid bonds because ratings firms place limits on how much of their capital can be tied up in such securities. Rosenberg said the next round of equity-strengthening probably will be in the form of common stock.
``It's like shampooing: lather, rinse, repeat -- write down, raise capital, repeat,'' Rosenberg said. ``How long can they keep doing it? Shareholders are in for a long ride.''
The following table lists 20 banks that have kept some of their writedowns on their balance sheets, along with the losses the banks have incurred in their income statements. All figures are in U.S. dollars, converted at the May 17 exchange rate if originally disclosed in another currency.
Firm Writedown & Hidden
Credit Loss Writedowns Total
Citigroup 40.9 2 42.9
Merrill Lynch 31.7 5.3 37
HSBC 18.3 1.3 19.5
IKB Deutsche 9 7 16
Washington Mutual 8.3 0.8 9.1
HBOS 5.9 1 6.9
Bayerische Landesbank 3.6 3.1 6.7
Fortis 5.1 1.5 6.6
ING 0.4 5.6 6
WestLB 3.2 1.6 4.8
LB Baden-Wuerttemberg 2 2 4
Natixis 3.2 0.2 3.4
Lloyds TSB 1.3 1.5 2.8
HSH Nordbank 2.3 0.2 2.5
Commerzbank 1.3 0.6 1.9
Alliance & Leicester 0.7 0.7 1.4
Sovereign Bancorp 0.3 0.7 0.9
Norddeutsche LB 0.6 0.3 0.9
HVB Group 0.6 0.1 0.7
Aozora Bank 0.5 0.1 0.6
____ _____ _____
TOTALS* 139 35.4 174.4
* Totals reflect figures before rounding. Some company names have
been abbreviated for space.