It makes perfect sense for banks to reduce principal on loans valued at less than par on their books, and to refuse to do so for other loans.

Let’s suppose we have a loan whose direct value will increase if we offer to reduce the principal owed. That’s not a rare situation. As Salmon writes, “a sensibly modified mortgage is likely to be much more profitable for a bank than forcing a homeowner into a short sale or foreclosure and trying to sell off the home in the current market.” Under these circumstances, one effect of a principal reduction is to increase the expected present value of the cash flows associated with the loan. Ka-ching!

However, there are two offsetting effects. The most widely discussed is moral hazard. Banks worry that borrowers for whom a principal reduction would impair rather than enhance the economic value of the loan will find ways of getting reductions too, by strategic mimicry or due to changing norms and public pressure. That helps to explain why (Salmon again), “principal reductions were being done on many mortgages which were actually current and in good standing, rather than on mortgages which were careening towards foreclosure.” Keeping principal modifications something that is offered only to “our best customers” keeps the practice voluntary. It preserves banks’ freedom to discriminate between profit-making and loss-making modifications.

The second offsetting effect of an otherwise desirable principal reduction is a matter of accounting. If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity.

Of course this is a matter of mere accounting. Whether or not a bank takes a capital hit has no bearing on whether a principal reduction will increase the realizable cash-flow value of the loan.

But accounting is destiny. The economic value of a bank franchise, both to shareholders and managers, is intimately wound up with its accounting position. A bank whose books are healthy may distribute cash to shareholders and managers, while a bank whose capital position has deteriorated will find itself constrained. A well-capitalized bank is free to take on lucrative, speculative new business, while a troubled bank must remain boringly and unprofitably vanilla. The option to distribute and the option to speculate have extraordinary economic value to bank shareholders and managers.

You cannot understand banking at all unless you understand that banks must be valued as portfolios of options. You can value some businesses by estimating the present value of cash flows from firm assets, and then subtracting liabilities. But banks are more complicated than that. The value of a bank is a ******** not only of expected cash flows, but of the shape of the probability distribution of those cash flows, and of the diverse arrangements that determine how different cash flow realizations will be split among a bank’s many stakeholders. A hit to a bank’s capital position narrows the distribution of future cash flows (by attracting regulatory scrutiny) and diminishes the degree to which cash flows can be appropriated by shareholders and managers rather than other parties. To say that a bank should only be concerned with maximizing the long-horizon value of its loan book is like arguing that the holder of a call option ought not object if her contract is rewritten at a higher strike price, because, after all, changing the strike price doesn’t reduce the economic value of the underlying. A bank’s accounting situation and regulatory environment define the terms of the options that are the main source of value for big-bank shareholders. Accounting changes imply real transfers of wealth.

Now the value of a bank to shareholders and managers is very different from the social value of a bank. If we aggregate the interests of all of a banks’ claimants — shareholders, managers, bondholders, depositors, counterparties, guarantors — there is far less optionality. From a “social perspective”, what we want banks to do is to lend into enterprises whose interest payments reflect real value generation and then maximize the expected value of those cash flows, irrespective of who gets what among bank claimants. If we were serious about that, we would force banks to write down their loan portfolios aggressively, so that going forward shareholders and managers have nothing to lose by offering principal modifications when doing so would maximize the cash flow value of their loans. But if we did force banks to write their loan portfolios down aggressively, the shareholders and managers with nothing to lose would be different people than the current shareholders and managers of large banks, via some resolution process or restructuring. Which is much of why we didn’t do that, when we had the chance, and why bank mismanagement of past loans continues to exert a drag on the real economy as we try and fail to go forward. This very minute, there are homeowners who are nervously hoarding cash, who are leaving factories idle and neighbors unemployed, in order to maximize the option value of the bank franchise to incumbent shareholders, managers, and uninsured creditors.

Iniciado por Marai

Waldmann (Interfluidity) explica fenomenal porqué cuesta tanto salir de una crisis de deuda y porqué, aunque perdonar parte de la deuda tiene mucho sentido, los bancos se resisten a ello:
Accounting is destiny

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But accounting is destiny. The economic value of a bank franchise, both to shareholders and managers, is intimately wound up with its accounting position. A bank whose books are healthy may distribute cash to shareholders and managers, while a bank whose capital position has deteriorated will find itself constrained. A well-capitalized bank is free to take on lucrative, speculative new business, while a troubled bank must remain boringly and unprofitably vanilla. The option to distribute and the option to speculate have extraordinary economic value to bank shareholders and managers.

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