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Sunday, Nov 8, 2009
Speaking as an accountant working on his CPA, let me offer a few points relevant to the discussion:
1.) "Negative Amortization" would not be reported as earnings, because "negative amortization" is a phrase that describes a trend in a loan's balance. Banks would report the interest charged on a loan as earnings, but they've always done that! This isn't shocking. Banks report interest charged on loans as income, and payments on loans as cashflow.
2.) Yes, as interest rates rise, and the interest charged on ARMs increases, the income banks generate from that interest would rise. However, any even remotely competent analyst would have to also evaluate their allowance for doubtful accounts. (That's the amount companies build into their budget for losses like loans that will never be repaid and other bills that they expect won't get paid) The Allowance for Doubtful Accounts would be reviewed monthly, as a matter of course, and if it was viewed as insufficient, then the company would have to increase it, which is an incurred expense. In other words, as these ARMs become more risky, the company would be forced to adjust their own projections of risk, which in turn would increase expenses tied to bad debt. More income, yes, but more expenses as well. Result: Net Income shouldn't change much. (but see point #3, for why it will change some)
3.) Banks make a certain number of loans every year. As rates rise, the new loans earn more interest, but the bank makes fewer loans, so there's some equilibruim there. However, ARMs would also revalue, earning more interest, creating the same effect as if they had made one new loans for each ARM while retiring the under-performing old loans. It's this revaluing of the interest rate that probably has the bankers excited. But there's an equilibruim here as well: as rates rise, outstanding ARMs become higher risk, with a higher amount of Bad Debt expensed in anticipation of defaults. The reaction to these increased expenses will be exactly what you think it would be:
a.) truly high risk mortgages would default, and the banks would have to eat the expenses of a lost debt.
b.) moderately risky mortages would be solicited and offered the chance to refinance into a fixed-rate loan by the bank; risk-averse banks would prefer to stabilize these loans, and customers would be ready for some relief.
c.) low-risk mortgages would be refinanced by the borrower if at all possible, but kept as ARMs by the lender if at all possible.
4.) Yes, higher rates mean ARMs generate more interest, which generates more earnings for the company. Higher rates mean more risk, which means more bad debt expense for the company, but let's take the pessimistic, "Enron economics" view, and say that the bank doesn't follow accounting rules and doesn't adjust their anticipated bad debt. This is one of the benefits to having not only an income statement, but a cash-flow statement. Interest on a loan is income, but it isn't cash income; mortgage payments are cash, but unpaid interest isn't. Likewise, increased expenses in anticipation of bad debt isn't a cash expense; like depreciation, bad debt expense doesn't represent cash that the company has to pay out then & there. (the cash was already out the door when the loan was made) However, when a lender defaults on their loan, and stops making payments, that DOES affect cash.
The Cash Flow statement is looked at a lot more closely now than in the Enron days. If a company reports substantial gains in income (as would be the case here), but the weight of those gains are, in fact, not cash-based, that's a warning sign for investors. That was the big red flag for Enron: the overwhelming majority of its income was not backed by cash but by non-cash income.
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