08/13/2009 05:12 am ET | Updated May 25, 2011

Banks Should Face the Truth

The Treasury Department continues to work out the details of its mammoth stimulus plan combating the financial crisis. Since its onset, the government has become the nation's biggest mortgage lender and taken equity stakes in nearly 600 banks, among other endeavors.

But now the stimulus strategy itself is becoming the center of debate. Is it possible that all that money spent is at best doing nothing more than delaying the inevitable, and at worst exacerbating the very problem it was meant to solve?

As new money is being handed to financial institutions all over the country, banks refrain from recognizing the true value of their loan books. Those loans are carried at high valuations that are no longer realistic.

It is true that the value of securitized products, those toxic securities backed by pools of mortgages, have largely been written down, totaling billions of dollars of losses for the banks. GAAP rules required those to be marked down to market prices.

But banks are not required to write down the trillions of dollars of loans they still carry on their balance sheets. Accounting rules let them classify those loans as "held to maturity," thus pretending they are not impaired. Most of those loans are still held at their original face values (which far exceeds their true value), and will remain so unless the borrower defaults (or the loan matures).

The assumption inherent in that accounting treatment is that prices of residential and commercial real estate will soon recover to their bubble-era price levels. You have to ask yourself if you believe that premise. No bubble in history recovered its peak prices. Will this one be the first?

Anyone who bought a house in California in the last few years most likely owes on it substantially more than the house is worth. Recall that California home prices are down an average of 57% from their peak, and in April the average foreclosed home in California had $412,000 in debt but was worth only $235,000 (California comprises 43% of the country's bad mortgage loans, measured in dollar value).

Therefore, many more are likely to default on their loans, especially if they lose their job or experience the shock of a sharply higher loan payment when their ARM loan adjusts. After all, so many people are defaulting that even the stigma has faded.

Unfortunately, this lugubrious scenario is taking place all over the country. As the economy loses jobs and housing inventories exceed demand, real estate prices are still declining, and loan values are declining with them. During the first five months of 2009, Wells Fargo, to take one prominent example, had defaults exceeding those of the entire year of 2008, which itself was a particularly grim one.

Yet until the moment of foreclosure the banks can carry these loans on their books at face value, record no loss and pretend things are still fine. The TARP cash is simply veiling the real picture of banks' financial situation, and the vast damage they sustained in falling loan values.

So government is helping banks avoid reality. But government is not the only culprit. Under GAAP, "held to maturity" does not sanction forbearance when impairment is palpably apparent. So the accountants who tolerate this conduct are also aiding and abetting this sordid deception.

The truth is never so bad that we cannot face it. Unless the banks mark down the value of their loans, they will simply be choking slowly, taking thousands of small losses for years to come, and spiraling down the cycle of eroding confidence and elusive growth.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at