It Ain't Over til the Weight-challenged Lady Sings

In a remarkably candid talk yesterday, Ed Clark, CEO of TD Bank said (somewhat disingenuously) that while the banking sector in Canada is quite healthy, the economy (truthfully) is in terrible shape, noting that

Just because our banks didn't collapse, Canadians are running around saying, wow, aren't we terrific. But the reality is this economy is going to get whacked just as hard as economies around the world.

In other words we are far from being out of this yet. And if one reads between the lines, Clark's talk indicates that the banks face troubled times too, first because they can no longer flog off sketchy debt as securitized bonds like they once did and second because troubles in the U.S. will slow the flow of funds into Canada that banks and their customers rely on. In other words, our banks will have to act like banks. Even given a massive injection of $125 billion and much softer rules on fair value accounting, we will see how profitable and stable they are then.

How Stable are Canadian Banks?

With Canadian banks being praised throughout the world for their stability and soundness in the face of a worldwide financial crisis, it might seem churlish to raise pointed questions about their health. Yet there are a few questions that I think at least need to be considered.

The question of the health of the banking sector first arose for me with the Harper government's Extraordinary Financing Framework introduced in the January budget. This initiative has earmarked $200-billion largely for the purchase of bank assets. This is an astronomical sum even if, as the government claims, the assets purchased will be performing assets and that there will be no cost (it is thus not a fiscal matter) and perhaps even a profit.

The question this raises for me is why, if the banks are so healthy, do they need this amount of backing, particularly at a time when they do not seem particularly anxious to lend? Could it be that their balance sheets include assets whose value is at risk or uncertain? And is the government set to purchase (or have they already purchased) assets that might be a good deal less stellar than we have been led to believe?

In his column today in the Globe and Mail, Jim Stanford, economist for the CAW, strongly suggested that balance sheets are less than they seem, stating:

Believe me, if Canada's banks were truly stable, Ottawa wouldn't have pumped $200-billion into the system.

In another column in today's Globe, Fabrice Taylor reminded readers that whatever press the banks are getting, markets aren't buying it, as reflected in share prices. So what is on those balance sheets? And surely more important, how are they being valued?

It turns out that last October the accounting rules for banks were substantially altered by the Canada Accounting Standards Board. These changes allowed banks to reclassify many investments to which fair value or mark-to-market accounting rules had applied. And these changes were backdated to July 1, 2008, to allow their effects to be reflected in the fourth quarter earnings which now look so favorable.

What does this mean? It means that assets for which there is little or no market (many of which have been termed "toxic assets") can now be re-evaluated or removed from balance sheets, making the banks appear healthier than they really are. As Hugh Anderson of the Financial Post noted last fall,

It's quite possible that such reclassifications will enable banks to report substantial net income boosts from reversing previous writedowns. Simultaneously, assets off the balance sheets will grow.

So I have two questions. First, to what extent are these changes reflected in the banks surprisingly rosy outlook? And second, what is our government buying with its $200-billion?

Extraordinary Financing Framework -- Bank Bailout the Canadian Way

I have had a chance to look a little further at the Harper government's initiative to ease credit markets and it is not reassuring.

Clearly restoration of credit markets will be a prerequisite for any recovery. But there are three aspects of this that I find deeply troubling.

The first is that Finance Minister Flaherty passed this off in his budget as a fiscally neutral measure, suggesting that

The EFF is expected to generate a positive return for the Government overall and therefore has no expected fiscal cost. The Government will undertake additional borrowing to make the EFF possible; this will increase the amount of Government of Canada debt sold to financial markets (Annex 4). As this debt will be matched with sound assets, the EFF will not lead to any increase in the federal debt (accumulated deficit).

In a scathing entry on her wonderfully irreverent blog, Sen. Elaine McCoy , an independent (to say the least) Tory senator from Alberta, describes how

[t]he government has blithely asserted that it's "expected to generate a positive return for the Government overall and therefore has no expected fiscal cost." I beg your pardon? A whopping $65 billion will be borrowed this year to finance Extraordinary Financing. If, as the the budget documents state, it will be offset by interest-bearing financial assets and so cost nothing, then why buy the assets from the banks? Surely there'll be a cost in the short term, notwithstanding repayment many years later.

In other words, while the government may recover some or even most of the money eventually, it will take time and there will be costs, unanticipated and even substantial. This is therefore a fiscal issue and it should be presented, and debated, as such.

The second is the glaring moral hazard of socializing risks while profits remain private. The bulk of this program involves the purchase of pooled mortgages. Sound familiar? Even the Americans have realized the necessity of an equity position in banks that are assisted on this scale. And if these are fully performing, risk free assets, producing a reliable stream of income, why would the banks want to sell them? And how have they been valued?

Finally, given the unprecedented scope (and risk) of this initiative, why has there been so very little public debate? It is no surprise that the government and the banks have been silent. As the Financial Post noted yesterday:

Addressing this will require new extraordinary short term interventions to restore confidence as well as structural reforms to make it easier for companies to raise money through credit markets, bankers say.

Yet executives are anxious not to strike an alarmist tone or be seen to criticise Ottawa, lest they provoke a political confrontation or rattle investor confidence.

Bill Downe, chief executive of BMO, acknowledged that in order to bring about a fresh round of action to stimulate markets and the economy, "the government of Canada will need to be pressured to do it".

But he said there was a risk a process like this would conjure up the kind of apocalyptic imagery that was invoked in the United States to get a $800-billion fiscal stimulus and $700-billion bank bail out package passed by Capitol Hill.

Like it or not, putting an amount equal to a seventh of our GDP at risk on this conjures up apocalyptic imagery. So where are the other party leaders and finance critics? And why aren't the tough (and obvious) questions being asked? Surely the other parties would be anxious to hold the minister to account both for the outcome of this gamble and for the specific "investment" decisions that are made, particularly in the context of continuing economic pain and a minority parliament. Perhaps the Liberals and/or NDP have plans for this, but I have seen no indication of it.

Our political leaders have not given this the attention it deserves. We can only hope that Senator McCoy continues to pursue this issue.