William Isaac, former chairman of the Federal Deposit Insurance Corp. (FDIC), says that a bank accounting rule is responsible for much of the $500-billion-and-counting in losses suffered by major financial institutions in the wake of the subprime mortgage meltdown.
The fair value accounting standard adopted in 1993 is "at the root of a lot of the problems," Isaac told Moneynews.com in an exclusive interview.
The standard requires banks to value their security holdings at current, fair-market value.
Clearly, the fair-market value of mortgage-related securities has dropped off a cliff, forcing much of the write-downs and losses that feed investor doubt.
"The fair value standard is highly pro-cyclical," Isaac points out.
"When things are going great, it puts more gasoline on the fire. When things are going poorly, it forces banks to take excessive losses, as they mark holdings to market in a climate where there is no market."
For instance, it's possible that many of the banks' asset-backed securities will ultimately rebound after the financial system stabilizes.
"My guess is that banks will have a significant recovery once we get through this period, and the markets reestablish themselves," Isaac says.
"I think they've been taking excessive write-downs. I do believe that the worst of the subprime losses are behind us."
As for loans and securities unrelated to the subprime mess, their fate is tied much more to the performance of the economy, Isaac says.
"If you predict a deep and long recession, my guess is that there will be a lot more losses," he says.
"If you predict this will be a mild and brief recession, or just a slowdown with no recession, then I don't see how you can predict large losses beyond what we've already had."
Whatever happens next, Isaac does expect more banks to go under.
"I think bank failures will certainly go up, because we have difficulties in the economy, most importantly real estate," he says.
"In addition, bank failures have been almost non-existent in the last seven to eight years. Failures have been at much lower levels than we're used to having in this country."
But Isaac isn't looking for any major institution to go under.
"The chairman of the FDIC [Sheila Bair] recently said she didn't envision any more failures of banks that are the size of Indymac or larger," he says.
On the issue of government-sponsored mortgage agencies Fannie Mae and Freddie Mac, Isaac says their future depends on whether they need help from the Treasury.
"If they do require government assistance, there is little doubt in my mind that they will be owned by the government once more," he says. Fannie went public in 1968 and Freddie in 1989.
If the two companies don't need government aid, they can remain in the private sector, Isaac maintains.
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