Flashback: NYT on Zions Bank 2007

Floyd Norris described certain activities at Zions in 2007 in a piece titled Now You See Those Securities, Now You Don’t dated January 4, 2008 as follows(I added bold highlights):

“One end-of-year incident in 2007 illustrates two absurdities: the techniques that banks use to make themselves appear healthier than they really are, and the determination of some portfolio managers to get dubious-looking securities out of their portfolios by the end of the year.

Perhaps, just perhaps, it also shows that some investors have overreacted to the credit squeeze of 2007, and that there really are buying opportunities around.

The bank in question is Zions Bancorporation, which operates in 10 Western states from a base in Utah. On the afternoon of Dec. 31, it notified the Securities and Exchange Commission that it had been forced to bail out an off-balance-sheet affiliate by purchasing $840 million of securities from it. That move produced an immediate loss of $33 million, since Zions paid more than the securities were worth.

Zions added that the affiliate, called Lockhart Funding, still owns $2.1 billion of securities, which it estimates are worth $22 million less than book value. Under the current accounting rules, it doesn’t have to take that loss. At least not yet.

Let’s first look at Lockhart and why it exists. In a world with sensible bank regulations, and accounting that reflected economic reality, it would never have been created.

Lockhart, which was set up by Zions in 2000, provides the cash for Zions to make small business loans. Zions turns those loans into securities and sells the securities to Lockhart, which then borrows money in the commercial paper market. Lockhart also buys securities not put together by Zions.

Why bother? First, the loans disappear from Zions’ books. Second, the bank regulators accept that fiction when they calculate how much capital Zions needs to have. As Clark B. Hinckley, a Zions senior vice president, told me, “It enabled us to essentially originate these loans and not have to keep tangible capital behind them”…as 2007 ended Lockhart found it impossible to sell enough asset-backed commercial paper, even though Zions itself has purchased $710 million of Lockhart paper. Since Lockhart could not sell the paper, Zions had to buy the assets.

And that brings us to the evidence of investor absurdity. An investor buying Lockhart’s asset-backed commercial paper knew that Lockhart’s assets backed the commercial paper. If that was not enough, the liquidity agreement means Zions effectively stands behind the paper.

Mr. Hinckley reports that these days Zions can, and does, borrow in the unsecured commercial paper market, and at lower rates than Lockhart was offering to pay. That seems odd. Why would anyone prefer lower-yielding paper with less security? If I’m willing to lend you money without collateral, why would I refuse to lend if the loan was backed by both collateral and your promise to repay, and had a higher interest rate?

The answer is that asset-backed commercial paper has gotten a bad name, as unwary investors learned that the assets in question sometimes were funny securities backed by subprime mortgages. So money managers, whose year-end portfolios will be subject to scrutiny by customers, fled from such paper.”

Being able to originate loans with ZERO tangible capital means you can make essentially an infinite amount of loans…until you run out of suppliers of actual tangible capital.  Which leads us to the situation that the global financial system is in now.


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