What is ‘classified’?
When a bank is being examined, assets can be deemed as being inadequately protected from principal loss. Assets can be classified in one of three ways:
- Substandard: expectation is that you will get anything less than 100 cents on the dollar at maturity(par).
- Doubtful: this is a substandard asset with more uncertainty about its ability to pay.
- Loss: considered uncollectable and requires a full write off.
What is the impact of ‘classified’ assets?
The “classified” designation is being applied to mortgage backed securities (MBS) based on policy guidance from the O.C.C. According to the O.C.C. the main measurement of an assets quality is its rating.
The problem with using the rating as the main determination of credit quality, is that all ratings are based on the presumption that bonds will mature at 100 cents on the dollar(par). This rating metric is a good measure of an assets impact on the bank, only if the purchase price is par. For any security purchased at less than par, the rating understates the real credit quality.
What If an assets is purchased for less than par, say 50 cents on the dollar. Is appropriate to classify that asset as substandard( expectation that you will receive anything less than 100 cents on the dollar? The current regulatory environment is discouraging banks and thrifts from buying good assets at discount prices because the “substandard” designation of any asset forces the bank to add up all of their substandard assets and compare them to their regulatory capital. This process can leave banks in the position of having a portfolio of bonds that are performing, and a regulatory metric that want to shut them down for being imprudent.
The clarifications of existing definitions by the leadership of the Regulatory and Accounting community would help unclog the credit markets, stop the de-capitalization of the banks and provide a boost to the economy that will require zero taxpayer dollars and realistically describe the financial condition of the banks.
