First, a little review of Accounting 101 — If you subtract total liabilities from total assets, you get net worth or capital.  If you sustain a loss on the sale of an asset, you decrease net income by the amount of the loss.  If you have no net income, you must decrease net worth or capital by the amount of the loss.  For banks, if you expect a loss on a loan repayment, you must decrease net income by the amount of the expected loss.  If you have no net income, you must decrease net worth or capital by that amount.  Thus, when banks are running short of capital, they don’t want to recognize any loan losses, because they have no income and must decrease their net worth, making the capital shortage worse.

Years ago in Texas, I was appointed by the Governor to serve on the four-member Texas State Depository Board with the State Treasurer, State Controller, and State Banking Commissioner.  This was during the infamous “Savings and Loan Crisis.”  As those financial institutions had no income, they were forced to decrease their capital or net worth every time they had an expected loss on some loan, that would not be repaid in full.  Not surprisingly, they were reluctant to admit any loan was bad loan.  They were motivated to extend any loan that came due and pretend they would eventually receive full payment, i.e., “extend & pretend.”

Of course, as regulators, we were always suspicious of any financial statements, as they may not be properly recognizing loan losses.  In addition, the outside auditors checked for evidence of this accounting practice.  Eventually, the crisis passed . . . after taxpayers lost about $300 billion.

I think we are seeing the same thing again, only on a vaster scale.  The recent Long-Term Refinancing Operation (LTRO) of the ECB essentially tells European banks that no loans are due for three years and that no losses should be expected at this time.  Quietly, over the weekend, the Chinese government told their banks to rollover or renew all municipal bonds/loans for the next three years and pretend those bonds/loans contain no losses.

“Extend & Pretend” was an accounting trick used by Texas financial institutions.  Then, a central bank practiced it.  Now, a major government is doing it.

This is more than just “kicking the can down the road,” because we don’t want to deal with a problem now.  It is buying time during a crisis.  Monetary policy is being used to buy enough time for fiscal policy to do whatever needs to be done, i.e., decrease entitlements and increase taxes.

Fortunately, it also buys time for the bulls to run . . .