Thursday, February 26, 2009

Banks’ Books Finally Start Seeping Some Truth

By Jonathan Weil (Bloomberg)

Investors looking at the assets on a bank’s balance sheet simply want a good estimate of how much they are worth. It’s not easy getting a straight answer.

Consider yesterday’s disclosures by Regions Financial Corp. in the annual report it filed with securities regulators. For purposes of its balance sheet, Regions said it finished last year with $94.9 billion of loans that it was holding as investments. In a footnote, however, it said the “fair value” of those same loans was $79.9 billion, or $15 billion less.

It’s a similar story at Huntington Bancshares Inc. The balance-sheet value for its loan portfolio was $40.2 billion as of Dec. 31. Yet Huntington said the fair value of those loans was $33.9 billion. The bank’s annual report said the lower figure “reflected discounts that Huntington believed are consistent with transactions occurring in the market place.”

Put another way, “there’s a lot more skepticism out there about the value of these assets,” Huntington’s chief financial officer, Donald Kimble, told me. He’ll get no argument there.

The reason why the balance-sheet amounts were so much higher is that the accounting rules don’t require lenders to mark all their loans to market values on a quarterly basis. Instead, loans typically are carried on the balance sheet at historical cost and get written down only to reflect credit losses that the lenders’ executives have deemed probable.

Once a year, though, companies are required to include footnotes in their audited financial statements that show the differences between the fair values and carrying amounts for all their financial instruments, including loans. The Financial Accounting Standards Board has proposed requiring these disclosures on a quarterly basis, starting as soon as next month. That change in the rules, known as Financial Accounting Standard No. 107, is long overdue.

Fair-Value Push

The debate over whether loans should be marked to market values on the balance sheet -- just like derivatives and many other financial instruments -- has raged for years. Since 2005, the FASB and its London-based counterpart, the International Accounting Standards Board, have said they eventually want all financial instruments, including loans, to be measured at fair value, with gains and losses recognized on a quarterly basis.

U.S. banking regulators, echoing many bankers’ views, oppose expanding fair-value accounting further. They say it would be too difficult to implement for hard-to-value items and result in too much volatility in the numbers on banks’ financial statements.

Less Than Zero

In the marketplace, this argument is largely moot. The stock prices of Regions and Huntington, for example, already trade at huge discounts to the net asset values the banks claim on their books. The accounting rules say lenders can choose to record all their loans at fair value, if they want to. Like most banks, Regions and Huntington have chosen not to.

Regions’ stock-market value is now $2.6 billion, or 19 percent of the bank’s $13.5 billion of common shareholder equity. Take away the $15 billion of excess value on its loan portfolio, and the company’s common equity would be less than zero. A spokesman for the Birmingham, Alabama-based bank, Tim Deighton, declined to comment.

Huntington’s market capitalization is $608 million, a smidgeon of its $5.3 billion book value. The Columbus, Ohio- based bank also would have negative common equity were it not for the rules that say it doesn’t have to mark all loans at fair value.

The infuriating part about these disclosures is that the banks knew all last year that the market values of their loan portfolios were plunging. And yet they weren’t required to disclose the numbers so investors could see for themselves. Even so, the market figured out on its own not to trust the banks’ balance sheets.

Crazy Math

The fair values have implications for the banks’ capital, too. The purpose of a balance sheet is to provide a snapshot of a company’s financial position at a given moment in time. And the whole point of having a capital cushion is to help a financial institution absorb losses. If a bank’s assets in real life aren’t worth what the balance sheet says, its capital is illusory, no matter what crazy math the government uses to prettify banks’ official capital measures.

Think about it: If you were applying for a loan today, which figure do you think the lender would use to appraise your collateral? The price it would fetch now in an orderly sale? Or the value that you hope to realize someday when market prices supposedly get better? This is a no-brainer.

While good disclosure does not cure bad accounting, it does provide valuable information to investors willing to look for it. And one thing’s for certain: These FAS 107 disclosures are bound to become some of this year’s hottest, must-read footnotes.

For all the banks’ complaints about fair-value accounting, the truth is that investors can’t and don’t get enough of it. The shame is that they had to wait so long for this wee, little glimpse of transparency. Getting a bank to tell investors how much its assets are worth should never be this hard again.

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