Friday, October 16, 2009

Mark-to-Make-Believe Turns Junk Loans to Gold: Jonathan Weil

Posted on Bloomberg by Jonathan Weil:

Here’s the best tip I ever got on how to read a company’s financial statements: Read the footnotes first, because that’s usually where the bodies are buried.

The main caveat is that the notes might not tell the whole truth either. That’s especially the case with banks.

A big improvement to the accounting rules this year is that lenders now must disclose their loans’ fair-market values every quarter, rather than just once a year. When a bank says its loans are worth much less than their balance-sheet amount, that means a large portion of its capital cushion may be illusory.

Such gaps arise because loans don’t have to be carried on the balance sheet at fair value, giving lenders lots of wiggle room to play with.

One irksome problem: Sometimes the numbers in the fair- value footnotes look more like mark-to-make-believe than mark- to-market, particularly when weak banks say their loan values are rock-hard.

I’ll get to some of the big-name banks such as Citigroup Inc. shortly. First, consider an Illinois lender with $3.6 billion of assets on its books called Midwest Banc Holdings Inc.

Midwest said its loans had a fair value of $2.53 billion as of June 30, which was about $35 million more than their carrying amount on the bank’s balance sheet. There are reasons to be skeptical, though.

Fair value is supposed to represent the price at which an asset would change hands in an orderly, arm’s-length transaction. Judging by Midwest’s stock price, it’s hard to believe those loans are worth quite so much.

Lack of Trust

Midwest’s shares trade for 62 cents, giving the company a $17 million stock-market value. That’s less than 20 percent of its reported book value, or common shareholder equity, which tells you the market doesn’t trust the bank’s asset values. The stock hasn’t traded for more than a buck since June 22.

Meanwhile, Midwest missed its last two scheduled dividend payments under the Treasury Department’s Troubled Asset Relief Program. In August, it said it had not made a required $5 million principal payment to one of its lenders. If its assets are so valuable, management should buy the company for themselves.

Midwest is one of 33 banks that skipped paying TARP dividends to the U.S. bailout program in August, according to SNL Financial, a bank-research firm. It’s not the only one of them with funny-looking fair-value numbers.

Focusing on Auditors

Seacoast Banking Corp., based in Stuart, Florida, for example, said its loans were worth slightly more than the $1.5 billion on its balance sheet, as of June 30. First Bancorp, based in Puerto Rico, said the fair value of its loans exceeded their $12.7 billion carrying value. Both stocks trade at steep discounts to book value.

One reason to care about these lenders is that their outside auditors also are responsible for checking the numbers at the country’s largest, too-big-to-fail banks.

Midwest is audited by PricewaterhouseCoopers LLP, as is First Bancorp. Seacoast’s auditor is KPMG LLP. The accounting firms are required to conduct quarterly reviews of the companies’ financial statements, in addition to their full-blown yearly audits. Let’s hope they’re scrubbing the books carefully.

Citigroup, which is audited by KPMG, estimated its loans had a fair value of $601.3 billion as of June 30, just 0.2 percent less than their carrying amount. By comparison, the fair-value shortfall was 7.3 percent at Bank of America Corp., 4.3 percent at Wells Fargo & Co., and 2.5 percent at JPMorgan Chase & Co. PwC audits Bank of America and JPMorgan, while KPMG audits Wells.

Citigroup’s Loan

The banks all say their estimates were reasonable, of course. For a company that needed a government bailout, though, Citigroup’s loan values look amazingly solid, given the fair- value gaps at those other lenders.

Elsewhere, BB&T Corp., a PwC audit client based in Winston- Salem, North Carolina, said its loans were worth 1.5 percent more than their $94.3 billion carrying value as of June 30. Commerce Bancshares Inc., a KPMG client based in Kansas City, Missouri, said its loans’ fair value was 2.3 percent more than the $11.1 billion on its books.

BB&T and Commerce showed the highest such percentages among companies in the KBW Bank Index. Were those values legit? Beats me. All but seven of the 24 banks in the index said their loans’ fair values were less than what their balance sheets showed. My guess is some banks may be interpreting the Financial Accounting Standards Board’s rules differently than others.

Interpreting the Rules

One chief executive who has made this same point is Dowd Ritter of Birmingham, Alabama-based Regions Financial Corp. To be sure, he has reason to be defensive.

Regions, an audit client of Ernst & Young LLP, estimated the loans on its books as of June 30 were worth 25 percent less than their $90.9 billion carrying value. That was no surprise, though. Its shares trade for less than half the company’s book value. BB&T and Commerce, for instance, trade for more than book.

“We and our accountants interpreted that in the strictest manner,” Ritter said at a Sept. 15 investor conference, referring to the FASB fair-value rules. “I don’t think we’ll hear anything probably from the SEC. But I’d be surprised if some other banks don’t, or else we and our accountants missed something.”

Memo to Securities and Exchange Commission Chairman Mary Schapiro: Did you catch that?

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