Monday, March 15, 2010

Banks Face a Mark-to-Market Challenge

Original posted in the Wall Street Journal by David Reilly:

The war over mark-to-market accounting is about to get hot, again. In coming weeks, the Financial Accounting Standards Board is likely to propose that banks expand their use of market values for financial assets such as loans, according to people familiar with the matter. That departs from current practices in which banks hold loans at their original cost and create a reserve based on their own view of potential losses.

The result, if the proposal flies, would be big changes to bank balance sheets, the shape of income statements and some of the metrics investors use to evaluate financial institutions.

At the four biggest banks—J.P. Morgan Chase, Bank of America, Citigroup and Wells Fargo—$2.8 trillion of loans could be affected, or about 40% of their total assets. Smaller banks would see a bigger impact because more of their assets are loans that aren't marked to market prices.

Don't expect changes without a fight from banks. Yet the battle could provide a headwind for recently high-flying bank stocks. After all, markets cheered last spring when Congress browbeat FASB into watering down mark-to-market rules.

Banks generally loathe mark-to-market rules, which rely on what they feel are too-often irrational market prices. The market value of some loans did fall excessively in the depths of the crisis. And many bankers, and bank regulators, believe the rules worsened the financial crisis.

But that argument ignores the fact that banks clearly didn't pay enough heed of market values in the run-up to the crisis, and their own estimates of potential losses were woefully inadequate.

This left bank balance sheets, and investors, unprepared for the credit crunch. If banks had focused on market values as well as internal models, many may have acted sooner to raise equity.

If anything, FASB's proposals may not go far enough. Many swings in the market value of loans, for example, still likely won't hit net profit. Even so, the potential changes are far-reaching.

First, under the proposals, banks would show loans on their balance sheets at historical cost, and then adjust them for both loan-loss reserves and market values. That would allow investors to see the difference between what management has provisioned against losses and what investors think the loans are actually worth.

Second, banks' financial holdings would be divided between those they trade and those they hold. Changes in the value of tradable assets would hit profit as today. Non-trading assets would be also be marked to market, but those changes would go to a portion of shareholders' equity called other comprehensive income.

Third, income statements would show more than just net profit. After that line would be added an "other-comprehensive-income" category reflecting changes in the market value of loans and securities. That would be added to net income to create a new bottom-line figure called comprehensive income. Earnings per share would still be based on net profit.

While the FASB will likely come under fire for these approaches, it may have found an ally last week in House Financial Services Chairman Barney Frank. In a letter to the big four banks, Mr. Frank said banks were refusing to accept reality when it came to the value of second-lien mortgages such as home-equity loans.

"Because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans," Mr. Frank wrote.

Marking such loans to market values, and making the impact more prominent in accounts, would be a step toward forcing banks to take the more-realistic view—as Mr. Frank and many investors want.

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