In an commentary piece on Bloomberg.com called Next Bubble to Burst Is Banks’ Big Loan Values, Johnathan Weil exposes some distressing nuggets of information that are buried in the footnotes of banks’ quarterly reports. We encourage every investor to read the entire commentary, but a key portion is reprinted below.
“It’s amazing what a little sunshine can accomplish.
Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.
So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”
While disclosures of this sort aren’t new, their frequency is. This summer’s round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Board’s rules.” — Johnathan Weil, Bloomberg.com
Because of a recent change to Financial Accounting Standard’s Board rules, banks are now required to report on the fair-value accounting (also known as mark to market accounting) for the loans on their balance sheet each quarter. Since, the FASB relaxed mark to market accounting rules, banks do not have to write-down loans that have lost value, unless they plan on selling them or they are nearing to maturity. Mark to market accounting rules get a lot of blame for adversely impacting bank’s balance sheets as the market spiraled downward. Interestingly, the market’s spring lows correspond almost perfectly with congressional hearings on MTM accounting. The “relaxed” standards mean that although banks do have to specify the “fair-value” of their loans, they do not effect net income if the bank’s management intends to hold the loan to maturity.
Weil did the leg work and looked through a bunch of banks’ quarterly reports and found that a great number of them are in more trouble than it first appears. Regions Financial (RF) is the most extreme case, but Bank of America (BAC) and Wells Fargo (WFC) as well as regional banks SunTrust (STI) and Keycorp (KEY) appear much less capitalized when looking at the value of their loans. So, much of the recent rally has been built upon the foundation of a stronger financial sector. Sure, banks are reporting profits again, but there are also a lot of nasty loans on the balance sheets of major banks.
Clearly, the relaxation of mark to market has served the purpose of giving banks a breather from book value destroying write-downs. However, as Weil exposed, book value is really simply accounting fiction. We are hopeful that in the balance of time a lot of these loans recover a substantial amount of value, but we do not want to invest based on hope. Many of the credit issues that caused this mess are still yet to be worked out, and at Ockham we remain very wary of bank stocks.