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I would like to recommend another article on bank accounting practices. This is an article written by Michael Rapoport in the Monday’s Wall Street Journal entitled “’Toxic’ Assets Still Lurking At Banks.” I don’t want to repeat all that is in the article so I highly suggest you read the whole thing. But the issue has to do with when and how one recognizes the value of loans and securities on the balance sheet of a bank.

How does one know what value should be placed on a commercial bank franchise?

The answer: In the current environment, one doesn’t.

I have had my say (once again) on the “mark-to-market” controversy (see “Risk Management: Key in Future Economic Performance for Banks"). In my mind, not only are bankers attempting to fool the regulators and the investment community…they are trying as hard as they can to fool themselves.

Rapoport quotes the banking expert Bert Ely:

In a lot of cases banks are probably deluding themselves" about the future value of those securities, and whether they will ultimately recover as much from those securities as they contend they will.

Bankers are notorious for “deluding “ themselves. (“The sun will come out…tomorrow…bet your bottom dollar…that tomorrow…”) But Rapoport just discusses information from the top 10 banks in asset size and the data come from the September 30 financial reports.

As readers of this blog know, much of my concern has been with the banks that are smaller than the biggest 10 banks…or the biggest 25 banks. We just don’t have any idea how deep the pool of trouble is for most of the banking system.

We get some encouragement from a recent Congressional study. Quoting from another Wall Street Journal article (see here):

A year ago, Elizabeth Warren, who headed the congressional panel overseeing the Troubled Asset Relief Program, predicted a "tidal wave of commercial-loan failures.

On Friday, at a follow-up hearing on commercial real estate held by the same oversight panel, Patrick Parkinson, a Federal Reserve official, said that

worst-case scenarios are becoming increasingly unlikely.

One year ago, Elizabeth Warren stated at a Congressional hearing that 3,000 commercial banks were going to experience serious problems in their portfolio of commercial real estate. I am glad to hear that “worst-case scenarios are becoming increasingly unlikely.”

So, how many commercial banks are going to experience serious problems in their commercial loan portfolios? How many more are going to experience more problems in their securities portfolios? How many more have not recognized on their balance sheets assets that are still “toxic” or “troubled”?

In order to obtain some idea of how bad the condition is of the “smaller” banks, I look at the behavior of the bank regulators that should know.

First, the Federal Reserve System: the Federal Reserve System has put over $1.1 trillion in excess reserve into the commercial banking system and is still engaging in “quantitative easing” to “get banks to start lending again.” However, the “smaller” banks are still not lending.

Second, the behavior of the Federal Deposit Insurance Corporation: the FDIC continues to close 3 banks per week and it looks as if it will continue to close 3 banks a week for the indefinite future. And, this does not include the banks that disappear from the system because they have been acquired.

These are the two government agencies that really should know how bad off the banking system is...and they are acting in this way?

The Fed is providing funds to keep a lot of commercial banks open so that they can either be closed in an orderly fashion by the FDIC or be acquired outright by another bank, domestically or by a foreign source.

The problem is that because of the accounting rules, investors, regulators, and even bankers don’t know what shape the banking system is in. But every quarter we seem to get several “surprises”, banks being taken over or acquired because of their financial condition. And, no one seems to have seen these “surprises” coming. How many more Wilmington Trust’s are there out there?

Source: Accounting Practices: The Games That Banks Play