Banks Don't Need Goodwill

Let me see if I have this correct: A midsize bank buys smaller bank at a price substantially above book value, and thus creates an intangible asset, goodwill, that goes on its balance sheet. A big bank then buys the midsize bank (also for more than book value), absorbs the midsized bank's existing goodwill and then creates some more of its own.

As this process rolls along, the ultimate acquirer might easily end up with 50% or more of its capital made up of goodwill. In fact, it happens all the time. Some examples:

Goodwill obviously can't be deployed or invested--it's intangible--and so generates a return of zero. At the same time, auditors will watch it like a hawk for signs of impairment. Writedowns, sometimes very large ones, aren't infrequent. For their part, regulators have no use for goodwill, and subtract it from book capital to create real capital.

Meanwhile, the banks, in order to pretend they're putting up strong numbers, start reporting returns on tangible assets and tangible equity, and pretend that all the goodwill they've generated by overpaying for deals doesn't exist after all.

Why, they will argue, should they be required to show earning on air?

Here's why: If you pay too much for an acquisition, you should have to live with the consequences, which are diminished returns. In such a case, almost no acquirer can report an acceptable return on capital and almost no acquisition justified.

Finally, when the goodwill turns out to be a mirage (witness multi-billion write-offs at Sovereign (SOV), Banco Santander (STD), WaMu (WM)) we are told it doesn't matter because these are non-cash charges.

In the current environment, billions upon billions of goodwill write-offs have occurred ($4.2 billion in the fourth quarter alone) and billions more are coming.

This is fantasy. Goodwill is an accounting fiction. It distorts our understanding of bank financials. Pooling was a much better option; at least it did not create fictitious assets.

What is the solution? Either eliminate goodwill accounting, or eliminate stupid acquisitions. In the meantime, investors (and banks) should look at return on total capital, not just tangible capital.

Comments

[Nate C:]

Great article. I have always found it interesting that banks can over pay for another bank and record it as an asset. We need a better alternative to GAAP accounting principles that are more transparent.

2008 Feb 16 02:55 PM

[Sticks:]

Vernon Hill continues to make smart commentary regarding the banking sector. A bank's "goodwill" analysis would be greatly enhanced by full transparency from all the banks as to how they and their board's justify any of the "goodwill" on their books. Perhaps a separate quarterly commentary that articulates to the shareholders a banks skill (or lack thereof) in valueing their bank's goodwill assets.

2008 Mar 03 08:18 AM