The Blatant Opacity of Banks' Balance Sheets

Accountants can be creative people. Bankers can be sneaky people. Put the two together, and funny things happen.

Bloomberg's Jonathan Weil recently penned a fantastic article highlighting the flexible rules banks use to account for and value loans. Weil focuses on an accounting rule that lets banks carry loans at, frankly, whatever value management sees fit. By declaring loans as "held to maturity," banks can value loans at their amortized cost -- an assumption that can indicate the loan will be paid off in full. Only when management decides losses are probable do writedowns occur.

The alternative to this is fair value accounting, whereby loans are valued at current market prices -- the same way you and I value our stock portfolios. 

For the first time ever, banks now have to footnote loan values using both accounting measures on a quarterly basis, rather than just annually. Even if a bank uses hold-to-maturity accounting when it reports its books, it has to disclose the "fair value," or market value, of those loans as well.

Not surprisingly, as Weil shows, the disparity between the two accounting procedures can be quite large:


Stated Value of Loans

Fair Value of Loans


Tier 1 Capital

Bank of America (NYSE: BAC  )

$886 billion

$822 billion

$64 billion

$191 billion

Wells Fargo (NYSE: WFC  )

$799 billion

$764 billion

$35 billion

$103 billion

Regions Financial (NYSE: RF  )

$91 billion

$68 billion

$23 billion

$13 billion

SunTrust Banks (NYSE: STI  )

$120 billion

$106 billion

$14 billion

$19 billion

KeyCorp (NYSE: KEY  )

$68 billion

$60 billion

$8 billion

$12 billion

Sources: Company filings, as of Q2 2009.

These are seriously large differences -- depending on what accounting method you use, Regions Financial is either doing great, or about to blow up.

Now, there is a decent argument for why banks should be allowed to ignore market values. If they hold the loan until maturity, all that matters is the long-term cash flows from that loan, not the current market value. And if banks were required to mark everything to market, capital requirements would be all over the map, going from overcapitalized to the brink of default, depending on the mood of the market. This is especially true during times like the post-Lehman-Brothers-failure week, when it's safe to say that nothing was accurately priced. A world where everything is always marked to market can be as dangerous as one in which nothing is.

Still, there are reasons to be suspicious of this accounting leniency:

  • Most of the time, the market value of loans should reflect a good estimation of intrinsic value. The difference between a loan's market value and the carrying value a bank designates is nothing more than accountants disagreeing with the wisdom of the market.

    That may sound like Chicagonian "no such thing as an inefficient market" extremism, but seriously: After the meltdown of the past two years, giving banks the benefit of the doubt seems insane. Banks have proven utterly incapable of valuing assets and pricing risk. Why we should suddenly assume they've mastered this field, and take them at their word, is beyond reason. Given the choice of believing the collective opinion of the market, or trusting a banker whose bonus is contingent on reporting desired results, the choice should be obvious.
  • Banks can, and do, log gains when the market value of default risk rises on their debt. The assumption is that when a bank's debt falls in value, the bank could theoretically repurchase it at a discount, calling the difference between par and the repurchase price "income." Even if the bank doesn't repurchase the debt, it can still report the difference as a sort of magical gain. Such accounting shenanigans have become big hits with banks like Citigroup (NYSE: C  ) and B of A in recent quarters.

The absurdity here is impressive: Banks can simultaneously say "We choose to ignore market values on our assets, because we don't feel the market has a clue what they're really worth," and "We choose to take the market at its word and mark our liabilities at whatever it says they're worth." When you're trying to meet your quarterly numbers, this setup can be quite convenient.        

If anything, these accounting discrepancies should drive home an important point: Banks' books are enormously subjective. Their value is largely based on the opinions of people whose livelihoods rely on these values. If you believe in the power of incentives, that's a scary thing.

It's easy to look at banks today and say "Such-and-such is cheap because it's trading below book value!" This may be true, and it may not be. It's true insofar as you take stated book value at face value. Depending on what accounting measure you choose to use, that's no sure thing.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.

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  • Report this Comment On August 19, 2009, at 12:45 PM, Fool4Graham wrote:

    Amen! Those toxic assets that took BofA down went NOWHERE, the government simply leaned on the FAS Board to change the mark-to-market rule to let them value the assets any way they want to.

    Lo and behold, at the exact same time the government comes up with the stress tests based on the new rules, and BofA passes it by raising a mere few billion. But they still hold those assets.

    They can't play this game for too long. At some point, probably this coming quarter, they're going to have to take some medicine on their various portfolio of CRE loans, toxic debt, CC defaults, and so on. Right now they're valued at an astounding P/E of 27 assuming the numbers hold up! Priced for perfection (and perfect manipulation). The slightest prick will POP the BofA bubble.

  • Report this Comment On August 19, 2009, at 3:55 PM, wuff3t wrote:

    Fascinating stuff. However I wonder whether (conspiracy theory alert!) there's a behind-the-scenes agreement by politicians and regulators to let banks get away with this, because if we forced banks to tell the truth about the shape they're in there'd be a second wave of panic and a second great market crash as a result?

  • Report this Comment On August 19, 2009, at 4:28 PM, mikeness30 wrote:

    While some of what you write about is absolutely true, the problem with mark to markets, having been something I did in another part of my work life, is that unless your underlying asset is highly liquid i.e. OTC stocks, bonds etc, mark to markets can in fact skew the numbers to high in good times and too low in bad times. The ultimate value of any kind of mortgage is in fact the payment streams any lender recieves. Statistics tell us over time that if the lender has to reposses the property this is almost always a losing proposition and ends up giving the lender some kind of loss on the initial loan.

    It would make more sense to tier loan loss accruals as assets hit different days outstanding and ultimately writing them down to zero after they have been at 90 or more days past due if you truly want to see a real time asset revaluation. Certainly there will need to be very strict guidelines as to how and when this happens, but using mark to market when there is too liquid of a market or too illiquid of a market is putting forth an even bigger lie regarding asset valution.

    There are other methodologies too, hybrids as it were, that would be more accurate as well.

  • Report this Comment On August 19, 2009, at 5:05 PM, Melaschasm wrote:

    Are we talking about GAAP accounting profits or are we talking about Federal regulations regarding liquidity?

    From a GAAP accounting standpoint, mark to market has value, and should be reported.

    From a Federal regulations standpoint, cash flow liquidity is more important than short term fluctuations in market asset prices.

    IMO an FDIC insured "bank" should have strict limits on total corporate leverage. Institutions which are not "banks" should have less regulation while being required to alert their customers to the lack of Federal protection for assets invested with said company.

  • Report this Comment On August 19, 2009, at 7:33 PM, eldetorre wrote:

    "Mark to markets can in fact skew the numbers to high in good times and too low in bad times."

    This objection can be easily overcome. To avoid valuation based upon short term market dips or spikes, the quarterly report should not reflect the days market price but the trailing average price for the immediately past quarter or perhaps 6 mos.

    I am a strong believer in proper valuation. transparency or at least translucency, is a must!

  • Report this Comment On August 19, 2009, at 9:15 PM, j9910 wrote:

    Mr. Housel, with all due respect, you don't know what you're talking about. Of course bank management wants to value their loans at the highest value possilble. I can state as a career banking regulator, that they never want to write off any portion of their loan portfolios. It is when the regulators come in and assess the loan portfolios, classifying loans as either standard (no action), substandard, doubtful, or loss that the bankers MUST write down their loan portfolios against their loan valuation reserves based on the regulators' assessments. This has been going on, worldwide, for centuries and you should be aware that it is going on even more-so under the Obama regime. Get informed and get real.

    Jim Brooks

  • Report this Comment On August 19, 2009, at 10:34 PM, cmfhousel wrote:


    This is from another Bloomberg article,

    "Loans, for instance, typically are carried at historical cost, reduced only by management’s estimate of how much money the bank will lose on the loans it has made."

    Out of curiosity, do you you disagree with that as well? Furthermore, do bank regulators not rely heavily on management's estimates to assess loans in the first place?

  • Report this Comment On August 19, 2009, at 10:47 PM, crookedceos wrote:

    The USA is in for some very bad times, the people know it . The top media people know it. Buffet knows it.

    We will survive if there is no panic. But there might be , and if it happens now our world will change in the blink of an eye. I hope not . One storm or earthquake and my friends it is truly over for the next 20 years ,at least. NYC is going to crash into hell very soon. If we thought crime was bad in the 70's , get ready for the next wave. 50% of republicans have dropped out of the race. I think ,they think, our president is at risk from the instigators like RUSH,BECK,And FOX -- if something happens to him kiss you stocks goodbye and our country.

  • Report this Comment On August 19, 2009, at 10:49 PM, jerryguru69 wrote:

    A couple of days ago in the Financial Times, Scholes and Black (yes, that Scholes and Black) wrote an editorial advocating a return to the old mark-to-market FASB standard. Although I am just a duffer and ignorant of high-finance, even I know this is wrong. TMF author has it right:

    capital requirements would be all over the map, going from overcapitalized to the brink of default, depending on the mood of the market.

    And this with the same stuff in the vault, no changes. Illiquid and thinly traded securities are not like T, trading every millisecond or so, with a concrete determinant value. MTM makes good aesthetic sense, but little else. Take, example, a hypothetical example of Elvis’ guitars.

    2 of these things are in museums or private collections, and well documented; when trading hands, they fetch $1M. A third, however, was found in a safe deposit box and sold unwittingly on eBay for $500. Does this mean that the other 2 Elvis guitars are now only worth $500? Under MTM rules, the answer is yes.

    Besides: these illiquid “assets” generate a reliable cash flow, and their value can certainly be calculated using tried and true DCF formulas. Besides, the banks say that they will hold them to maturity; what if they really do? In this case, do not banks have the right to value them according DCF or whatever, and not MTM standards?

    Besides: we have seen what havoc MTM rules do bank balance sheets in times of distress. In their editorial, Black and Scholes had a brilliant idea: have the FDIC change capital requirements taking into account the value of these thinly traded securities on bank balance sheets?

  • Report this Comment On August 19, 2009, at 10:59 PM, jerryguru69 wrote:

    Part 2:

    The author’s characterization of “Opacity” is not correct. We know EXACTLY the difference between the banks’ “fair value” and “stated value”. He even has a chart and calculates the difference.

  • Report this Comment On August 19, 2009, at 11:20 PM, x1x2x3x4444 wrote:

    Unless I have this wrong, and I don't think so, politicians leaned on FASB during the past six or nine months to allow banks - and perhaps other financial institutions - to no longer be required to mark to market. This WAS the rule. But the government, lobbyists, bailed-out bankers, and all the rest leaned on FASB and it changed its rules. This was not done for "accuracy" - but for political and economic expediency. Let's face it - without taxpayer intervention, our banking system would have collapsed - both commercial/retail and investment. Let us not forget that if it were not for the FDIC insured deposits, all these banks would have been overrun by depositors, demanding their money. I'm convinced Paulson, Bernanke, Bush, Obama, etc. were worried that throwing millions of people out of work would have been the least of their worries - a systemic collapse would have led to civil unrest, including food riots and looting, that would have made bank failures seem like a gentile exercise in the lessons of economic risk.

  • Report this Comment On August 19, 2009, at 11:26 PM, x1x2x3x4444 wrote:

    Part 2

    I think the author's point is not that he couldn't "do the math" and subtract "fair value" from "state value" - I think his point - and it's a fair one - is that all these numbers are suspect.

    I think he has a fair point. After all, we have all seen that the penalty for lying is to be billions in taxpayer money which you can use for bonuses, lavish expenses and, oh yeah, .....I forget, what do banks do again?

  • Report this Comment On August 20, 2009, at 12:12 AM, mikeness30 wrote:

    It still all comes down to what is the intent, function and purpose of a financial instrument. After that what is the underlying and lastly how liquid is the asset and or underlying asset?

    Once you answer these questions you can then begin to put together a more honest and more importantly realistic valuation for any asset and or derivative instrument you are looking at.

    Mortgate are about as simple an instrument as there is. You have on average a very illiquid instrument that on average for residential markets changes has about a 7 year life span. Might be a bit shorter after all of this mess, still, I would argue a bit harder to move in and out of.

    You then look at the other factors, loan to value, which of course as we have seen is not only easily screwed up by appraisers but counties got wise all over the country and tax values are no longer of much use either. Current six month rolling sales values of comps from the area are probably your most reliable.

    Utlimately what is something worth: what someone will pay you for it.

    Still, unless we get 25 or more percent default rates on residential mortgages, I know I know, CRE is the next shoe to fall and I agree it is. I know a wee bit about it from the big to the small and the excessive leveraging put on owners in this fied over the past six or seven years, still, CRE is a notional drop in the bucket compared to residential and I don't think we will see anything more then 15% of these truly default and get turned back over to the bank based on the outstanding notional amount in the U.S. That means loses, if everyting were to be worth zero of no more than $2 trillion worst cas scenerio. Without this you can from region to region with some honest good old fashioned excel spreadsheet work come up with some pretty accurate values. You just need to know what the underlying property is and have access to some local databases. Not that complicated.

    Most importantly if you have folks in the homes paying as agreed, you have all of the valuation you need right there in front of you.

    Heck, the federal government and all of it's illustrious components have put out at least 3 trillion to 4 trillion in funny money chasing this problem beginning back in August of last year.

    You can give me all of the hype about mark to markets, you can paint me every picture you want about how to value these assets outside of the facts of the mortgage contract and a well researched and thought out updated assessment there is nothing more that can be proven on paper that is more accurate regarding the value of these assets then what you had at the time of the origination of the mortgage.

    Don't give me conjecture, give me reality, reality wins every single time. You don't get to high and you don't get to low with reality valuations. See bubble/bust.

    Everyone has reasons to value things a certain way from auditors to bankers to rating agencies to regulators. No one comes at it without prejudice. Heck, with all the egg that regulators at every level have on their face after all of this they might be the most biased regarding valuations in a negative light.

    To think congress has a clue what it is doing is to assign intelligence to a very large group of very stupid people. Most of those clowns can not even spell mark to markets. It is as Adams said: one foolish man is a travesty, two foolish men are a law firm and three or more are a congress.

    The market was way over built. Too many homes chasing to few buyers in several very importatnt regional markets that were simply bombs waiting to go off. Now we de-leverage not only regarding our spend-thrift, debt ridden ways but also our housing markets deleverage and homes sit empty now for a while. Thank you Fannie Mae, thank you Mr. Greenspan and the Fed, and thank you congress. Others to blame, but those are the consistent players in our cycles of going from bubble to bubble.

    Simple as that.

  • Report this Comment On August 20, 2009, at 1:01 AM, yarbtly wrote:

    This is situation is no different than the CRE crisis in the late 1980's involving banks and S&Ls only on a bigger scale.

    As a bank examiner I spent a decade (before the CRE crisis we had the "oil and gas crisis") trying to assess the value of distressed assets. I worked on examinations that closed several large regional banks.

    We also struggled to determine the "fair value" of distressed assets that had no market.

    Left to themselves however, bankers won't come close to valuing assets at anywhere close to fair value. What banker is going to declare themselves insolvent?

    Our job was to categorize loans into five classifications: Pass, Other Assets Especially Mentioned (OAEM), Substandard, and Losses.

    As part of the process we would assess the banks' Allowance for Loan Losses and require the bank to make additional provisions, if necessary. There was some negations with the bank but our assessment was final.

    Despite the banks' venomous protests the one lesson I learned over years was that in hindsight we were always too liberal (i.e. easy) in our assessments of loan values.

    I am retired now but it is obvious that the bank regulators have bowed to political pressure or are not being allowed to do their jobs.

    Finally if you notice, plenty of small banks are being closed. They don’t seem to be having problems determining distressed asset values.

    Tim Y.

  • Report this Comment On August 20, 2009, at 8:58 AM, scottcpacma wrote:

    Banks have other problems. There are off balance sheet special enities that have no cash or reserves tied to theses trusts. Citicorp has approximatley 1.2 Trillion on off balance sheet assets. When these trusts get into trouble they go back on the books of the bank and the bank tries of bail out the trust. These potential liabilities show banks to be more leveraged than a reader of the statements can determine. These special outside trusts were used by Enron to hide the true financial picture of the company.

  • Report this Comment On August 20, 2009, at 11:31 AM, slpmn wrote:

    Good article that raises good points and asks good questions. Even as a skeptical bank analyst, I question how much fair value reporting of assets and liabilities adds to the puzzle of how to value a bank as an investment. Its nice to see the fair value of loans as a footnote, but investors need to keep in mind its a number based on lots of assumptions plugged into a model. The traditional way of reporting loans, which is essentially cost less an allowance for expected losses, shouldn't be dismissed out of hand. I've seen hundreds of calculations of the loan loss reserve - some are optimistic, some are pessimistic, and some are middle of the road. It depends on management and the culture of the bank.

  • Report this Comment On August 20, 2009, at 12:59 PM, rfaramir wrote:

    With regular banks and bank-like entities having this much trouble with valuation, it makes it all the more important to Audit The Fed. No transparency there at all, and it's the source of a lot of our current problems. Undoubtably there will be a lot of technical objections as this article shows the complexity of the situation, and of course there will be political objections (blow through those!), but a clear accounting (as clear as possible, at least) is desperately needed.

  • Report this Comment On August 21, 2009, at 11:16 AM, miteycasey wrote:

    I disagree that "These are seriously large differences" I see the difference as only being 10%. --with the exception being Regions Financial .

    Is that really that much?

    many companies get to write that much in goodwill when they make an asset purchase.

    As another poster said it's the off balance sheet assets that would scare me.

  • Report this Comment On August 22, 2009, at 1:07 AM, 2humble2fool wrote:

    I have to agree with miteycasey. Inventory write-offs are another area that is often very subjective and the true value is disclosed well after when it was first recognized by management. As a CPA and an auditor for several years I know this happens fairly routinely. If you look at any public companies audit report you will note the auditor's opinion states that the financial statement are materially correct. While materiality is not defined in any accouting standards I know of, generally + or - 10% is considered materially correct. I'm not saying this is right, it's just the way things are for all public companies not just banks. I'm not sure why this author always wants to throw dirt on all the banks, but it really seems to be counter productive. Banking has been with us since the dawn of time and I don't see it going away anytime soon. If you think it stinks, then don't invest in them. If not identifing which ones might have a sustainable competitive advantage coming out of this mess is what should be an investor's goal. Continious bank bashing doesn't benefit anyone.

  • Report this Comment On August 22, 2009, at 5:07 PM, speckledbrain wrote:

    If these "assets"are so toxic, why not call them as they really are - POISONOUS LIABILITIES?? This would indicate to the public the reality of the society's genuine debt to corpritism as an economic system!

    Speckled Brain

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