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The Time Bomb on Banks' Books

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Today is a great time to slip one past earnings-focused investors. That fact isn't lost on banks. Accounting-rule makers recently backed away from a proposed rule change that bankers fought. If you own bank stocks, that's cause for pause.

Back to the future
The proposal would have reversed a 2009 rule change. During the financial crisis, Congress pressured the Financial Accounting Standards Board, or FASB, into relaxing rules on how banks value loans.

Wouldn't it be nice if you could live as if the value of your assets never declined below what you paid for them? That's essentially what the 2009 rule change allowed for banks. Before the financial crisis, loans -- which are "assets" for banks -- went on their books at "fair value," i.e., what a buyer was willing to pay that day. After market prices for loans crashed, the 2009 rule change allowed banks to put loans on their books based on what they paid for them. The fair (market) value was relegated to footnotes in SEC filings.

That rule change was akin to changing your brokerage statement to highlight what you paid for your investments instead of what they're worth now. In this alternative world, the current value would be disclosed in footnotes of a long legal document. Trouble is, you can't retire on what you paid for investments. Unlike banks, you have to live with the fair value buried in the footnotes. 

Banks got the rule change by arguing that fair-value accounting could have exacerbated the financial crisis. More bluntly, revealing the true value of banks' assets would have made them look even shakier. The rule change was retroactive … in time for the Federal Reserve's bank stress tests. Fancy that.

Extend and pretend
Asset values were expected to recover once the markets settled down. Last May, FASB proposed reversing the 2009 rule so that loans would again go on banks' books at fair value. The CFA Institute supported FASB's proposal. But although the markets had settled down, banks lobbied hard against it.

Why is it that banks still don't want loans' true values on their books? Banks said it would hurt lending and unfairly reduce their book values. That's true, except for the "unfair" part. What's unfair is having inflated asset values in banks' financial statements. That's akin getting a mortgage based what you paid for your home instead of what it would fetch in the market today. Or selling your home for what it cost you. Good luck with that.

But although the 2009 rule change would not get toxic assets off balance sheets, it had the potential to boost banks' earnings and allow them to defer writedowns.

Billions and billions
Bankers wouldn't fight fair-value accounting unless it was going to inflict pain. To get a sense for how much, the following table shows how changes in fair value have affected quarterly bank earnings. (When the fair values of assets rise, the increase is added to earnings, and vice versa.)

As suspected, the figures are large. And these are just changes in fair value. Pay close attention to the bold rows indicating just how much the accounting change that banks sought has affected earnings.

Bank of America (NYSE: BAC  )


Earnings Impact of Change in Fair Value (FV)

Earnings Before Taxes (EBT)

FV Change Impact as % of EBT

Q4 2008 ($9,961) ($3,802) 262%
Q1 2009 $2,658 $5,376 48%
Q2 2009 $4,758 $2,379 200%
Q3 2009 $143 ($1,976) 7%
Q4 2009 N/A ($1,419) N/A
Q1 2010 $1,530 $4,389 35%
Q2 2010 $706 $3,795 19%
Q3 2010 $891 ($5,912) 15%
Q4 2010 N/A ($3,595) N/A

JPMorgan Chase (NYSE: JPM  )


Earnings Impact of Change in Fair Value (FV)

Earnings Before Taxes (EBT)

FV Change Impact as % of EBT

Q4 2008 ($1,595) ($1,342) 119%
Q1 2009 ($2,730) $3,056 (89%)
Q2 2009 ($843) $4,072 (21%)
Q3 2009 ($7,208) $5,063 (142%)
Q4 2009 $13,041 $3,876 336%
Q1 2010 ($1,714) $4,537 (38%)
Q2 2010 ($2,362) $7,107 (33%)
Q3 2010 ($1,191) $6,203 (19%)
Q4 2010 N/A $7,012 N/A

U.S. Bancorp (NYSE: USB  )


Earnings Impact of Change in Fair Value (FV)

Earnings Before Taxes (EBT)

FV Change Impact as % of EBT

Q4 2008 $557 $379 147%
Q1 2009 ($331) $646 (51%)
Q2 2009 ($656) $585 (112%)
Q3 2009 ($52) $691 (8%)
Q4 2009 ($441) $710 (62%)
Q1 2010 ($121) $824 (15%)
Q2 2010 $80 $951 8%
Q3 2010 $84 $1,154 7%
Q4 2010 N/A $1,271 N/A

Wells Fargo (NYSE: WFC  )


Earnings Impact of Change in Fair Value (FV)

Earnings Before Taxes (EBT)

FV Change Impact as % of EBT

Q4 2008 ($6,060) ($4,777) 127%
Q1 2009 ($2,998) $4,641 (65%)
Q2 2009 $277 $4,724 6%
Q3 2009 ($1,636) $4,671 (35%)
Q4 2009 $409 $3,962 10%
Q1 2010 ($688) $4,001 (17%)
Q2 2010 ($2,213) $4,659 (47%)
Q3 2010 ($347) $5,176 (7%)
Q4 2010 $929 $5,165 18%

Data from Capital IQ, a division of Standard & Poor's. Dollar figures in millions.

The big quarterly swings make one wonder whether management is using fair-value changes to manage quarterly earnings. For example, in the fourth quarter of 2009, a fair-value increase boosted JPMorgan Chase's pre-tax earnings by $13.0 billion, from a $9.2 billion loss to a $3.9 billion profit. That probably boosted bonuses, too.

It appears BofA may have taken what accountants refer to as a "big bath," writing off $9.96 billion in late 2008. Increasing the value of those assets in subsequent quarters has since helped earnings. TARP poster bank Citigroup (NYSE: C  ) isn't in the table because the numbers were too elusive.

Small and midsized banks are dangerous, too. Indeed, loans generally account for more of their assets than at large banks. Bad loans were behind the FDIC's closure of 157 banks in 2010.   

Foolish takeaway
By killing FASB's proposal, banks can keep the fair value of their assets tucked into footnotes and continue disguising their true financial condition. Bad loans could sit on bank balance sheets for years, quietly ticking away.

Warren Buffett advises against investing in something you don't understand. Under the current accounting rules, bank earnings and book values cannot be relied upon. Investors who are willing to dig through footnotes in SEC filings and are able to analyze banks' true financial condition should have an edge. If you're not one of them, you run the risk of being dumb money on the other side of their trades.

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Fool contributor Cindy Johnson has been underweight financials since 2008, which has been a good move overall … albeit not lately. She understands bank financials only well enough to hear an ominous ticking sound. She owns no shares in any of the companies in this story. No way. The Fool owns shares of JPMorgan Chase and Wells Fargo. Through separate "Rising Star" portfolios, the Fool is both long and short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (5) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 05, 2011, at 9:18 PM, stockmajor wrote:

    Yes, bank accounting is and will be smoke and mirrors for some time to come, but that is exactly what makes them good investments.

    Don't you get it? Uncle Sam gave the banks a get out of jail free card and the intent is to allow them to slowly work the bad assets off their balance sheets and allow them to return to normal operating profitability. Note the zero interest rate policy and yield spread gift to the banks from their beneficent uncle.

    I think Uncle Sam has been making the right moves with TARP and mark to market, etc. We couldn't allow our financial system to collapse.

    So, with our big uncle behind the banks and the game plan of making sure that they survive and thrive, the banks are just about as guaranteed an investment as one can make.

    I'm in big on Citi and Bank of America. In a couple of years you will see the balance sheets largely cleared up and the stock values should double from their current values. They may possibly be higher if stock buy backs are initiated.

  • Report this Comment On February 05, 2011, at 10:27 PM, erational wrote:

    Cindy you have some decent points in here but need to do your homework, the fair value proposal was a change from the traditional use of historical cost /impairment model . You incorrectly state that loans at banks had previously been accounted for in a fair value manner and that, for the most part is incorrect. There were some limited circumstances, with say a trading book where they were carried at fair value.

  • Report this Comment On February 06, 2011, at 8:55 AM, ronbeasley wrote:

    This article is a good reflection of the broad misunderstanding of this issue. Trading assets, assets held for resale, are and should be carried at fair value. But what a loan can be sold for today is not relevant if it is performing, i.e. the borrower is making payments. The same holds for loans that are being renegotiated. How would you like it if your bank could call for immediate repayment of a portion of your mortgage based on what they could sell it for today? That is the author's logic here. Mark-to-market accounting for operating assets, which loans are to a bank, would create massive chaos and instability in the marketplace and bear no relationship to the bank's ongoing earnings quality.

  • Report this Comment On February 06, 2011, at 12:54 PM, michjksn wrote:

    "...but that is exactly what makes them good investments. Don't you get it?"

    "Cindy you have some decent points in here but need to do your homework,..."

    "This article is a good reflection of the broad misunderstanding of this issue."

    Folks, this is a ridiculous hit piece; nothing more. All three of you have responded with real facts that render the writer's doomsday innuendo both non-substantive and false. There are countless more that do the same, and writer knows it.

    However, by responding other than to point out the dishonesty of the 'drive-by journalism' by arguing facts, gains nothing. If anything, replying with civil discussion gives the writer a modicum of respectability which is totally unwarranted.

    99% of bank stock investors know why they are invested. That is what is important. Painfully obvious, disingenuous innuendo aimed at creating chaos where there is none is not worthy of discussion.

  • Report this Comment On February 07, 2011, at 9:33 AM, DrRoberts1 wrote:

    The Cindy Johnson article is just another of the seemingly never ending series of hit pieces on the country's banking system. She either has an agenda or she falls into the camp that a little knowledge is dangerous.

    This investor is certainly no fan of once in her lifetime correct (not even as good of a track record as a broken clock) bank bear Meredith Whitney but even she had the sense to now try to fool investors into thinking she is a muni bond expert. In other words, she quit fighting the tape on the major banks.

    The old adage "know your banker" is still the best advice one can give a potential shareholder. Kind of humorous that management at this site is long two of the very best while allowing the above drivel to occupy space.

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