Why Investors Are Terrified of Big Bank Balance Sheets

A big bank's balance sheet can be a dark and scary place. Some of the world's smartest investors have sworn off allocating any of their dollars to the financial behemoths. Some of these concerns are legitimate, but some of this resistance comes from fund managers dreading the conversations with their investors if another financial crisis emerged. One can imagine that hardworking doctors and lawyers might not be too happy if told that their investments eroded because their advisor was overweight in financials, again.

One of the most opaque elements of an institution like Bank of America (NYSE: BAC  ) or JPMorgan Chase (NYSE: JPM  ) is the constantly changing nature of its balance sheet as a result of broader market changes. Due to some relatively new and incredibly fascinating accounting rules, banks are required to carry some of their assets as fair value. Obviously, some assets that are highly liquid, think U.S. Treasuries or corporate bonds, are easily recorded at a reliable market value. However, some assets on bank balance sheets that were acquired before the financial crisis in markets that have since dried up -- think exotic collateralized debt obligations (CDOs) -- are not easily valued.

Every bank now follows this structure in terms of classifying its assets that are recorded at fair value on a recurring basis:

The most common recurring fair value asset level at the largest U.S. bank is level 2. Bank of America, JPMorgan, and Citigroup (NYSE: C  ) all have at least 87% of fair value assets in this bucket. It may come as a surprise to some that Wells Fargo (NYSE: WFC  ) , typically seen as the safest and most reliable of all of the big banks, has the largest portion of these assets in the Level 3 bucket with over 12% at the end of 2012. 

Source: S&P Capital IQ. Data as of end of 2012.

But before Wells Fargo investors start to fear the contents of the bank's books, it is worth noting that mortgage servicing rights fall into this Level 3 category. At the end of 2012, over 22% of Wells Fargo's Level 3 assets were MSRs, compared to less than 16% at B of A. The value of MSRs depends on changes in the interest rate environment. If rates go up, refinancing becomes less likely, thus the value of MSR assets increases. If rates fall, refinancing becomes more likely (just like the past couple of years) and MSRs decline in value.

While MSR assets increased the level of these mystery assets, Wells Fargo didn't just sit idly by and watch value erode as rates fell. The bank hedged its exposure and actually settled for a net profit $681 million in 2012 ($2.9 billion decrease in the fair value of the MSRs offset by a $3.6 billion hedge gain).

The takeaway for investors is not for them to tirelessly dig to try and find the ultimate value of these assets. Given the lack of transparency, searching for a definite answer is undoubtedly a futile task. However, this is true for almost any company, be it a bank or a sporting goods store. There will always be uncertainty and volatility. The important thing for investors to do is look at broader trends in those murky areas. For example, since 2007, Citigroup has reduced its Level 3 assets by 63%. Since 2009, B of A has reduced its Level 3 assets by almost 65%.

Surely these banks still have exposure to legacy assets and frozen markets, but executives at these banks are more aware than ever about the importance of a clean and strong balance sheet, which will ultimately result in a safer, more stable, and more investable banking system.

Bank of America's stock doubled in 2012. Is there more yet to come? With significant challenges still ahead, it's critical to have a solid understanding of this megabank before adding it to your portfolio. In The Motley Fool's premium research report on B of A, analysts Anand Chokkavelu, CFA, and Matt Koppenheffer, Financials bureau chief, lift the veil on the bank's operations, including detailing three reasons to buy and three reasons to sell. Click here now to claim your copy.

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