The Blatant Opacity of Banks' Balance Sheetshttp://www.fool.com/investing/general/2009/08/19/the-blatant-opacity-of-banks-balance-sheets.aspx Morgan Housel
August 19, 2009
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:
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: