Banks' Next Roadblock: Accepting Reality

"In my opinion, nearly every major bank would be insolvent if they marked their assets to market," hedge fund manager Andrew Lahde wrote to his clients in 2007. Lahde made a fortune betting against the financial industry, and he isn't known for mincing words.

How serious was he? We might soon find out.

Last week, the Financial Accounting Standards Board (FASB) proposed altering a rule that allows banks to value loans on their own terms while ignoring market values. If the proposal actually becomes a rule, it could have a seriously awful impact on some (but not all) banks.

When a bank reports the value of assets on its balance sheet, there's a good amount of subjective wiggle room that goes into the calculation. On the assumption that management knows its customers better than anyone, and that banks typically intend on holding loans forever, banks are allowed to value assets with a combination of mark-to-model (a value based on management's assumptions) and amortized cost, which is basically the full value at which the loans were made, less loss reserves.

Mind the gap
To appease the suspicious (like me), banks are also required to disclose the market value of loans -- the price a loan would fetch if it were sold today. These values are invariably lower than those management comes up with. Not surprisingly, then, market values are almost never used for anything meaningful -- they're just disclosed. And by "disclosed," I mean "buried deep in regulatory filings, surrounded by legalspeak designed to induce aneurysms."

Yet if FASB gets its way, banks will be forced to use market values when calculating balance sheet figures. What will that mean? Here are a few examples:

All numbers in billions. Numbers may not add perfectly due to rounding.
Source: Company filings, as of end of fiscal year 2009.

That's a big range. For Citigroup and JPMorgan, the rule change wouldn't be a major deal. For Bank of America and Wells Fargo, it'd be really serious. For Regions Financial, it'd be utterly fatal.

In truth, the change's potential to cause mayhem makes me think the odds of it becoming a rule are slim at best. Regulators can't really be eager about a rule that, with a pen stroke, could effectively sign some banks' death warrants.

Likewise, bankers and their faithful lawyers will no doubt fight this proposal to the death. Their main defense, I assume, will be that market values are always less than stated values because of liquidity discounts. Basically, this means that it's tough to sell loans, so market buyers demand a discount to compensate for the possibility of being stuck with assets they don't want. Banks say they don't need to factor in this discount, because they intend to hold loans forever.

This is mostly true, but here's the thing: Banks have absolutely zero credibility when it comes to valuing assets on their own. Really. Zero. Bankers whose short-term compensation is tied to balance sheet strength will forever and always go with the valuation that suits them best, even if it's bogus. Also, the only time capital ratios are truly important is when a bank gets into trouble. And what do most troubled banks need to do? Sell assets -- even those they never intended to. So I'd say the market price is the most relevant price, even when it's flawed.

Yes, market prices can be irrational, schizophrenic, and sometimes wildly wrong, which can lead to chaos. But really, what would you call Wall Street's record over the past few years? Consistently right? Of course not.

Given the choice of trusting market values or a made-up number produced by management, I'd take the market any day. Market prices don't cause as many problems as they uncover. FASB clearly feels the same way. (I'd highly recommend fellow Fool Bill Mann's article on this topic.)

At any rate, stories like this reinforce an important point. More so than any other industry, what you see on a banks' balance sheet is often just the opinion of someone whose interests might be miles away from presenting reality. Never forget that.