The Time Bomb on Banks' Books

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.

Fantasyland
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.

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.

More on bank stocks:

• Avoid These Banks in 2011
• The Bank Stocks to Buy for 2011
• Big Accounting Charge-Offs at Bank of America

Want to follow your favorite stocks? Add them to My Watchlist, which will find all of our Foolish analysis on them.