Bank Loans Marked to Fantasy – The Next Bubble to Burst

posted by Nima

August 19, 2009 · Posted in General Economics 

I came across this interesting Bloomberg article in Mish’s blog, Next Bubble to Burst Is Banks’ Big Loan Values: Jonathan Weil:

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

While disclosures of this sort aren’t new, their frequency is. This summer’s round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Board’s rules.

The timing of the revelations is uncanny. Last month, in a move that has the banking lobby fuming, the FASB said it would proceed with a plan to expand the use of fair-value accounting for financial instruments. In short, all financial assets and most financial liabilities would have to be recorded at market values on the balance sheet each quarter, although not all fluctuations in their values would count in net income. A formal proposal could be released by year’s end.

Recognizing Loan Losses

The biggest change would be to the treatment of loans. The FASB’s current rules let lenders carry most of the loans on their books at historical cost, by labeling them as held-to- maturity or held-for-investment. Generally, this means loan losses get recognized only when management deems them probable, which may be long after they are foreseeable. Using fair-value accounting would speed up the recognition of loan losses, resulting in lower earnings and reduced book values.

While Regions may be an extreme example of inflated loan values, it’s not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the company’s Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies.

Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

Please also consider what I posted in April regarding GE & Mark to Market:

The world’s biggest maker of jet engines and power turbines told shareholders last week that 2 percent of GE Capital Corp.’s assets are being valued based on market prices. The remaining $624 billion is being carried at levels that GE, the last original member of the Dow Jones Industrial Average, established in many cases years ago, according to CreditSights Inc.

“The notion of having 98 percent opaque and 2 percent valued with clarity is something that by its very nature would make investors nervous,” said Robert Arnott, founder of Research Affiliates LLC, which oversees $30 billion in Newport Beach, California and owned 481,201 GE shares as of Dec. 31. “Having some clarity on what the other 98 percent is worth is valuable.”

98% valued at fantasy prices, 2% at real world prices means that there is nothing but trouble down the road for GE.

I noted recently in Total US Credit and Loans – How Much Contraction Since Peak?:

Since the peak in October 2008, total credit and loans/leases outstanding have fallen by $725 billion, a 4.3% drop. And this doesn’t even take into account the decline in outstanding bond prices and unfunded liabilities. It is, indeed, tough to ascertain whether there is a decline in the net present value of unfunded liabilities. Thus we shall ignore them for now. However, bond prices have definitely declined across the board.

On top of that, I don’t think that people are oblivious to the fact that there is absolutely no way that all social security and medicare benefits will ever be paid. Thus it would only be reasonable to conservatively assume that the present value of those liabilities has dropped by the same amount. This would almost double the total contraction to around $4 trillion.

It is rather questionable whether all this credit is marked to market. I would say that all this number gives us at the moment is at the low end of the range.

The real contraction is obviously much more than stated in official reports. This may change in case the FASB follows through on its planned changes to accounting rules. It is rather remarkable that in spite of false over reporting of loan values, credit is contracting at this pace. I ask: How much will it be once they have to report real losses?

Whether they change the rules of this delusion game sooner or later or not at all. Bank loans are reported at ridiculous values and there is no chance of a substantial recovery until and unless the bad apples are sorted out.

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