March 5 (Bloomberg) -- The more the big banks lift their skirts, the scarier their dwindling capital starts to look.

Perhaps never before have so many banks’ balance sheets been so patently full of hot air. Bank of America Corp. last week disclosed that its loans at the end of 2008 were worth $44.6 billion less than what its balance sheet said. Wells Fargo & Co. said its loans were worth $14.2 billion less than their book value. The spread at SunTrust Banks Inc. was $13.7 billion.

Keep in mind: These are the banks’ own numbers. If there’s any bias in them, it’s bound to be on the side of optimism.

Those gaps underscore how investors may be placing too much faith in a metric called tangible common equity when evaluating banks’ financial strength and their ability to cope with losses. This measure is supposed to give a bare-bones look at a company’s net worth. The problem is that the figures in the calculation come straight from banks’ balance sheets, which often bear little resemblance to reality.

Loans, for instance, typically are carried at historical cost, reduced only by management’s estimate of how much money the bank will lose on the loans it has made. Meanwhile, market values for many loans have tanked, along with the collateral backing them (if any), as more borrowers miss their payments and investors worry that the banks’ loss forecasts are too low.

Fortunately, all companies once a year are required to disclose estimated fair market values for all their financial instruments, including loans. The footnote disclosures give outsiders the means to get a better look at banks’ balance sheets, using more relevant numbers.

Capital Benchmark

Tangible common equity has become the capital benchmark of choice for investors because the government’s main capital measure, known as Tier 1, has lost credibility. Under Tier 1, banks get to pretend many losses don’t matter, and they are even allowed to count certain types of debt -- or money owed to someone else -- as capital.

Tangible common starts with common shareholder equity. This amounts to a company’s net assets, minus preferred stock, which is left out because it acts like debt. Tangible common also excludes squishy intangible assets such as goodwill, which is a bookkeeping entry leftover from acquiring other companies, and mortgage-servicing rights, which reflect the value of future income from collecting and processing loan payments.

Going Underground

Bank of America, for instance, had $35.8 billion of tangible common equity as of Dec. 31, before it completed its government-aided acquisition of Merrill Lynch & Co. That figure falls to negative $1.7 billion once it’s adjusted so that all financial assets and liabilities are measured at fair value, using the numbers BofA disclosed in its footnote. The fair-value version shows BofA needs lots more common equity -- badly.

Wells Fargo’s tangible common equity was $13.5 billion as of Dec. 31. On a fair-value basis, it was negative $133 million. That makes the bank’s $40.9 billion stock-market capitalization look awfully rich.

In total, eight of the 24 banks in the KBW Bank Index had negative tangible common equity on a fair-value basis, including SunTrust, KeyCorp, Fifth Third Bancorp, Huntington Bancshares Inc., Marshall & Ilsley Corp. and Regions Financial Corp.

Even with those fair-value tweaks, tangible common still might overstate a bank’s ability to absorb losses. It includes deferred-tax assets, which are pent-up losses that companies hope to use someday to cut their tax bills. The problem with those is that they’re valuable only to profitable companies that are paying income taxes. Wells Fargo’s capital would look even worse if its $13.9 billion of net deferred taxes were excluded. Same at Bank of America, which said it had $8.7 billion of the stuff.

Good News

The news isn’t all gloomy. Seven banks in the KBW index said the fair values of their loans were higher than their carrying amounts: Bank of New York Mellon Corp., Northern Trust Corp., People’s United Financial Inc., Comerica Inc., BB&T Corp., Cullen/Frost Bankers Inc. and Commerce Bancshares Inc.

For all but one of those companies, Bank of New York, tangible common equity wound up being higher on a fair-value basis. The same was true at Citigroup Inc. because of lower fair-value figures for its debt.

JPMorgan Chase & Co.’s tangible common equity drops to $56.4 billion, or just 2.7 percent of tangible assets, from $71.9 billion if you plug in the bank’s fair-value figures. Mainly that’s because JPMorgan said its loans were worth $21.7 billion less than their carrying value as of Dec. 31.

Fair-value footnotes of this sort aren’t new. The Financial Accounting Standards Board has required them annually since 1993. The board plans to start mandating them on a quarterly basis, beginning this month. So they’re sure to gain prominence.

Back in November 1992, in the wake of the savings-and-loan mess, Henry B. Gonzalez, the U.S. House Banking Committee’s chairman at the time, wrote a letter to Federal Reserve Chairman Alan Greenspan in praise of the FASB disclosure rules. The fair- value revelations would pierce “accounting camouflage” and “prove numerous banks to be insolvent,” he wrote, according to a Jan. 5, 1993, article in the New York Times.

Man, was he right.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net

Last Updated: March 5, 2009 00:01 EST