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Mark-to-Make-Believe Perfumes Rotten Bank Loans: Jonathan Weil

Just when it looked like U.S. banks were starting to reveal the true values of their loans, it turns out there’s an accounting loophole they can exploit to keep bad news buried.

Ever since new rules took effect last year, lenders have been required to disclose the “fair value” of their loans each quarter. The results have been something of a mystery, though. Some banks show large disparities between these numbers and the loan values on their balance sheets. Others don’t.

One big reason: Thanks to the loophole, they don’t all have to follow the same definition of fair value. My guess is most investors don’t know this. Often lenders’ disclosures don’t clearly explain which approach they’re using, or that companies have a choice. Unsuspecting readers of their financial statements easily could be misled.

Consider the recent events at Wilmington Trust Corp. The Delaware bank on Nov. 1 said it would sell itself to M&T Bank Corp. for $351 million, which was 46 percent less than its stock-market value at the time. In August, Wilmington had said the fair value of its loans was only $40 million less than their $8 billion balance-sheet value as of June 30.

That term, fair value, was supposed to have been given a uniform definition under a FASB standard issued in 2006 called Statement 157. For financial assets, including loans, the FASB defined it as the sale price that would be received in an orderly, arm’s length transaction. This is known as an “exit price.”

Make-Believe Numbers

Wilmington didn’t use that definition for its loan disclosure. The loophole instead let Wilmington show an “entry price” estimate of how much it would cost to originate similar loans, rather than what its loans would be worth in a sale. That proved to be more like mark-to-make-believe than mark-to-market. Wilmington’s investors got blindsided as a result.

Wilmington disclosed its sale plans the same day it said its third-quarter loss widened to $365.3 million from $5.9 million a year earlier. It also said M&T had identified $506 million of additional credit losses. It’s unfathomable to think that none of those losses started happening until last quarter. An exit-price approach should have provided an early warning. A Wilmington spokesman, Bill Benintende, declined to comment.

Lenders generally aren’t required to show their loans at fair value on their balance sheets. Loans are usually carried instead at amortized cost, which includes adjustments for principal repayments and write-offs, while fair-value numbers appear only in the footnotes.

Footnote Hell

The tricky part for investors is deciphering the technical, often impenetrable jargon companies use to describe their valuation methods. For this column I reviewed the third-quarter footnotes for all 24 companies in the KBW Bank Index. Most don’t explicitly say if they’re showing exit prices for their loan values. To be sure, even when they use the loophole method, that doesn’t necessarily mean they have anything to hide.

The loophole for loan-value disclosures came about by accident. Before 2006, different definitions of fair value existed throughout the accounting rules. The FASB had promised Statement 157 would bring “a single definition” of the term and greater consistency in companies’ measurements.

The board missed some spots, though, including one in its standard on fair-value disclosures for financial instruments. Those rules show two approaches for loans, one of which still uses a pre-2006 definition for fair value. The exception remains in place today. (Before last year, such footnote disclosures were required only annually, not quarterly.)

Hiding Risk

Specifically, the loophole lets companies estimate loan values by “discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.” This is the approach Wilmington used, the bank’s disclosures show. Unlike exit prices, this approach doesn’t include certain factors such as liquidity risk.

Compare that with Regions Financial Corp.’s disclosures. Regions said its loan portfolio was worth $69.1 billion as of Sept. 30, 12.8 percent less than the carrying amount on its balance sheet. Regions said its method “assumes sale of the loans to a third-party financial investor.”

In other words, Regions shows an exit price. SunTrust Banks Inc. and Bank of America Corp. do, too. SunTrust said its loan portfolio was worth 4.8 percent less than its $112 billion carrying amount. Bank of America said its loans were worth slightly less than its balance sheet showed. JPMorgan Chase & Co. said its loans’ fair value was a few billion dollars higher. JPMorgan’s number seemed to be an exit price. A company spokesman, Joe Evangelisti, declined to comment.

This Is Disclosure?

Commerce Bancshares Inc. and People’s United Financial Inc. showed so-called fair values that exceeded their loans’ carrying amounts. Both also expressly disclosed that they don’t show exit-price measurements. There’s no telling what the loans would be worth in a sale. At least they’re upfront about it.

Citigroup said its loans were worth 2.5 percent less than their $608.2 billion carrying amount as of Sept. 30. I couldn’t tell from its disclosure if that was an exit price. A company spokeswoman, Shannon Bell, declined to say.

Wells Fargo & Co.’s loan disclosure doesn’t show an exit price, said Mary Eshet, a company spokeswoman. Wells said its loans’ fair value was $10.3 billion less their $716.6 billion carrying amount. Eshet declined to say whether an exit price would have shown a higher or lower value.

The FASB should close this loophole immediately.

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

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