May 10 (Bloomberg) -- Wouldn’t it be nice if investing in the stock market were as easy as Bank of America Corp. is making it look?
The second-largest U.S. lender this week settled a five-year legal battle with MBIA Inc., the struggling bond insurer, over losses tied to bad mortgages. The net payment to MBIA will be $1.7 billion. But the total package has a lot of parts moving back and forth, including loans, cash and rights to buy equity.
Under the deal’s terms, Bank of America will receive five-year warrants to buy almost 10 million MBIA shares at $9.59 each, which was within their trading range last week. MBIA’s stock soared on news of the deal and now trades for $15.67, or 63 percent more than the exercise price.
Surely both companies knew ahead of time that the market would react enthusiastically. Bank of America is extending a lifeline to its former adversary. The settlement includes a three-year agreement for MBIA to borrow as much as $500 million.
Would the loan terms have been less favorable to MBIA were it not for the spring-loaded warrants? Perhaps not. The settlement has so many components that there is simply no way for outsiders to know.
What we can say for sure is that the accounting rules encourage lenders to engage in this sort of horse trading -- exchanging more-generous loan terms in multifaceted transactions for upfront gains that make their numbers look better. It’s a problem the accounting rule makers aren’t doing anything about.
The best illustration I have seen of what’s wrong with loan accounting was in a 2009 speech by Robert Herz, then the chairman of the Financial Accounting Standards Board, which sets U.S. accounting rules. He gave a hypothetical example of four $100 loans, with maturities ranging from three to 15 years. One had a floating-interest rate, while the others had fixed rates of 4 percent to 8 percent. The present value of the cash to be collected over the life of each loan ran from $90 to $125.
Yet each loan’s value was the same on the bank’s balance sheet: $100. The differences in economic value didn’t matter for accounting purposes. That’s what the rules allow. And it is how banks account for their loans most of the time: at historical cost, rather than how much they are worth.
The rules can lead to perverse incentives, some of which Goldman Sachs Group Inc. pointed out in a 2010 comment letter to the FASB. For instance, current standards encourage investment banks to engage in what Goldman Sachs called “lend to play” practices when competing for initial public offerings.
It’s common for companies to demand loans at below-market terms as a condition of giving banks their underwriting business. Because loans aren’t recorded at fair market value, “sales incentives and pricing discounts are not properly recorded, resulting in overstated investment banking revenues,” wrote Matthew Schroeder, Goldman Sachs’s head of accounting policy.
At the time of his letter, the FASB had proposed rule changes to make lenders show loans at fair market value on their balance sheets. The banking industry protested, saying it’s too hard to estimate such values. (Goldman Sachs was a notable exception.) And the FASB scrapped its plan.
The board’s latest proposal would have lenders book loan losses more quickly. One of the big problems that led to the 2008 financial crisis is that many banks were too slow to write down bad loans, which undermined confidence in their financial statements. In general, the new trigger would be whether a credit loss is “expected,” rather than if it’s “probable,” which is a higher threshold.
This should result in earlier, more aggressive recognition of losses. However, it may lead to earnings smoothing, which also can mislead investors. Banks may find it easier to book excessive losses during good years so they can mask poor performance in down times -- which often makes their problems worse. They also might stay in denial about their bad loans anyway, regardless of the change in the rules.
Whatever the case, the FASB’s proposal ignores crucial information about what loans are worth. The 15-year, $100 loan with a 4 percent rate would still go on the balance sheet at the same value as a nine-year, $100 loan with an 8 percent rate.
It’s true that many loans may be difficult to value. It’s also the case that the existing rules call for an answer that is wrong. Assuming the new rules go through, we’ll be trading one standard that ignores economic reality for another. Investors can be forgiven for wondering what the point is.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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