Discovering Holes in the Balance Sheet

Be wary of bank balances sheets, especially when a company make an announcement late on a Friday afternoon.

There's no time like late on a Friday afternoon after the stock market has closed for a company to bury unpleasant news in a Securities and Exchange Commission filing. A small lender named Severn Bancorp Inc. offered a classic specimen last week.

Usually I don't delve into the financials of little companies, unless they can be used to illustrate some larger point. At Severn, one lesson for investors is to look out for companies doing late Friday data dumps. Another is that the accounting rules for loans are easily gamed, which is why investors remain skeptical of many banks' balance sheets.

On Sept. 27 after the market closed, Annapolis, Maryland-based Severn said it had sold a group of loans for $23 million, and that this would result in a $10 million pretax charge to earnings. The company said it had been carrying the loans on its books at $33 million. The loss is no small amount to Severn, which had about $109 million of shareholder equity as of June 30. The buyer didn't care what the balance-sheet value was -- only what the loans were actually worth.

It was hardly obvious from the company's accounting that a loss of this magnitude was in the offing. As of June 30, Severn classified only $11.8 million of loans as "held for sale." So there's no way that all of the loans it sold were included in that bucket. Severn classified the rest of its loans as "loans receivable." That category had $630 million, net, as of June 30. Yet the company's allowance for loan losses was only $12.8 million -- not much more than the $10 million loss Severn realized from selling a small fraction of its loans.

One of the fundamental problems for bank investors is that loan values for accounting purposes may bear little resemblance to economic reality. Loans typically are recorded and presented at historical cost. Lenders are supposed to set up allowances (often called loan-loss reserves) on their books and record charges to earnings for loan losses. They often are slowto do so, however, which helps explain why a lot of banks still trade for less than book value, or common shareholder equity. Severn finished last week with a $51 million stock-market value, less than half of its book value.

The accounting rules also require lenders to show the fair-market values of their loans each quarter. These footnote disclosures may not be of much help, either. Severn said its loans receivable had a fair value of $659.5 million as of June 30. That was about $29 million more than their carrying amount on Severn's balance sheet. So an investor probably wouldn't have guessed from that number that a $10 million loss was lurking on only a $33 million portion of Severn's loan book.

It is worth mentioning that Severn recentlychanged audit firms. On Sept. 3, the bank disclosed in an SEC filing that it had dismissed the accounting firm ParenteBeard LLC as its outside auditor and replaced it with BDO USA, LLP. I have no idea if the decision to sell the loans and eat the loss was related to the switch, but you have to wonder.

Severn listed only one contact person on its news release last Friday: Thomas Bevivino, its chief operating officer. He already had left for vacation when I called and e-mailed him Friday afternoon, according to his voice-mail greeting and the auto-reply e-mail I got back from him. (That was a nice touch on his part.) He didn't respond to requests for comment.

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