Are these five banks hiding more than $140 billion in losses?

Jonathan Weil at Bloomberg has quite a contention: on a mark-to-market basis, a number of banks -- such as Regions Financial (RF), SunTrust Banks (STI), and KeyCorp (KEY) -- would have negative regulatory equity. Meanwhile, others -- including giants like Bank of America (BAC) and Wells Fargo (WFC) -- would be insolvent or undercapitalized, with hidden loan losses of more than $140 billion. In a world blind to "too big to fail," the former group would be shuttered by the FDIC, and the latter would either need to raise capital or risk a similar fate.

As Weil correctly points out, footnotes disclosing the fair market value of loans on Regions' balance sheet show a $22 billion gap between the value currently carried on the books currently and the price that they could be sold for. At quarter's end, this exceeds stockholders equity of $18.7 billion. However, accounting and regulatory rules allow those loans to be labeled as "held to maturity," meaning that they are excluded from being marked-to-market -- thus leading to two different values that can paint drastically different pictures of a bank's health.

A spokesman for Regions Financial confirmed that the $90.85 billion (in book value) of loans are all earning assets and are still paying. By comparison, actual non-performing assets are just $3.4 billion, while there are $613 million in other loans that are 90 days past due. Regions has set aside an allowance of $2.3 billion to cover future losses, and the stock has already discounted plenty of trouble. Currently, it trades at a 60 percent discount-to-book value even after shares rallied on news that hedge fund manager John Paulson -- who made billions shorting the subprime market -- disclosed a stake in the company. Is Regions a winning investment, a zombie bank, or a hopeless case, destined to be closed by regulators?

The answer hinges on whether one believes that market values should be used to determine the value of loans outstanding. When a bank makes a loan, the book value is recorded as the principal balance outstanding. This is simple enough, and devoid of the volatility that might be taking place in the market. The problem, of course, is that not all loans get repaid. If management isn't forthcoming to investors, it leads to a situation in which income looks smooth until loan values "blow up" and default.

Given the less-than-stellar risk management and underwriting at banks, there has been a push to require banks to mark their assets to a market price at the end of quarters. The key assumption has been that the market will be more prescient in assessing default risk, and drop loan values accordingly before actual losses occur. On the other hand, the idea that markets are efficient has also suffered a real black eye in the last two years. So, like many accounting issues, there is not one definitive answer here.

There's something to be said for marking assets to market: it forces more rigorous risk management because of the constant need to track market prices. But it's also dangerous, because it exacerbates the inherent liquidity risk that banks take from borrowing short and lending long, leading to more pro-cyclicality. Shifting to fair value accounting places more faith in market prices, and markets (as we were recently reminded) can be extremely fickle. As for a practical reason, however, you won't see fair value marks on loans resulting in bank closures: it goes against the current policy of playing for time, and would hurt large banks, likely requiring another major bailout in the immediate future.

James Cullen edits and writes at CollegeAnalysts.com. He is the Vice-President of the Boston College Investment Club, which owns BAC, but has no personal position in the stocks mentioned above.


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