Mark-to-make-believe perfumes rotten loans

Just when it looked like US 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 November 1 said it would sell itself to M&T Bank Corp for $351 million, which was 46 per cent 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."

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 amortised cost, which includes adjustments for principal repayments and write-offs, while fair-value numbers appear only in the footnotes.

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.