A Friday accounting curio courtesy of Fitch Ratings.
The agency’s done a report on the US banks and fair value, looking at a sample of 20 of ‘em to estimate the impact of potential new accounting rules.
The US is considering requiring all financial instruments, including loans, to be measured on the balance sheet at fair value — that’s the sort of consensus price at which the asset could be expected to sell in a `normal’ market. The proposal is expected to be unveiled in the first quarter of next year, according to Fitch, and would also get rid of the `held for sale’ and `held for investment’ categories in current accounting for loans.
At the moment banks generally have the option to classify a loan in one of those three categories — held for sale (measured at amortised cost) or held for investment (also amortised cost), or fair value.
So this is a potentially timely report from Fitch.
And here’s a summary of the key findings:
As noted earlier, Fitch reviewed the fair value disclosures of 20 large banks in the U.S. This review showed some interesting trends. As shown in [this chart], the weighted average fair value of loans declined from a multiyear high of 102.5% of net book value at Dec. 31, 2002, to a multiyear low of 95.4% as at June 30, 2009.
Hypothetically, if the proposal for loans was adopted in the third quarter of 2009, it would result in a decrease in shareholders’ equity of $130 billion (approximately 14% of the combined total equity of all the 20 banks reviewed). This reduction excludes offsets from applying fair value to the liabilities that fund the loans.
Clearly if the fair value proposals are implemented from 2011, as expected by Fitch, they’ll result in different numbers but you get the idea.
Remember that fair value is not necessarily the same as mark-to-market, though it’s often pretty close. Sometimes financials use internal models to come up with a `fair’ price, which is how you get Level 1, Level 2 and Level 3 assets. The value of Level 3 assets, for instance, is based on prices using internal models because there’s no available `observable input’ like market price. In otherwords, there’s room for divergence between reported fair value and broader market prices.
On that note, here’s the other interesting chart from the Fitch report, showing the average reported fair value as a percentage of the 20 banks’ net book value, and a benchmark secondary loan market price:
Why the sudden divergence between 2007 and 2009?
The period should give you a clue, but here’s Fitch’s theorising:
- The limited use of secondary market data in valuing loan portfolios. Thus, the fair value valuations are based primarily on internal models — i.e. Level 2 or Level 3 — and the assumptions and methodology of Level 3 can be subjective.
- According to some banks, the primary driver of the differences in fair value and carrying value is liquidity risk. Therefore, the very sharp drop in secondary market prices at December 2008 may have been primarily a reflection of the extraordinary seizure experienced by global credit markets in the third quarter of 2008.
- Some banks may not be fully applying the exit value notion of fair value in the reported numbers.
You can see why banks are lobbying so vociferously against the measure.
Full report in the usual place.
Related links:
Herz: Not all assets need to be at fair value – WebCPA
Don’t let banks hide bad assets – WSJ
More flexible accounting rules for banks – NYT DealBook
Brussels warning on fair value shake-up – FT