http://www.bloomberg.com/apps/news?pid=20601039&sid=a04oVutXQybk Next Bubble to Burst Is Banksâ Big Loan Values: Jonathan Weil Share | Email | Print | A A A Commentary by Jonathan Weil Aug. 13 (Bloomberg) -- Itâs amazing what a little sunshine can accomplish. Check out the footnotes to Regions Financial Corp.âs latest quarterly report, and youâll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bankâs shareholder equity, by comparison, was just $18.7 billion. So, if it werenât for the inflated loan values, Regionsâ equity would be less than zero. Meanwhile, the government continues to classify Regions as âwell capitalized.â While disclosures of this sort arenât new, their frequency is. This summerâs round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Boardâs rules. The timing of the revelations is uncanny. Last month, in a move that has the banking lobby fuming, the FASB said it would proceed with a plan to expand the use of fair-value accounting for financial instruments. In short, all financial assets and most financial liabilities would have to be recorded at market values on the balance sheet each quarter, although not all fluctuations in their values would count in net income. A formal proposal could be released by yearâs end. Recognizing Loan Losses The biggest change would be to the treatment of loans. The FASBâs current rules let lenders carry most of the loans on their books at historical cost, by labeling them as held-to- maturity or held-for-investment. Generally, this means loan losses get recognized only when management deems them probable, which may be long after they are foreseeable. Using fair-value accounting would speed up the recognition of loan losses, resulting in lower earnings and reduced book values. While Regions may be an extreme example of inflated loan values, itâs not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the companyâs Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies. Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bankâs Tier 1 common equity, by comparison, was $47.1 billion. Widening Gaps The disparities in those banksâ loan values grew as the year progressed. Bank of America said the fair-value gap in its loans was $44.6 billion as of Dec. 31. Wells Fargoâs was just $14.2 billion at the end of 2008, less than half what it was six months later. At Regions, it had been $13.2 billion. Other lenders with large divergences in their loan values included SunTrust Banks Inc. It showed a $13.6 billion gap as of June 30, which exceeded its $11.1 billion of Tier 1 common equity. KeyCorp said its loans were worth $8.6 billion less than their book value; its Tier 1 common was just $7.1 billion. When a loanâs market value falls, it might be that the lender would charge higher borrowing costs for the same loan today. It also could be that outsiders perceive a greater chance of default than management is assuming. Perhaps the underlying collateral has collapsed in value, even if the borrower hasnât missed a payment. The trend in banksâ loan values is not uniform. Twelve of the 24 companies in the KBW Bank Index, including Citigroup Inc., said their loansâ fair values were within 1 percent of their carrying amounts, more or less. Citigroup said the fair value of its loans was $601.3 billion, just $1.3 billion less than their book value. The gap had been $18.2 billion at the end of 2008. Covering Liabilities History provides some lessons here. A common problem at savings-and-loans that failed during the 1980s was that they relied on short-term funding at market rates to finance their operations, which consisted mainly of issuing long-term, fixed- rate mortgages. When rates rose sharply, the thrifts fell in a trap where their assets werenât generating sufficient returns to cover their liabilities. The accounting rules also left open the opportunity for gains-trading, whereby companies post profits by selling their winners and keeping losers on the books at their old, inflated values. Had the thrifts been marking loans to market values on their balance sheets, their troubles would have been clearer to outsiders much sooner. (The FASB didnât require annual fair- value footnote disclosures until 1993.) Arbitrary Accounting If nothing else, todayâs fair-value gaps highlight the arbitrariness of book values and regulatory capital. Banks already have the option to carry loans at fair value under the accounting rules. For the vast majority of loans, most banks elect not to, on the grounds that they intend to keep them until maturity and hope the cash rolls in. Consequently, the difference between being well capitalized and woefully undercapitalized may come down to nothing more than some highly paid chief executiveâs state of mind. Fair-value estimates in the short-term can be a poor indicator of an assetâs eventual worth, especially when markets arenât functioning smoothly. The problem with relying on managementâs intentions is that they may be even less reliable. At least now weâre getting some real numbers, even if you have to dig through the footnotes to get them.