Bank Solvency Has Still Not Been Addressed

As readers of this blog know, the issue of bank solvency has still not been addressed.  In an article, The Wall Street Journal reminds us that it is not only European banks that have solvency issues, but also US banks that have solvency issues because they still have 'toxic' assets on their balance sheets. [emphasis added]

During the financial crisis, investors fretted over "toxic," hard-to-value assets that banks were carrying. Those fears have faded as bank profits have rebounded, loan delinquencies have declined, and bank stocks have soared 25% in the past five months. 

Some banks have yet to reckon with all their "toxic" assets, among them mortgage-backed securities, whose values took a hit when the housing market cratered.  

But banks still hold plenty of the bad assets that once spooked investors: mortgage-backed securities, collateralized debt obligations and other risky instruments. Their potential impact concerns some accounting and banking observers. 

In part due to those bad assets, the top 10 U.S.-owned banks had $13.8 billion in "unrealized losses" that have lasted at least a year in their investment portfolios as of Sept. 30, according to a Wall Street Journal analysis. 

Such losses are baked into banks' book value, but don't get counted against earnings as long as the banks believe the investments will later rebound. If those losses were assessed against earnings, it would have reduced the banks' pretax income for the first nine months of 2010 by 21%, according to the Journal analysis.

Unrealized losses are just one way in which the troubled assets obscure banks' true financial condition, accounting experts say. With the banking recovery well under way, they think the banks should no longer delay a reckoning and should count those losses against earnings. 

Another problem: Even when banks do take real charges because of their securities losses, accounting rules allow them to keep some of those charges from hurting their bottom line.
Making the picture even murkier, the value of many risky assets are based solely on the banks' own estimates—leaving valuations uncertain and, some critics say, overstated.
"They're still inflated because I don't think the bullet ever really got bitten," said Jack Ciesielski, publisher of the Analyst's Accounting Observer. 

The banks say they mostly don't need to take charges for losses on their risky assets. They say they will ultimately realize the assets' full value by holding onto the securities and collecting the principal and interest payments associated with them. 

One problem centers largely on "Level 3" securities, illiquid investments that can't be easily valued using market prices. According to the Journal analysis, as of Sept. 30, the top 10 banks had $360.7 billion in "Level 3" securities. That amounts to 42.6% of the banks' shareholder equity, a pile of assets whose value is hard to verify. 

To be sure, banks aren't quite as exposed to bad assets as they used to be. At the top 10 banks, Level 3 securities have declined 24% in the past two years, while Level 1 and Level 2 securities, which are much easier to value, rose. The amount fell as banks sold some Level 3 assets, switched them to Levels 1 or 2, or wrote some down. Unrealized losses also have declined. 

..."In a lot of cases banks are probably deluding themselves" about the future value of those securities, and whether they will ultimately recover as much from those securities as they contend they will, said Bert Ely, an independent banking consultant. 

Often, the impact of these assets isn't easily visible. Much of the information about risky assets is only in the banks' regulatory filings, not in their earnings releases. Though major banks have announced their fourth-quarter earnings, investors won't be able to see how much in risky assets the banks are currently holding until they file their annual reports with the Securities and Exchange Commission in about a month. 

Citigroup Inc., for instance, didn't mention its high level of Level 3 securities when it announced fourth-quarter earnings. As of Sept. 30, the bank held $79.1 billion of Level 3 assets—equal to 48% of its book value. That includes billions in credit derivatives, asset-backed securities and some subprime-mortgage-backed securities.

Jon Diat, a Citi spokesman, said the bank is "comfortable with its treatment of Level 3 assets," provides extensive disclosure and "adheres to all applicable accounting policies and standards."

The bottom line:  given the mark to myth on the asset side of the balance sheet, bank capital is also a mythical number.  Without disclosure of current asset-level data, investors have no idea who is solvent and who is insolvent.