Mark to Market for Lending Dies -- Good News or Not?

Although a mark-to-market rule for bank loans is off the table, loan troubles persist.

Last March, I opined about how the Financial Accounting Standards Board and the issue of mark to market may return to the table, in this case to all of lending (see Mark to Market Lending: FASB Dances on Banking's Toes). At risk was a potential accounting rule from FASB that would "stomp (not dance) on every banker's toes." At the extreme, mark to market for all loans, from credit cards with balances to billion-dollar leveraged buyout loans would create chaos. I stated in last March's column, "As a former banker and long time industry analyst, I know marking a loan portfolio to market will be bad for banking."

Last week (Jan. 26, 2011) the Wall Street Journal reported that "Accounting rule makers, bowing to an intense lobbying campaign, took a key step Tuesday to reverse a controversial proposal that would have required banks to use market prices rather than cost in order to value the loans they hold on their balance sheets." So, mark to market for lending as a process has fallen off the table for loans as a broad asset category. However, mark to market is far from dead as an issue, as traded instruments, including actively traded loans, and securities will still follow mark-to-market processes and a market pricing discipline. Loans held to maturity or payoff will continue to use the loan's amortized cost. Assuming the preliminary vote is confirmed, FASB and the International Accounting Standards Board will be more closely aligned on this subject. Is this good news or not for banks, investors, and the overall economy? Will any players benefit from this development?

Banks in general are relieved on this issue and have been occupied with other pressing regulatory issues, like contending with the implementation of the Dodd-Frank bill's provisions, the Fed's interchange fee proposal, and more. One potentially contentious area that will remain on the horizon is real estate related debt/loans/securities that are already on the books. Distressed real estate that is in some form of extended default (say past 90 days due) or foreclosure is still eligible for the collector's version of mark to market. What is the property worth to a buyer?

Many local housing markets remain in severe pricing distress relative to the market peak five or six years ago. The default mortgage backlog remains at or very near record levels, suggesting that recovery may not really take hold until somewhere between mid-2012 to 2014. For many community banks, commercial real estate is a much bigger problem asset type than home loans. While major markets (e.g., New York, Chicago, Boston) are reporting a rebound in high end commercial property values, retail strip malls, C class office buildings in smaller markets, and the like are a drag on the capital and profitability of many banks. While we believe the annual volume of FDIC failures peaked in 2010, the FDIC's list of problem institutions continues to expand slowly each quarter, weighed down by the increasing number of smaller institutions as part of this mix.

Investors will have to raise their due diligence on banks with a meaningful basket of troubled or non performing loans. Publicly held banks have some level of reporting on these assets, but getting the data from smaller banks is just about impossible. Analyzing problems at a loan portfolio level has risks as there may be new, lurking problem loans that have not yet hit the default status and can quickly drive a bank from "adequate" performance to "a problem." The broader economy will benefit simply because the biggest banks, which drive the market, will not be distracted or forced to make severe mark to market write downs at a critical time in this recovery's cycle. Bank IT vendors with credit risk management tools and/or collaborative loan workout solutions have a strong market opportunity. Loan oriented mark-to-market consultants need a new game plan.

Bill Bradway, founder and managing director of Bradway Research LLC, analyzes the business strategies and IT investments of U.S. banks and credit unions.